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Executives

Mark Veeh - Investor Relations Manager

Brian L. Halla - Chairman, Chief Executive Officer

Donald Macleod - President, Chief Operating Officer

Lewis Chew - Chief Financial Officer, Senior Vice President - Finance

Analysts

John Pitzer - Credit Suisse

Chris Danely - J.P. Morgan

Ross Seymore - Deutsche Bank - North America

Uche Orji - UBS Securities

Craig Ellis - Citigroup

Mark Lipacis – Morgan Stanley

Douglas Freedman – American Technology Research

Romit Shah – Lehman Brothers

National Semiconductor Corporation (NSM) F1Q09 Earnings Call September 5, 2008 11:30 AM ET

Operator

Welcome to the National Semiconductor Q1 fiscal year 2009 results conference call. (Operator Instructions) I would now like to turn the call over to Mark Veeh, Investor Relations Manager.

Mark Veeh

I’d like to welcome everyone to National Semiconductor’s first quarter fiscal year 2009 earnings call. Joining me on the call today are Brian Halla, Chairman and Chief Executive Officer, Lewis Chew, Chief Financial Officer, and Don Macleod, President and Chief Operating Officer. In today’s call I will provide a recap of the first quarter financial results, Brian Halla will give an overview of the business environment and an update on the company’s focus and priorities going forward, Lewis Chew will expand on the first quarter results and provide the background to our outlook for the second quarter of fiscal year 2009, and lastly, Don Macleod will then discuss market trends and products in more detail. We will then take questions until approximately 9:30 a.m. Pacific Daylight Time.

As a reminder, this call will contain forward-looking statements that involve risk factors that could National’s results to differ materially from management’s current expectations. You should review the Safe Harbor statement contained in the press release published today as well as our most recent SEC filings for a complete description of those risks.

Also in compliance with SEC Regulation FD, this call is being broadcast live over our Investor Relations website. For those of you who have missed the press release or would like a replay of the call, you can find it on National’s IR website at www.national.com.

Now moving on to our first quarter results. Sales were $465.6 million, up 1% from $462 million in Q4 fiscal year 2008 and down 1% from $471.5 million in last year’s first quarter. Gross margins in Q1 of 66% set another company record up from 65.9% in the prior quarter and 63% in last year’s first quarter. Operating expenses in the first quarter were $171.4 million. Severances and restructuring was $1.1 million in connection with our previously announced actions. Net interest expense was $14.5 million and the effective tax rate for the quarter was 32.3%. As a result, National posted GAAP net earnings of $79.6 million or $0.33 per diluted share in Q1 fiscal year 2009. The fully diluted share count for the first quarter was 241.3 million shares.

So before I turn it over to Brian, there are a couple of administrative items that I would like to highlight.

First I’d like to inform everyone of our joint upcoming annual shareholders meeting and analyst day which will be held at the American Conference Center in New York on Thursday, September 25, at 10:00 a.m. Eastern Time. We will have the formal annual meeting of stockholders immediately held by the analyst meeting. Please visit National’s IR website for more information on these events.

Second of all, we will be holding our Q2 earnings call on Monday, December 8, 2008 instead of Thursday, December 4. The reason for the change is that the company will lose two working days the first week of the quarter as we will be closed to observe the Thanksgiving holiday.

And lastly, approximately every six years we must add an additional week to our fiscal year to end on the last Sunday in May. As a result, this year we will be adding one additional week to our third quarter of fiscal year 2009 or our February ending quarter.

With that I will now turn it over to Brian.

Brian L. Halla

Actually business is reasonable. Revenues came in at $465.6 million and gross margins at 66%, another historic time. Earnings per share came in at $0.33 which includes a minor restructuring charge. Bookings were down after some up quarter trimming but the opening backlog is up. So with expectations for reasonable turns, we’re comfortable guiding a $470 million to $480 million kind of number, 1% to 3% growth for another reasonable quarter.

Over the last several days I’ve been scratching my head sifting through all the data and events of these times trying to prepare for this call. Quite a few of you listening to the call probably look at National Semiconductor as somewhat of an industry bellwether or industry proxy that can hopefully shed some light on where we are in the cycle and how close we are to the next upturn. Most of you are also interested in what’s happening in the handset market and since about a third of our revenues come from that segment and since our top customers are all the leaders in that market, you’re justified in thinking that these guys ought to have some reasonable level of visibility. And some of you are on this call to track the progress of National Semiconductor, specifically “How is business?” “Have you hit the limits of your gross margin pursuits?” “Are the other guys gaining market share at your expense?” “And now that you’ve cleared the decks of the non-analog businesses, when can we expect to return to growth?”

All these are valid questions and all deserve our most thoughtful and insightful response. As to the National specific questions, I’ll do my best to construct a framework of our direction strategy and philosophy and then I’ll let Lewis and Donnie provide more of the drywall, stucco and landscaping.

As to asking us to be a proxy for the analog semiconductor industry or worse, for the whole semiconductor industry, let me offer up that I hope we can become more of a standout as we aggressively pursue markets arising out of the new megatrends with technology born out of collaboration across our product lines and underscored by our leadership and power management allowing us to consistently offer high performance at the lowest power consuming circuits. We believe this direction sets us apart from the peer group and we’re already beginning to see positive results. So while I’d be naïve to think that I could dissuade you from using us as somewhat of a bellwether, I would at least ask you to listen to our report card and see if there might be a contrast or two compared with the other analog companies.

National just completed its fifth consecutive fiscal year of ROIC or return on invested capital of over 20%, 23% as we head into 09. National today announced record gross margins of 66%. Our ASPs again saw yearly growth at +4% though I’ll grant you we’re coming from relatively low historic numbers.

Our manufacturing organization continues to reduce costs despite the low utilization rates and continues to win accolades from our customers as being head and shoulders above the rest. We’re a clear leader according to the SIAWSTS and others in the area of power management now at about half of our revenues. By the way being a leader in power efficient circuits and a world hurtling towards a global energy crisis gives us a unique opportunity to help solve the corresponding problems.

You’re still waiting for the answer to “Where’s the growth?” As part of our heritage of power management optimized processes, tools and circuits, we’ve developed a bunch of products optimized to work together for the most power efficient customer systems which we’ve grouped in a category called PowerWise. Over 300 power efficient circuits including amplifiers, data converters, regulators, references and simple switches have been optimized to work together to maximize power efficiency at a system level. And we provide a web based family of tools to help our customers design those systems.

With an eye toward looking ahead to tomorrow’s demanding growth drivers, we focused our company to attack these new markets and provide the early solutions driven by these new megatrends. Our increasing emphasis and larger percentage of new investments will be made more and more in key market segments or KMSs. Examples of today’s KMSs include healthcare, security, sensing and detection, personal mobile devices, and of course alternate energy sources.

Our first entry into this latter exciting market was launched last quarter. We call it SolarMagic, named by the way by one of our first prospects to see the demo. It’s a technology that’s panel agnostic; that is, it works with silicon, crystalline, and thin film panel technologies. It’s a device that bolts on to solar panels that restores power lost as a result of clouds going over, shade from trees or chimneys, bird droppings and even non-uniformity of glass. Field trial results showed that our technology SolarMagic can restore up to 40% to 50% of the power lost due to interference such as shade and can restore on average 10% to 20% of the power lost during a typical day.

Of course we face some interesting new challenges in this new market selling a module versus a chip. UL certification I guess is bad form if someone’s roof catches on fire, channels different than our traditional distributors, different trade show venues, etc. But everyone here is having a lot of fun with this product line. We’ll keep you posted here as we get closer to the rollout pending the various certifications.

“So Brian, does everything you’ve said here so far mean that you’re leaving the date that brought you to the party, the cell phone market, to strike out for bigger and better things, among them growth and profit?” Nope. Our date will be well attended as we still do 1/3 of our revenues in that space. The beauty here is that our growth in that space comes from the high end fully featured Smart Phones like the 3Gi phone and many of the new Rim Blackberry offerings.

Without going into detail, there’s some cool stuff on the horizon. By the way, we saw 14% year-on-year growth in our comms infrastructure business, a good portion of which was driven from the emerging markets like China and India putting in their GSM and Edge infrastructure. We believe that other exciting growth opportunities will come from the alternate lighting solutions like LEDs or lightomini diodes. In fact we’ve already seen more than 60 design wins in China alone for street lighting applications. Additionally, power efficient portable health care devices will begin to come on the market given what we’ve been seeing from a design perspective. Lowering health care costs through what we call distributed medical treatment will drive large volumes in that business and become an excellent example of what we call the quality of life megatrends.

Environmental and other sensing and detecting applications will provide not only health benefits but will find applications in security and surveillance systems such as gunshot and glass breaking detection and cargo container monitoring, and we’ll be rolling out future generations of our SolarMagic technology including technology designed to maximize mileage on electric vehicles.

So business is okay especially given the environment. Starting with a higher backlog and a reasonable expectation for turns gives us a chance to grow again in the quarter, not only growth in revenue but our plan in the short term is for continued growth in ASPs, gross margins and operating margins. And beyond the quarter and farther out we’ll look for growth in the new key market segments as those materialize.

Over to you Lewis.

Lewis Chew

Here are the items I’ll cover in my segment of the call today. I’ll talk about bookings and turns orders heading into Q2 and as part of that I’ll go over what we saw in the distribution channel in terms of resale rates and inventory levels as well as opening backlog. I’ll discuss our gross margin trends and what things were driving in that area right now, and I’ll go over the outlook for the various line items in our P&L for Q2 and explain the key drivers that impact our operating expenses as they transition from Q1 to Q2. Then I’ll make a couple of comments about the balance sheet and key operating measures before I turn it over to Don.

As I often do, let me start by looking back before I look forward. At the beginning of this quarter just completed, what did we say about our guidance and what assumptions did we bake into those estimates. And how did the quarter play out compared to those original assumptions and projections? We had originally guided Q1 revenue to a range of $460 million to $475 million and what I said was that we expected distributor resales to be seasonally down and OEM activity to be slightly up. I also said that turns would probably be sequentially down and that the high end of our revenue range would require the same level of turns as Q4.

So, during Q1 distributor resales were in fact seasonally down and as a result our turns orders were down quarter-on-quarter. Distributor inventory dollars were up very slightly for the quarter while weeks of inventory ended the quarter at around 9.5 weeks. From a geographical perspective, just the inventory weeks were down in Asia Pacific while they were flat in the Americas and up in Europe.

With respect to the overall order patterns during Q1, our bookings were down in June compared to May; then they increased modestly in July and August such that the weekly run rate of bookings was about the same in the last two months of this quarter. Overall bookings for the quarter were down about 7%. Some of this was in the form of lower turns orders which I already discussed above. Also, we truncated some longer dated backlog in our Japan region so that the aging profile would be more consistent with the other regions. Notwithstanding the overall bookings decline, our opening 13-week backlog for Q2 was higher compared to what it was at the beginning of Q1.

Going forward into the November quarter, we do expect a seasonal uptick in billed activity in our customer base. How much of an increase is really the question of the day. At this time we are assuming a modest increase that is probably slightly less than what you might consider to be normal seasonality. Based on the inputs we’ve received from our distributors we also expect that distributor resales will increase modestly, but at this point we are assuming that distributors will not be increasing their inventory levels during the quarter.

Factoring in the business elements I just went over, the second quarter revenue range we are guiding to as Brian said is $470 million to $480 million.

I will now move on to gross margin. In Q1 our gross margin of 66% was up from what we had in Q4 and was at the high end of what we had originally anticipated. The positive gross margin was due to a combination of better product mix along with improvement in manufacturing performance that was driven by the actions that we launched a couple of quarters ago. Our fab utilization in Q1 was essentially unchanged at approximately 70% and our internal inventories also remained flat in Q1 compared to Q4.

In Q2 gross margin is expected to increase slightly within the range up to 66.5%. This improvement will be driven mainly by better net manufacturing costs as we expect to hold our fab utilization percentage relatively steady.

Let me shift over now to discuss operating expenses. First, an overall comment. As we transition from Q1 to Q2 we will see a net increase in overall operating expenses. This increase in operating expenses is almost entirely due to (a) the focal salary increases that go into effect at the beginning of Q2 which is the same pattern we’ve had in past years and (b) a seasonal spike in stock compensation expense that always comes in Q2. This spike in Q2 is due to the accounting treatment of stock-based grants made to employees who are eligible for retirement and since we make our broad employee grants each year in the latter part of July, we get a spike in stock expense in Q2 with a subsequent drop-off in Q3 and Q4. This is the same pattern we have seen in each of the last two years since we started accounting for options, etc. under FAS B123R.

In Q2 R&D expense is expected to range from $91 million to $94 million. SG&A expense is projected to range from $87 million to $89 million in Q2. Other income and expense is expected to be around $1 million of expense. Net interest expense which factors in both interest income and interest expense is projected to be $14 million to $15 million of expenses which is relatively consistent with what we saw in Q1.

Included in the Q2 gross margin and operating expense estimates I just provided are approximately $25 million of total stock compensation expenses which can be broken down by category as follows: Cost of sales about $4 million, R&D $8 million, and SG&A about $13 million. And finally, the Q2 effective tax rate should range from 30% to 32%. I should note that the Q1 tax rate of 32.3% was a little higher than projected due to some discreet expense related to foreign taxes that we wouldn’t expect to see every quarter.

Let’s move on to the balance sheet. Our capital expenditures in Q1 were about $22 million. In Q2 we anticipate that capital spending will run between $30 million to $35 million. Our days of inventory at the end of Q1 was about 86 days, the same as it was last quarter. Our days of receivables at the end of Q1 was around 31 days, which was very good and at the low end of the range we typically like to see. By the way, the 27 days we achieved last quarter was due to stronger-than-usual collections at the end of the quarter. Our cash reserves ended Q1 at about $693 million compared to $736 million in Q4. We bought back $105 million of stock or roughly 5 million shares during the quarter, and going into Q2 we still have about $150 million of available buy-back authorization remaining.

Operating margin in Q1 was about 29% which is consistent with what we achieved in Q4 and return on invested capital was about 23% in Q1. Both of these measures include the impact of stock compensation expense.

As we focus on growing the top line, our business model continues to have good leverage opportunity to the bottom line. I mentioned earlier that our fab utilization is only around 70%. We can achieve higher gross margin with higher utilization. Also, our product mix keeps getting better over time which also has a positive impact on margins. And we will continue to manage our core operating expenses tightly in this current environment. Ultimately, the objective over time of course is to translate top line growth into even higher EPS growth.

With that let me turn it over to Don Macleod.

Donald Macleod

Let me now briefly cover some of the trends we saw in the quarter in our key markets and product areas. But I’d like to spend most of my time highlighting where we see opportunities to grow our top line in short to medium term.

So first, what did we see in our key markets? Sales to our largest market, mobile phones and other personal mobile devices, which accounted for about a third of our sales in the quarter grew between 3% and 4% sequentially and a similar percentage year-on-year. Growth for us mainly came from shipments to customers launching or ramping new Smart Phones in the quarter. Based on current backlog from our mobile phone customers we also expect to see this market place represent most of our sequential revenue growth in the second quarter.

Sales to communications and networking customers also held up in the first quarter at the same improved rate that we saw in the fourth quarter. Year sales went up about 14% on last year’s first quarter as we continue to grow our business with China based wireless infrastructure customers and GSM Edge infrastructure builds in China and India. This communications and networking sector accounted for just over 10% of our sales in the quarter.

From a product perspective using SIAWSTS industry product definitions, our largest product area power management at 47% of our sales was flat sequentially. Amplifier sales were down about 5% sequentially at 23% of our sales. Interface sales grew over 30% sequentially and accounted for 11% of our sales. Data converters were down about 4% sequentially at 5% of our sales.

As I discussed earlier product selling into the mobile phone and other personal mobile devices area showed growth while slower sales to our distributors over the summer quarter impacted sales of our product analog building block portfolio.

So enough about this quarter. Let me now move on to discuss the products and market areas where we see revenue growth opportunities as we look ahead to calendar year 09 and beyond.

Our power management capability is our crown jewel and this product category represents nearly half of our sales today. Our new national three point repositioning initiative launched just one year ago, we’ve built on this with our PowerWise theme with energy and power efficiency as the cornerstone of our product and system level offerings going forward. We want to be viewed by our customers as the experts in power and energy efficient solutions for their systems. This includes energy generation, energy conservation and energy storage applications all macro growth trend themes whether National Semiconductor’s enabling them or not.

The fast growing LED lighting area is an example of a market that can benefit from our new PowerWise system level energy conservation in power management. As I mentioned in our last quarter’s earnings call we’re allocating more of our R&D investments in this area. We actually reassigned two of our design centers to this new initiative in our May quarter. Last fiscal year we started addressing this LED lighting space by initially repositioning some of our existing voltage regulators as constant current drivers for LEDs. We followed this with higher voltage products from our proprietary ABCD fab processors that for example allowed us to drive longer strings of LEDs. Two of these products are incidentally shipping in the Mac Book Pro 15” and 17” Notebook PCs where they drive the display LEDs with much better lighting uniformity and increased dimming range than the older CCFL backlight LCD technologies.

Beyond these constant current drivers we recently introduced controllers which combined with our drivers further maximize the overall efficiency of our LED solution. In addition, we are now sampling to customers what we think is the most elegant full range integrated socket based LED dimming solutions. As you might know CCFL or compact fluorescent lighting solutions today do not dim very well.

Our next generation of products will further integrate more lighting control features including for example temperature sensor using our in-house multiple dye packaging capability. You can see that we’re taking a full system level approach here, not just a catalog of building block [youth]. A good market methodology is to partner with LED suppliers. If you go to our lighting web-based design tool, you can see many of the leading LED providers’ products matched with our specific power management solutions. We’re also working with our distributors on innovative ways to address new to us customer base across new markets such as signage, architectural, display lighting, street lighting, residential, etc. applications for LEDs. Based on our early work as Brian already mentioned, we have more than 60 design wins in street lighting applications in China alone. As an example of the diversity of our LED applications, in Europe we have design wins in automotive customers for deer lights, running lights and brake lights, etc. In the US we have design wins in military and public safety applications.

Outside mobile phones for portable device lighting applications where we’ve traditionally had a strong position in LED lighting, we did less than $5 million in revenue in the LED lighting application area in our fiscal year 08. We’re driving this to be a $100 million business for us in three to five years’ time.

In mobile devices where today we already have about a third of our revenues, we’re focused on increasing our value in Smart Phones and other high-end mobile devices leveraging our LED lighting capability. As I talked about earlier, new phones and multi-function handheld devices are already shipping with our display drivers and backlight drivers. In addition, new flash lighting devices are shipping with two of the market leaders and next calendar year we’ll be shipping our flash lighting for 5 megapixel phone camera applications. At National Semiconductor we have deep system level understanding of both display and lighting applications and how they’re efficiently powered.

In personal mobile devices we also have deep system level knowledge in efficiently managing power in the RF block. As higher-end mobile devices become multi-mode and even more multi-band capable, they often have multiple dedicated power amplifiers. So the RF section becomes extremely power hungry. Our power management supervisory units on our reference designs with a number of power amplifier manufacturers and Qualcomm and Erickson mobile platforms. Some are shipping today but more volume should ramp in calendar year 09. At the system level we can usually demonstrate 25% to 60% extra battery life in these companion powered amplifier applications.

Our energy efficiency focus is now being extended beyond mobile devices to bigger devices such as set-top boxes, switches and routers. Here you should see in calendar 09 are PowerWise adaptable and scaling intellectual property shipping in some other company’s [inaudible]. For example in 10 gig controllers it will dramatically improve on the 1 watt per 1 gig power consumption norm of today. This enables high-speed connectivity for faster access to information and also enables more power efficient virtualization.

In last quarter’s earnings call we also previewed our system level opportunity in the portable take area, our SolarMagic initiative. That improves the efficiency of solar panel installations. Our initial field trials working with solar panel installers demonstrated 10% to 20% improvement in energy conversion in whole panel of reinstallations over the course of a whole day and 40% to 50% energy recovery for the whole array during periods of shading. We’re now in the second phase of our field trials and getting ready for UL certification, and we expect to generate first sales in this new growth thrust in calendar Q1 of 09.

We’re now aiming to leverage this power management intellectual property that we used in our SolarMagic capability to address high voltage battery charging storage management; for example as used in electric vehicles.

Another more traditional business for us in the power management area where we expect to see an opportunity for future revenue growth and it is well over a $100 million of annual revenue is our simple switcher portfolio. Here National is identified as the go-to place for generalist power supply designers looking for what we call the ease of use to design and build their systems power supply. Our web-based designer tool provides to our customers not just our power ICs but the suggested full bill of materials which is often some eight to 10 components that are required to quickly build an appropriate power supply.

In October we’ll be extending our capability in this area with the introduction of our fifth generation of our simple switchers. This is 26 new parts with more customer usable features that we have on our power designer web tool, which by the way is used by our customers more than a thousand times every day to create new power supply designs. At the same time, in October we’ll also expand our simple switcher offering with our first family of simple switcher controllers. This extends the ease of use capability to designs for higher current and higher power efficiency power supplies. In the future we also plan to extend our power supply solutions much further into the system level where we can capture multiple dollar ASPs in our customers’ power supplies.

Talking about ASPs or average selling price our company ASP for this quarter was up about 4% year-on-year and was flat sequentially with the fourth quarter. We also achieved record gross margins at 66% in the quarter in a quarter where our sales to a high volume consumer application the mobile phone and personal mobile device space actually grew, and sales to our highest margin brought distribution driven customer base were slower over the summer. We aim to keep up this ASP and gross margin discipline as we expect to see a future growth benefit from the various energy initiatives that I mentioned earlier. As a reminder, in our last earnings call we set a target range of 65% to 70% for our gross margin and 30% or better operating margins. This quarter was yet another step consistent with these goals and with more leverage from future revenue growth still to come.

Over to you Mark to moderate the Q&A.

Mark Veeh

At this time I will ask the operator to open up the lines to being the Q&A session. Please limit yourself to one question and one follow up so that we can accommodate as many people as possible. Operator, can we please have our first question?

Question-and-Answer Session

Operator

Our first question is from John Pitzer - Credit Suisse.

John Pitzer - Credit Suisse

The third of the revenue coming from cell phones, what percent of that right now is 3G/high end versus everything else? And I guess when you look at fiscal first quarter and fiscal second quarter guidance, if you can help me understand how those two buckets within cell phones are trending for you, that’d be helpful.

Donald Macleod

We don’t specifically break it out into the different standards that you talked about, but if you look at our revenue from the mobile phone space, we’re pretty broadly distributed. The top five players in the global market place will typically represent about 70% of our sales into that defined mobile phone space. And if you know the market place, these top five typically account for about 80% of the worldwide market. So we play pretty broadly. But we are seeing growth frankly on players that are not in the top five that have come to market with I would say high ASP multi-function Smart Phones that are growing significantly in consumer applications. When you look at the market place broadly even with the top five, our positioning with those is not in the volume low-end developing country type phones. It tends to be positioned to those higher ASP handsets where frankly the analog differentiates the offering that the mobile phone supplier has, whether it’s an offering that’s focused on audio, whether it’s focused on the display, or whether it’s focused just on the phone factor which obviously is influenced by how efficiently the power is used form the battery in these different applications.

John Pitzer - Credit Suisse

Then Don, just as my follow up, when you look at the new market opportunities, can you help size the solar market, one? And then two, can you help us understand the gross margin in ASPs of these new markets relative to the core business?

Donald Macleod

Brian, maybe you want to take the discussion about the solar market?

Brian L. Halla

Just before I do that I want to go ahead and address it straight on. One of our largest customers today obviously joined the sky is falling crowd. And I don’t know if it was a commentator on CNBC or if this was an actual quote but the statement was that “Market share was given up where the prices were so low that they didn’t want to participate,” and that would typically obviously be in the lower end phones. As Donnie said, our business with all the cell phone guys is typically at the higher end, not just Smart Phones like the Apple 3Gi phone but in the higher end of fully featured phones.

In terms of solar, typically people think of semiconductors as a cost plus kind of pricing. By the way the terms of the tam just to put things in perspective, Germany alone has covered more than 8% of the available roofs. In Northern California we are 0.4% coverage. So we’ve got a long ways to go. Typical panels are about $800 or $900 a panel to get 200 watts in the panel and then the installation kind of doubles that. Now we just talked about SolarMagic in terms of the technology that can restore 40% to 50% of the power lost in an individual panel over the course of a day, 10% to 20% recovery of all the energy lost due to clouding and other things. So if we can recover 10% to 20%, it seems very reasonable to me that the price we might put on one of our SolarMagic modules could easily be 10% to 20% the price of a panel. We won’t talk about it terms of cost plus but in terms of the value that we add.

Operator

Our next question comes from Chris Danely - J.P. Morgan.

Chris Danely - J.P. Morgan

Just to touch on the wireless stuff guys. Nokia just brought down their estimates today. We had two of your other top five suppliers, LG Samsung, talking things down over the last week. Have you seen any reductions from your top five cell phone suppliers or do you expect it, or is that incorporated into your guidance?

Donald Macleod

Clearly our customers in this space give us forecasts of their demand through the [inaudible] windows of time which in pretty much in all cases now covers what they expect to see built through the main part of the holiday season, which for us really takes off at the end of November. Based on what we have today, we think customers’ views on the fourth calendar quarter opportunity are built into our expectations and frankly when you look at the guidance we gave for this second quarter for us, which mostly ends with the fourth quarter of the calendar year, you can see that we’re giving what might be in prior years somewhat more muted guidance for the fourth quarter calendar year. And I think that reflects what these customers have indicated about their expectations for their market place.

Yes, I think we’ve built all that in as we can see it today. And frankly, I think one should see some good news in the current economic environment on that because at this time last year we were giving much stronger guidance. We had a much stronger second quarter for our selling season into the mobile phone market but I think most of you’ll remember what happened in December and January after that as our mobile phone customers cut back on their short-term demand based on the fact that they unsold older models that they’d built in to the fourth calendar quarter selling season. So I think this year we’re looking at a much more realistic outlook for that window and it’s kind of good that our customers have come public with those expectations on that because these are we think reflected in the expectations we’ve already given you.

Chris Danely - J.P. Morgan

What are the [distees] telling you guys? Do they want to bring inventory down? How do they feel about end demand? How cautious are they? And does anything change that the distees are telling you over say the last two or three weeks?

Lewis Chew

There are a couple of pieces to your questions that I’ll try to address. One is, what are they telling us? The first thing is that in fact even with the economy being weak, they are telling us that they expect their resales - again I’m making all these comments relative to National products; I can’t speak about what they’re reselling for everybody else - but they are telling us that resales for our Q2 should pick up. They are telling us that inventory levels are fine. We do think that they are leveraging us because our lead times have been very good and relatively low. They’re roughly six weeks for those of you who want to know what that number is. And it hasn’t changed much in the last year, and our supply chain management here at National is generally perceived at minimum excellent. So what they’re saying is, “Yes, business is going to pick u a little but we don’t need any more inventory so we’re not going to grow right now.” In terms of the quarter that we just finished, we did see our bookings go down from distee but they actually went up a little bit from our OEM. So I think the tone of the day from the distees is caution but like I said ultimately the resales are not driven by their caution but what their customers want. I think their customers still need product because the inventories are relatively low. How much products is always the guessing game they get into.

Operator

Our next question is from Ross Seymore - Deutsche Bank - North America.

Ross Seymore - Deutsche Bank - North America

In the prior quarter you gave a little bit more handset color about the top five guys, what you expected them to do and your guidance versus the Smart Phone-ish guys. Can you give us that level of detail again?

Donald Macleod

I don’t think we really give specific guidance about the top five but I think the general statement that I made earlier is that the growth in the short term that we saw in the wireless space was mostly driven by Smart Phones that were released by a couple of non-top five players and we see that trend being a continuing trend through our second quarter. But at the same time the volume market place which are really the top five also indicates to us that there should be some growth in shipments for us to that market as we go into our second quarter, and I think that’s reflected in the opening backlog we have going into the quarter.

Ross Seymore - Deutsche Bank - North America

Shifting gears a little bit, how should we think about the extra week hitting your February quarter? I’m not asking for explicit guidance or anything but what generally should we think about that doing to both revenue and op ex?

Lewis Chew

You kind of touched on it in the middle of your question there Ross that we are not in the habit of giving out-quarter guidance especially in this kind of environment where visibility is relatively low. But I don’t think we should shirk that question. The extra week by the way this year just happens that we had Thanksgiving, as you heard Mark say earlier in the call, we’re actually moving our earnings call because Thanksgiving week falls into Week 1 of Q3 and normally that would be in the last week of Q2. Now granted, US doesn’t represent the majority of our sales but it will have some impact so at this point I think it’s fair to expect that we would in whatever environment we’re in to get some additional sales impact from that extra week but it’s very hard to size that right now.

In terms of expenses, let me make a more generic comment that we have committed that we will continue to manage our expenses tightly, we do believe we are investing nicely in R&D, and to the extent that there are new areas that emerge that Don Macleod talked about we’ll do more of a reallocation as opposed to just piling on more expense. Now this quarter Q2 is something that we can’t avoid. We do have annual raises and we do have the stock comp thing but for all intents and purposes we’re trying to hold op ex relatively flat. Over Q3 we do get some benefit from the holidays so at this point I’m not going to give you op ex guidance but we’ll generically try to hold op ex pretty steady from where we are in Q2.

Operator

Our next question comes from Uche Orji - UBS Securities.

Uche Orji - UBS Securities

Is there any more upside or headroom to gross margins from the fab consolidation effort you’ve been involved in or is that all done now?

Lewis Chew

Yes.

Uche Orji - UBS Securities

How much longer or over what time period?

Lewis Chew

I’d say over the next several quarters. If you want to scale it as $1 million to $2 million, we continue to see benefits from this 8” conversion effort which also results in some consolidation that we’re going through. You may have noticed that this quarter our cap ex was relatively low. I think in this environment where we don’t need extra capacity, we’re buying equipment as needed for that conversion. But yes, as I’ve talked to you guys about before in the past, we do get benefits when we convert some of this equipment especially if we can trim back on the supporting op ex that goes around extra equipment that used to be 6” that we no longer need. The timeframe is over the next call it couple of quarters and the scale is probably $1 million to $2 million of upside.

Uche Orji - UBS Securities

Let me just ask you about Europe. Of late there’ve been a lot of comments about the slowdown in Europe seeming to have accelerated. What are you seeing in that region? I mean, I think in the US we’re all pretty much aware of what’s happening, but can you give any insight as to what you’re seeing among your customers based in Europe?

Lewis Chew

Europe is kind of interesting because that’s probably where we have the biggest concentration of what you might think of as our industrial business, but then we also have obvious business in areas like handset. For the quarter that we just completed, it is true that our Europe bookings were down probably reflecting a little bit of that as well as the fact that in Q4 we did see an uptick in bookings as they headed into the summer. So I would say that right now we’re probably seeing conditions that are consistent with what you hear on the outside, although I don’t know if it would necessarily be as negative as some of the reports I’ve seen just in recent days. But it’s very hard to buck a macro-trend like that. On the plus side though we do seem some encouraging design win activity in our Europe region because of some of our growth initiatives. Some of these things we’ll have to talk about in a couple of quarters as those turn into revenue, but for right now the macro conditions we see are similar to what you see going on broadly. And I think I mentioned to you that our weeks of inventory for the company was still pretty good and Asia weeks was actually down but Europe weeks of just the inventory went up in the quarter.

Operator

Our next question comes from Craig Ellis - Citigroup.

Craig Ellis - Citigroup

Lewis, just a follow up on the seasonal impact on operating expenses. I hear what you’re saying there, but at least when I look at my model it seems like the increase that we have guided for this quarter is about 2x the sequential increase we had on average over the last three years. So is there anything that’s incremental versus what’s seasonally normal?

Lewis Chew

No. The one thing I can say is that we’re pretty normalized right now. I think one of the questions that almost immediately follows that kind of a question is, “Hey. What kind of room do you have to do something if the economy goes bad?” and I hate those kind of questions but I suppose those kind of questions are fair. We’re pretty fully loaded up. We’re not doing anything weird with expenses this quarter but in terms of the actual impact really the net increase is substantially all driven by those tow items. And you can kind of work your numbers, right? Well, our op ex last quarter was $172 million. You can imagine that a large portion of that is salary and our focal increases there are pretty normal for an industrial company and then we have a $5 million increase in stock comp. I could waste a lot of words trying to explain those two things but that’s what it is.

Now, in past years maybe that would be been muted by other actions we were taking to suppress our expenses but those are typically short term actions, right? And we still have that in our holster because as you know we focus very carefully on managing our op ex relative to the environment so we do have those levers we can pull if we need to.

Craig Ellis - Citigroup

The followup is for Brian. Brian, at last year’s Analyst Days you outlined National 3.0. One of the things that you identified was the ability of 3.0 to ultimately bridge National back to an industry average or maybe even a better than industry average growth rate so given the commentary from Donald, how should we think about the growth relative to the industry in the coming year. Do you think the design wins that we’re starting to see are going to have a meaningful and a noticeable impact on your relative growth rate or is next year really the handoff to where we would start to see that in the following year?

Brian L. Halla

I think it’s some of both, Craig. We measure our management team, measure ourselves on a metric called new product revenue and that’s specifically because over the past three to five years during our 60/30/30 march we encouraged if you will R&D spending in the areas that added more value to our customers and were less commodity focused. And those are starting to hit as we speak. We saw very good growth and on target in the quarter in the new product revenue and that’s revenue generated from products prior to National 3.0.

What National 3.0 is all about is recognizing that whether we like it or not the typical man on the street, your neighbors, my neighbors measure our industry by what we’ve done for them lately. Everybody’s got a cell phone, everybody’s on the network, everybody’s got a PC but what have you really done for the cost of energy. What have you really done to reduce my health care costs? What have you done to increase my security given the world the way it is and so the National 3.0 is all about recognizing new megatrends that are emerging that will drive volume in the non-traditional markets.

So things like distributed health care or more diagnostic tools in the home; things like the Solar Magic and as Donnie said we’re not taking the Solar Magic technology and aligning it with battery management in electric cars so that we can get longer distance between charge. And so things like that will drive longer term growth. As Donnie said, Solar Magic will start kicking in in Q1 of 09 calendar but beyond that some of these things are a little farther out. But to go back to my first part of my statement, new product revenue has improved, is on target and we continue to monitor that.

Operator

Your next question is from Mark Lipacis – Morgan Stanley.

Mark Lipacis – Morgan Stanley

A couple questions for Lewis if I may. Lewis, it looks like over the last year or so you guys have been underfunding the depreciation expense with the cap ex. How should we think about depreciation expense going forward? It looks like this quarter it’s actually coming, the cap ex is coming up. So is that a change of trends? And the other question is on the cash. How much cash do you think you’d like to have on the balance sheet and how should we think about how you’re going to use the excess cash?

Lewis Chew

Let me address the deprecation in cap ex first. We have actually been running this last couple years where I think of cap ex and depreciation as probably being pretty much in parity with maybe cap ex being slightly lower so the first answer to your question is longer term, I still see a trend for the foreseeable future where depreciation continues to decline.

Now in terms of the Q1 to Q2 transition, I wouldn’t call that going up in the true sense because it’s the Q1 cap ex that was particularly low. I may remind you that last quarter when I guided cap ex for this quarter I gave a range of 30 to 35 which is the same range as I’m giving for Q2 and we actually underspent that. So we’re not actually increasing the rate of our cap ex or our model. We aim to run our model anywhere from 5% to 7% of revenue on an annualized basis and we’ve been running right in that level. So I think for the next couple years it’s not unreasonable to think that depreciation expense would be flat to slightly down.

On the cash side, right now we are running cash just around $700 million. There’s no absolute rule of thumb but we’ve not published our minimum amount of cash but I’d say at this point I wouldn’t think a huge portion of that cash as being considered excess; maybe $100 million or $200 million. And in terms of our cash flow, our cash flow continues to be very, very strong on a quarterly basis. You want to use a roundish type number, roughly $125 million to $150 million a quarter and to the extent that we generate that excess cash we probably will continue what we’ve been doing the last several years of looking for ways to return that to shareholders and again, continuing with things like stock buybacks and dividends. So it’s a very straightforward strategy on the cash. We’re not looking to build it up or anything like that.

Operator

Your next question comes from Douglas Freedman – American Technology Research.

Douglas Freedman – American Technology Research

You spent a lot of time talking about the markets and what the conditions are out there so I’ve got a pretty good read from you on that but can you talk a little bit about some of the things that you control such as, if I look at things comparing this year to last year, there’s a noticeable difference in the ratio of spending between R&D and SG&A. We’re seeing SG&A spending growing faster than R&D. What do you see the outlook for that doing going forward, especially with the efforts to try to invest in growth here? So would have expected to see more spending going on in the R&D line or is there more leverage from, let me know what your thoughts are there.

Lewis Chew

I’ll start that one, Doug, and then I’ll let Don finish it up with I think there’s multiple facets of that. But first of all, that doesn’t get lost on us but I would say that if you were comparing SG&A year-over-year it is true that from last year to this year we have incrementally added some, we’ll call it selling and marketing programs intended at expanding our presence for near term revenue. At this point we think that a lot of those programs in terms of the core spending expansion is already there so that rate of year-over-year increase that you’re looking at is leveling off.

In terms of R&D, that’s an interesting thing because we have in fact picked several areas where we have noticeably ratcheted up our R&D investment but I would also give credit to the product groups that they’ve had enough discipline to find things that were not meeting expectation and finding that to pick from and that’s why it looks like R&D has not grown for the whole company when in reality you go back to some of the comments Brian made, some of these emerging areas, these key market segments, we are in fact investing more R&D there. And in fact, Solar Magic is a good example; something where over this last year leading up to when we announced our product, we have been investing more money in there and things like alternative energy.

So it just so happens that in the R&D area you have more levers that you can pull whereas in selling and marketing we have said in the past, we’ve tried to add more field application engineers. We have spent more time spending people to customers and stuff like that.

Let me turn it over to Don to add a little more color to that.

Donald Macleod

Yes, to Doug, just strategically, clearly if you think about the implications of our 3.0 initiative of the company, we are making changes in our behavior that impact the way we spend money. And if you want R&D versus the SG&A space, if you think about our company in the past where our focus was on putting more and more catalog products right into the marketplace versus today where we’re focused on more differentiated solutions at both a system level in addition to the, if you want the part level, you can see some of the changes.

For example, when we were focused more on spends and derivatives, we needed more test development; we needed more product engineering. As we move forward and focus more on system level solutions and key market segments, our focus moves onto strategic marketing, business development and other capabilities like that. Now that does not mean that as we move forward we simply add expense; we’ve concessioned expense from those R&D areas that I talked about, i.e. less test development, less product engineering, etc. and reallocated those expense budgets to the areas that are focused on developing our business going forward in a more strategic way than we’ve addressed in the past.

And I think that’s the underlying macrobehavioral thing behind the change in the allocation of our costs in these two areas. And I guess I want to emphasize it’s a reallocation; it’s not us just adding cost to the overall aggregate.

Douglas Freedman – American Technology Research

If you could spend a little bit of time talking a little bit about what your position is on increasing ASPs. Clearly commodity prices have been coming up. Are you able to pass those along? What percent increase are you guys looking for or do you need to maintain margins? And also if you could talk about what percentage of the product portfolio do you think is really a standard product or commodity type of product today?

Donald Macleod

Yes, so Doug, obviously you mentioned the commodity and energy cost increases that clearly we’re all seeing as an industry and it doesn’t go without noticing that we’ve continued to improve our cost margins in that kind of background. You asked specifically about how we’re able to pass those costs on and if you look at our portfolio as a company today, a significant part of our portfolio today is proprietary products. We price those proprietary products based on value and we have a very disciplined approach to now determining what that value and the portions of that value that we can drive into the final ASP and that’s a big portion of our company; that’s one that’s growing over time.

We also have a proportion of our products, that I think you used the words standard products. I think in some cases we’d used the words commodity or even to some extent some of our older core products where the marketplace sees pricing as being cost driven and in some of the more commodity areas I would see it as frankly as being more opportunity driven in our sense to see what we can do in terms of getting the best possible price for our [inaudible].

So where we have products that are not value priced we have implemented price increases and those price increases are already out there in the customer base. That doesn’t mean that they’re all out there yet reflected in the ASP of the company because it takes time for those price increases to flow through, particularly where it comes to customers where we have annual contracts that are usually the calendar year and where we have distributors that enter into long term commitments with our customers. But the fact is we have raised our prices in those cost based areas of our portfolio and we’ll be seeing further benefit of those as we go through, particularly into calendar year 09.

Mark Veeh

Operator, we have time for one more question.

Operator

Your last question comes from Romit Shah – Lehman Brothers.

Romit Shah – Lehman Brothers

You gave a target last quarter of 15% to 20% earnings growth. I think a lot of that growth was expected to be driven by cost savings but given the demand environment, just wondering if that forecast is still on the table.

Lewis Chew

Well, Romit, this is Lewis and I guess twice in the same call I can use a short answer and just say yes. Obviously, when we give a range like that it’s trying to factor in what could happen in a macroenvironment but internally within National, I would say that we were still targeting to try to increase our earnings per share annually 15% to 20% but we’re not going to ignore what the environment looks like so that means it’ll be a challenge for us to touch on a couple things Brian and Don already said: get the new product revenue growth, make sure we get the margins continuing the right direction and also manage our op ex carefully. I think if we do that then we still have a fighting chance of meeting those kind of targets.

Romit Shah – Lehman Brothers

Just on your own internal inventories, around 86 days you guys have done a good job managing that. At what level would the inventories have to get to for you to start turning down your factories?

Lewis Chew

Well, I think we’ve been trying to manage it, Romit, more by the dollars than just the sheer days because unfortunately the days moves around with the revenue very quickly. Right now we’re very comfortable with where our inventory is and we continue to be, as you know, a company that doesn’t have write offs and stuff like that so it would probably have to get much worse for us to get be very concerned. I’d say right now it feels more like we’re at the bottom than the top of a cycle so we’re not that worried right now about burning off inventory.

If anything, there has been a continuing discussion about whether or not there’s too little inventory in the disty channel such that if there was a pickup in business, could they supply that? I’d say more of our conversation surrounds that than looking at our own inventory and saying how much do we need to burn off. So I think the 85 days, we’re fine with that and we’re certainly not the highest guy out there. I’d say we’re probably at the lower end relative to analog companies. I think one company maybe has a little bit lower inventory in days than we do.

Mark Veeh

So with that we’re now going to end the call. Let me remind you that the replay is available on our website and thank you for joining our call today.

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Source: National Semiconductor Corporation F1Q09 (Qtr End 08/24/08) Earnings Call Transcript
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