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Freescale Semiconductor, Inc. (NYSE:FSL)

Q3 2012 Earnings Call

October 25, 2012 5:00 p.m. EDT

Executives

Mitch Haws – VP, IR

Gregg Lowe – President and CEO

Alan Campbell – SVP, CFO

Analysts

Jim Covello – Goldman Sachs

Stacy Rasgon – Sanford Bernstein

Ross Seymore – Deutsche Bank

Doug Freedman – RBC Capital Markets

John Pitzer – Credit Suisse

C.J. Muse – Barclays Capital

Raji Gill – Needham & Co.

Franklin Jarman – Goldman Sachs

Glen Yeung – Citi

Steven Eliscu – UBS

Jeff Harlib – Barclays Capital

Operator

Welcome to Freescale’s third quarter 2012 results conference call.

[Operator Instructions]. Today’s call is being recorded. If anyone has any objections you may disconnect at this time.

I would now like to turn the call over to Mitch Haws. Sir, you may begin.

Mitch Haws

Thank you, and welcome to each of you to our third quarter 2012 earnings conference call. With me today are Gregg Lowe, our President and Chief Executive Officer, and Alan Campbell, Freescale’s Chief Financial Officer.

Before we begin today’s prepared remarks, I’d like to remind everyone that today’s discussion does contain forward-looking statements. They are based on our current outlook and as such do include certain risks and uncertainties. Please refer to our press release, our Form 10-K, and other SEC filings for more information on the specific areas that could cause actual results to differ from what we discuss today.

Also we will reference certain non-GAAP financial measures, and we will post the appropriate GAAP financial reconciliation to our website at freescale.com.

With that let me turn the call over to Gregg.

Gregg Lowe

Thank you. Good afternoon and welcome to our third quarter earnings call. I'll spend a couple of minutes highlighting our Q3 results, after which Alan will provide some additional commentary and insight into the financials. Following Alan's comments, I'll share an update on our strategic review. And then we'll take your questions.

Now looking at the Q3 results, revenues declined 2% to $1.01 billion. Our core product revenue excluding cellular and IP sales grew 2% from the second quarter. Gross margins decreased 75 basis points to 42.0%. And adjusted net earnings were $10 million and adjusted EPS was $0.04.

With that, let me turn the call over to Alan.

Alan Campbell

Well, good afternoon, and thank you again for joining. As I review the Q3 financial results in more detail, please note I will be focusing these results excluding the impact of certain one-time items and adjustments. We believe this to be a more meaningful representation of our ongoing financial performance. Please also note the majority of the purchase price accounting are no longer material.

Well, let me now look into Q3 in more detail, as Gregg said, revenues were $1.01 billion, representing a sequential decrease of 2%. It still declined by 12% compared to the third quarter of last year. Our core product revenues, which exclude IP and cellular, grew 2% sequentially. AISG product sales in the third quarter were $555 million, 2% below the second quarter and 6% below the third quarter of last year. Sales to the automotive market declined sequentially in line with normal seasonality. Our non-auto sales increased sequentially and declined compared to last year. Year-over-year revenues declined both in automotive and our non-auto NCU business.

NMSG revenues were $368 million in the quarter, up 10% from Q2 and down 9% from Q3 of last year. Sequentially, sales benefited from growth in wireless infrastructure, primarily in China. Sales of our application processors to the consumer market increased sequentially as well. And year-over-year networking revenues were negatively impacted by lower demand, primarily in the wireless infrastructure and consumer markets. Cellular product sales were $27 million, and this compares to $50 million in the second quarter and $97 million in the third quarter of last year.

Other products, which again consist primarily of IP revenue and phone resales, resulted in quarterly net sales of $59 million, and this compares to $76 million in the second quarter and $52 million last year. Our IP sales declined sequentially as expected following increased activity in the second quarter. Finally, sales to distributions were flat sequentially, down 5% compared to Q3 of last year.

Looking at distribution, inventory declined $8 million compared to the second quarter. Weeks of inventory was at 9.8 compared to 9.6 in the second quarter and 10.6 in the same period last year. Our book to book-to-bill ratio in the third quarter was 1.0, and this compares to 0.98 in the prior quarter.

Looking at gross margins now and operating expenses, gross margins were 42% compared to the 42.8% in the second quarter. Our gross margins were impacted sequentially by lower IP sales and a planned decline in capacity utilization as we worked to reach $70 in the quarter. Partially offsetting the impact of the lower sales and utilization were procurement savings and operating efficiencies, including product yields. Compared to the third quarter of last year, adjusted gross margins were down 400 basis points, primarily due to lower sales volume, lower utilization and the impact of product mix.

After adjusting for our Toulouse, France facility, our internal front-end factory utilization was approximately 78% in the third quarter. This compares to 83% in Q2 and 83% in the same period of last year. The major change in utilization was related to reductions in our 8-inch [ph] facilities, with an intent to reduce inventory. We do anticipate a further reduction in utilization during the fourth quarter as we continue to focus on inventory reduction.

Now looking at our operating expenses, we continue to manage expenses tightly given the uncertain micro environment. Our operating expenses declined $7 million sequentially and $32 million compared to last year. The key drivers were lower incentive compensation and overall reductions in discretionary expense.

Our SG&A was $110 million or 10.9% of sales. This represents a decline of approximately $6 million sequentially. Total SG&A dollars declined $90 million compared to the same period last year.

R&D in the quarter was $187 million or 18.5% of sales compared to $188 million in the second quarter. Total R&D declined $13 million from Q3 last year, again due to our managing discretionary expenses and incentives. The level of investment in R&D continues to support the growth initiatives we've targeted in our core markets and product areas.

Adjusted operating earnings were $127 million or 12.6% of sales, and this compares to $136 million and $200 million in the same period last year. Adjusted in the earnings were $10 million exclusive of reorganization charges, stock-based compensation and other adjustments in today's earnings release. This compares to $17 million in Q2 and $72 million in the same period last year. Adjusted earnings per share exclusive of any adjustments mentioned earlier was $0.04. This compares to $0.07 in Q2 and $0.29 in Q3 of last year.

Our EBITDA in Q3 was $186 million or 18.4% of sales, and this compares again to $192 million or 18.7% of sales in the second quarter and $270 million or 23.7% of sales in the third quarter of last year. Adjusted EBITDA was $922 million on a trailing 12-month basis.

Let's turn now to cash. We've made some nice progress in the third quarter with working capital, and this represented a $60 million source of cash in the quarter. Inventory dollars declined $10 million from the second quarter. Inventory days were 125 -- sorry, 124 compared to 125 in the second quarter. Excluding the inventory related to the Toulouse transition, inventory days were at 115.

Our cash and cash equivalents were $763 million. This compares to $881 million in the prior quarter. Recall, we used $102 million of cash in the third quarter to reduce our 2014 maturities. This will save us approximately $9 million of annual interest expense, and so far in 2012 we have reduced our overall annual interest expense by a run rate of $30 million.

Capital expenditures for the quarter were $30 million or 3% of sales. Now given our consistent execution on managing cash, we continue to have solid liquidity. Our cash, cash equivalents, coupled with our ongoing revolver of approximately $400 million, affords us the opportunity to continue to invest in the business under capital expenditures and continue to delever.

Finally, I'd like to provide you an update on the progress we've made to date on the closure of our two remaining 150mm wafer fabrication facilities in Japan and in France. The process of completing the transition from the Sendai facility is complete following an accelerated schedule we started in March of 2011 following the earthquake. At this time, the product qualifications and transitions have been completed. With respect to the facility in Toulouse, France, the final production from this facility was completed in the third quarter. We expect the gross margin benefit from the closure to begin in early 2013.

Finally, in connection with reallocating research and development expenses and redistributing sales resource, the company expects cash charges of approximately $35 million to $40 million. These charges relate to severance costs and the company expects the timing of the cash charges to occur primarily through the third quarter of 2013. We do expect annualized savings of a similar amount of $35 million to $40 million resulting from these actions.

Let me now take a few minutes to discuss our Q4 guidance. Based on the current outlook, we expect Q4 revenues to be in the range of $920 million to $960 million. To manage inventory, we will be reducing capacity utilization at our front-end factories by 600 to 700 basis points as we planned to our front-end factories during the end of the year holiday period. Based on those actions and the lower sales volumes in Q4, we expect gross margins to decline by approximately 300 basis points.

At this point, I'd like to turn the call back to Gregg.

Gregg Lowe

Thanks, Alan. Before we move to the Q&A session, I wanted to give you an update on our strategic review process at Freescale.

Over the course of my first three months or so, I've had numerous discussions and meetings with our employees, customers, suppliers and distribution partners to gain insight into our areas of strength and weakness. It's been an enlightening experience and one that reinforces my belief that we have what it takes to win. There's an insatiable appetite from all parties, and especially from our employees, for Freescale to be back on top. There is a common call for a clear objective, something that everyone can rally around and that would focus our company.

We came at the strategic review attempting to answer four key questions. What are Freescale's true differentiators? To what markets can we apply those differentiators? What are the dynamics within each market? And can we be a leader in those markets?

That was the force behind an extensive strategic review that is focusing the company in areas where we can grow and win. Our goal was simple. Identify areas that will enable us to grow and regain market share, and then resource those businesses to win. We've identified those areas and are beginning to make the changes needed to drive us forward, specifically reallocating our resources to support the strategic direction.

As an example, the product groups that will be our growth drivers will account for nearly 90% of our total R&D spend by the 2015. We will be reallocating our sales resources to align with the industry growth in Asia and increase the coverage of the broader of the market. As a result, we expect to increase the number of accounts covered and expand our presence in distribution.

We have two simple company's objectives, grow revenue to gain share and growth gross margin to improve profitability. From a company identity standpoint, two areas will stand out, microcontrollers and multicore processors. These product areas have a long history at Freescale and at Motorola SBS. A key element of this strategy is a focus to recapture the leadership brand image that we've had over the years.

Associated with these increases in our focus areas, there will be a subsequent decrease in spending in areas that did not substantially meet our -- the four criteria we set as a benchmark. We are resourcing these areas more appropriately to fit their ability to grow top line revenue and bottom line profit. To the maximum extent possible, we've moved people and teams from these areas to the focused growth opportunities. The net result is a significant increase in R&D in the focus areas, yet a modest decrease in overall OpEx run rate.

Finally, we're realigning our product groups to streamline the speed of decision-making, increase the clarity of role, drive more authority further down the organization, and increase the accountability along with that authority. The new product groups are as follows. First one is Microcontrollers, focused on general purpose, multi-market MCUs. Geoff Lees will run this group. Geoff joined Freescale in 2011 from NXP and previously served as our Vice President and GM of the Industrial and Multi-Market product group.

In order to create a single coherent general purpose MCU roadmap, we are combining all of our historical platforms together with the [Conatus], iDot MX and Vibrid products. Teams from these product groups will all be combined into this new entity and will form a foundation upon which we plan to drive significant growth over the coming years. General purpose microcontrollers will also be the primary platform driver for our overall MCU business, creating products and platforms that will eventually be deployed to our automotive MCU product group.

Digital networking will be run by Tom Deitrich. Tom has been with Freescale since 2006 and was previously the GM of our Networking and Multimedia business. This group will sharpen its focus on multicore processors, primarily in the networking space. With this move, we are combining our networking and wireless access products into a single product group. The team's sharpened focus will include a significant resource in both chip design and software resources for standard processors in networking and communications markets.

Automotive MCU will include the company's microcontrollers sold worldwide to the automotive markets. Our focus will be to gain market share in auto MCU, capture new growth opportunities in Asia and Japan, and expand our gross margin. Bob Conrad will run this group. He recently joined Freescale from Fairchild Semiconductor, having run their analog and mobile dig discrete business, along with technology development and strategy. Prior to that, Bob managed Analog Devices, DSP Group, and was the Automotive Microcontroller Manager at Texas Instruments.

Analog and sensors will include our automotive analog, mixed-signal analog and sensors products. James Bates will run this group. James recently joined the company having held previous positions at Maxim. The focus of this group will change from being primarily automotive focused to a more balanced approach between automotive and mixed-signal analog, with an emphasis on developing analog products that complement our microcontroller products. We believe this will enable analog to both grow top line revenue and improve gross margins.

RF will include the company's RF power amplifiers. Ritu Favre will run this product group. Ritu joined Freescale as an engineer in 1988 and she has been the General Manager of RF since October 2010. We have a strong position in RF with solid margins. Ritu's mission will be to utilize an increased resourcing pool to drive into new markets and to grow top lines faster.

Along with these changes, we'll be combining all of our manufacturing operations into a single leader to drive a sharper focus on execution, efficiency and reduce manufacturing costs. David Reed is joining Freescale to run our manufacturing operations. Our fabs, assembly test operations, planning, procurement, quality and technology organizations will now report into this newly-created role. David joins Freescale from Global Foundries where he spent the last two years leading Global's 28nm production in Dresden, Germany. Prior to that, David spent over 20 years at Texas Instruments managing fabs, assembly tests and other operations supporting analog, digital and the MEMS business at TI.

In summary, the management team at Freescale is setting out on a clear path with two simple objectives, grow revenue to gain share and drive gross margin to improve profitability. We have assembled a talented and focused management team and we are investing to win. As a team, we are confident we can grow Freescale to a truly great company.

Over the course of the quarter, we'll be meeting with many of you at various different conferences and other forums. Alan, Mitch and I look forward for the opportunity to share the strategies with you in more detail.

And with that, Alan, Mitch and I happy to address your questions.

Question-and-Answer Session

Operator

Thank you. [Operator Instructions].

And our first question comes from Jim Covello with Goldman Sachs. Your line is open.

Jim Covello – Goldman Sachs

Great. Good afternoon, guys. Thank you so much for the chance to ask a question, I appreciate it. I guess the first question is on the restructuring of the realignment. How standalone are each of these businesses going to be run? And just to get to the heart of the point is, if it becomes necessary in the future to streamline or to sell off any of these businesses, how easy is that going to be to kind of prune one off from the others?

Gregg Lowe

Well, as I mentioned in the monolog, one of the things we're going to be doing is pushing decision authority down the organization. So these businesses will be able to operate more efficiently, more quickly, decisions get done faster, and again, accountability will be raised as those decisions get pushed down the organization. So the intent is to have these businesses pretty focused. Obviously there's going to be a lot of teamwork across the organization. There's going to be some amount of IP sharing and so forth; that's normal across any kind of semiconductor company. But our focus is really to focus these businesses and to give them the capability and the ability to drive the two objectives that we have.

Jim Covello – Goldman Sachs

And then, Gregg, if I could ask, I mean was this realignment of restructuring based on any experience that you had at Texas Instruments or was there another model that you used to design things this way?

Gregg Lowe

Well, I think really the focus that I've had over the three months here is really to dive in and really get to understand what's going on at Freescale. And the bottom line I think is that we've got an incredible team of engineers. We've got an ability to resource things. And I think we've had, over the last couple of years, perhaps too many irons in the fire. And I think investing our R&D in the areas where we're going to grow, I think is our best way to actually drive that growth versus kind of peanut-butter spreading across the organization.

I think what that drives is we've got to make some decisions. And I think with this process, we spent quite a bit of time talking to customers, we spent quite a bit of time talking to employees, distribution partners, etc., getting everyone's sort of take on it. And the bottom line is I think the direction we're going to go is to one customers are really going to be excited about. And we're going to make the tough decisions to move resources from areas that we don't believe meet those criteria into areas that do.

Jim Covello – Goldman Sachs

I appreciate it very much. Thanks. Good luck.

Gregg Lowe

Thank you.

Operator

Thank you. Our next question comes from Stacy Rasgon with Sanford Bernstein.

Stacy Rasgon – Sanford Bernstein

Hi, guys. Thanks for taking my questions. I have a few on, I guess first on gross margins, first of all, I guess in the short term you're looking for 300 basis points of margin compression with about 600 basis points or more of utilization. I thought the old rule-of-thumb was about one point of utilization was 25 basis points across margins. So it seems like you're getting a little more than would be strictly accounted for from the lower utilization.

I think the second question I would have is around the profile of gross margins as Toulouse kind of ramps in, as well as by any sort of other improvements toward the margin model you may think that the consolidation of manufacturing operations might have, and what is the trajectory of margins, given all those drivers, going to look like going forward.

Alan Campbell

Yeah, let me take that one, Tracy. First of all, maybe I could just talk briefly about some of the elements in the third quarter because that kind of leads into also some of the opportunities in the fourth quarter. In the third quarter we dropped gross margins by 80 basis points. Our utilizations did drop by 500 basis points, which represented roughly about 150 basis points of native gross margin. We were able to offset that with some of the procurement operational efficiencies, etc. So to your question, it's running about 25% to 30% for every point of utilization. And that really is a function of at what point, where does utilization fall?

As we looked into the fourth quarter, we made the decision to continue to reduce utilization. So the utilization will drop from 78 into the 70, 71 rate. And that'll represent roughly about 200 basis points of the 300 that we have guided to. The balance of that, however, is due to some IP. As we said in the second quarter, we will see IP getting a little bit lumpy. IP does decline, and that's the other balance of the reduction in gross margin.

What we haven't incorporated in there, and as I just mentioned, for the fourth quarter, was opportunity and upside associated with procurement or operational efficiencies. So the 300-basis-point really has utilization and IP, and we're driving hard on some of the other elements to minimize that.

In terms of the Toulouse question, we have been bundling off inventory with some of the end-of-life. The factory closed in the middle of the year, going into the beginning of third quarter. The expectation, though, is that we will get some improvement in gross margin, and that will build up to about $18 million I think it is per quarter.

So we will see gross margins improving as we go forward. We do continue to have conviction confidence around the gross margin initiatives that we do have. We have laid out what each of those initiatives are, but short term it has been impacted by this utilization.

Stacy Rasgon – Sanford Bernstein

Helpful. And just very briefly, are there any changes to your OpEx model in the wake of the refocusing and restructuring? Are you still looking at those kind of, what was it, 17% R&D and 11% SG&A? Are there any changes?

Alan Campbell

Yeah. Directionally, that's correct. I mean what we said is that in our Opex we continue to manage relative to the current environment. We've done a lot of work in reducing discretionary expense. As we look into the fourth quarter and into next year, we will see a reduction in OpEx associated with some of the charges that we are also going to take in the fourth quarter. But directionally, that's right, 17%, 18% R&D, and 11% for SG&A.

Stacy Rasgon – Sanford Bernstein

Thank you, guys.

Operator

Thank you. Our next question comes from Ross Seymore with Deutsche Bank.

Ross Seymore – Deutsche Bank

Hi, guys. The first question for Gregg on the restructuring plan. What sort of milestones should we look forward to for evidence of this restructuring working? Or maybe said differently, when should we start to see the financial implications from a cost perspective, and then potentially even more importantly, from a revenue perspective?

Gregg Lowe

Okay, Ross. Thanks for the question. Well, a couple of things. One is we're beginning this -- the actions associated with this right now, and those will continue through the second quarter of next year as we ramp down projects and wrap up some things that we've got customer commitments on and so forth. So from a bottom line profitability standpoint, we'll see some improvement as that rolls out, and then that will obviously show up as well in 2013 from a bottom line perspective. So the costs will again start coming out now and will ramp through the second quarter of next year.

From a top line standpoint, I guess I would say a couple of things. One is obviously the markets we're in are good markets, they're stable markets, they're markets that have longevity associated with them, and those are all good things. On the flip side of it, you've got to get designed in and then ramp those things into production. And so I would anticipate that actions that we take right now, which are really if you think about it reinforcing the overall strategy that was talked about during the IPO, it's reinforcing it pretty significantly by taking R&D and plowing it into those areas. I think we'll start driving design wins relatively soon, but that top line impact, I think, just based on our overall, you know, the segments that we're in and so forth, is probably something that ramps anywhere from a year to three years from now.

Ross Seymore – Deutsche Bank

Okay. And then I guess as my follow-up, given this restructuring in the cost side specifically, is the plan for deleveraging the balance sheet in any way accelerated? And maybe more precisely, I believe, Alan, you've said before about $750 million of growth cash is the level you want, anything above that tends to go to share or to debt repurchase. Is that still the threshold or does the restructuring plan lower that?

Alan Campbell

That's still the threshold. I would say that overall, Ross, again in the third quarter we were able to take $100 million of our cash to delever. As we look out into fourth quarter and into early 2013, we still have confidence with the cash. So our current thought process there is anything in excess of $750 million should be and could be used to continue to delever. The cash costs associated with this restructuring is absorbed, and we can offset that with some incremental cash from other sources, so nothing changes from the company's perspective in terms of the intent to delever.

Ross Seymore – Deutsche Bank

Great. Thank you.

Operator

Okay. Thank you. Our next question comes from Doug Freedman with RBC.

Doug Freedman – RBC Capital Markets

Great. Thanks for taking my question, guys. I guess to start with, looking at the restructuring, are you going to change your reporting structure to align with the new product groups? Are we going to see revenues by -- broken out that way?

Mitch Haws

Yeah. Doug, what we'll do, starting in Q4, is we'll provide revenue based on this kind of strategic framework. So if we look at microcontrollers, networking, auto MCU, grouping them in a way that lines up strategically with what Gregg outlined today. So the idea would be to start that process in Q4.

Doug Freedman – RBC Capital Markets

Okay. And I guess before we do that, could you give us some indication of your outlook for Q4, where we're seeing the softness and where the softness, you know, what the different product groups are seeing as far as their outlook?

Alan Campbell

As we look out into -- maybe I can take that Mitch -- but as we look out into Q4, it's fairly consistent with how some of the competition have communicated. There's no doubt that it's challenging; there's a tremendous amount of uncertainty. I wouldn't say that the one specific product group is showing any major differences. So we're seeing that the sequential declines in the gains we've given, Doug, really across the automotive networking and industrial market. So it really is across the board.

Doug Freedman – RBC Capital Markets

And how about the cellular business unit? You still -- you recorded $27 million this past quarter. How long is that going to take to wind down?

Alan Campbell

Well, we're getting close to the bottom of that, side of it, for cellular. So we'd expect that maybe to decline slightly into the fourth quarter or really flat now thereafter into 2013.

Doug Freedman – RBC Capital Markets

Okay. And then if I could focus in on your strategic actions too on the OpEx side, the annualized savings that you cite, can you give us a -- what is the baseline that we should be using for the spending levels? It's been, you know, this last quarter you reported 285 on a pro forma basis; quarter before that it was up almost over 300. What's the right baseline for me to use for that annualized $30 million to $40 million?

Alan Campbell

Yeah. The current baseline if you look at the third quarter and use that as a baseline, I think that that's the expectation to see savings from that kind of run rate.

Doug Freedman – RBC Capital Markets

Terrific. And then my last question if I could, what are the options available to you as far as your debt and trying to do something to negotiate with the present bond holders? Are there any triggers in any of your debt that would enable you to bring the coupon rate down to something that's more in line with market?

Alan Campbell

Well, we continue to execute, and if you look at how we've performed over the last number of years now, we continue to execute I think fairly well on the [calcum] structure. Our debt is covenant-light. That's an [encumbrance-based] structure. So our focus really is one of generating cash flow to continue to pay down. We, at the same time, we'll continue to look at some of the economics out there to see if opportunity exists to refinance. The predominant focus for the company is always to generate the cash, to continue to adjust.

Doug Freedman – RBC Capital Markets

Great. Thanks very much for taking all my questions.

Operator

Thank you. Our next question comes from John Pitzer with Credit Suisse.

John Pitzer – Credit Suisse

Yeah. Good afternoon, guys. Thanks for letting me ask the question. Gregg, in a response to an earlier question, you kind of mentioned that the strategy today is really a reinforcement of the strategy from the IPO. I guess I'm trying to understand a little bit better, at the IPO, which I know predates you, there was of conversation and charts about design funnels and socket wins that were expected to ramp into market share gains. If memory serves me correctly, at the end of last year coming into this year, that didn't really materialize, and I know we're in a bad macro environment, bad semi environment. But I'm just trying to get a better sense of specifically what you're doing differently with this restructuring versus kind of the strategy that has always been to regain market share in some of your core markets?

Gregg Lowe

I think the real key difference here is how we're going to resource the areas that we believe are going to drive our growth. And I was sort of asking that same question that you just asked during this process. And so when we look at, and I don't want to go through a whole lot of history, but when you look at it, there's been limited amounts of change in how we've been deploying our R&D dollars throughout the last number of years. And with this change, there's a relatively sizeable change in the amount of money that we're going to be spending in these areas that we believe will drive growth.

I mentioned that over the next three years we'll be taking 90% of our R&D dollars and moving in into those functions. The R&D in those areas will actually grow over the next three years by more than 30% and yet at the same, at the company level, we'll see OpEx coming down slightly. So I think this is a pretty meaningful shift in where we're actually spending money that reinforces areas that we believe have great growth opportunity, where we have differentiation, where the market dynamics are favorable to us, and where we believe we can make a meaningful impact and win. So I think that's probably the most significant change that's going on here, John.

John Pitzer – Credit Suisse

Great. That's very helpful. I guess, can you help me understand, because typically as companies kind of go through these transitions, you never get the new revenue growth fast enough relative to some of the areas where you're de-emphasizing. And I'm just curious, when you look at kind of the three core areas where you're going to throw 90% of R&D in the future, do you feel like you're at a point where market share is at least stable in that area? And specifically if you could talk to the networking area, it'd be helpful.

Gregg Lowe

Well, let me just in general first off, there's been a lot of, as you mentioned earlier, design activity, working with customers and so forth. We didn't come into this thing from a standing stop or what-have-you so there's been a lot of drive and actions associated with that. Between -- excuse me, between June when I came on board and November, just one month from now, I will have visited customers three times in China, three times in Europe, twice in Japan, and a whole bunch of times in the U.S. And what I can tell you is customers are excited about what we're doing. They're excited to see us reemphasizing the areas that are these growth areas that I talked about and so forth.

The other thing that I would mention just as about the areas that we are kind of resetting, if you will, or won't be part of the core growth going forward, most of these businesses also have the same dynamics associated with our overall business, meaning these are businesses that have long product lifecycles and so forth. So we would anticipate that these things would have a gradual decline in revenue. And we've modeled it as such.

I think in terms of the overall ability for us to grow in the core businesses, obviously, with us making these pretty big changes in R&D spend, we've come to the conclusion that momentum is behind us, that -- meaning it's positive for us, and I think our ability to get traction in these areas is pretty solid.

John Pitzer – Credit Suisse

Great. My last question for Alan. Alan, some of the cost cutting initiative that hit in the first half of '13, can you help me size those on the gross margin lines? So, assuming that revenue doesn't grow and utilization kind of stays at these levels, as some of these cost cuts kind of bleed into the model, how do I think about gross margins from Q4 levels on a kind of a flattish revenue, flattish utilization environment?

Alan Campbell

Yeah. The improvement in gross margin, first of all, wouldn't just be around the cost cutting, although that would be an element. I think the improvement in gross margins will be the building blocks we've talked about in the past which will be cost cutting utilization, procurement savings, operational efficiencies. And we are seeing a little bit of a drag at the moment because of the utilization that we've talked about.

I think that, as we look into this, Toulouse will have a big impact for us as we go into the first half of next year, John. We didn't get any impact, didn't get any benefit from Toulouse. And we've said before, that probably could be 150-basis-point type improvement in gross margin.

I do believe also that as we are getting into a situation today and reducing our overall utilization to reduce inventory, hopefully we're getting to the bottom here of the market, and we should see that slightly improve as we go forward. And then on top of that, we have the operational efficiencies. So with all that being said, I think, you know, we've given guidance before of 50 to 75 basis points each quarter. I think that would be fairly conservative in this environment only because utilization is so low.

John Pitzer – Credit Suisse

Perfect. Helpful, guys. Thank you.

Operator

Thank you. Our next question comes from C.J. Muse with Barclays.

C.J. Muse – Barclays Capital

Yeah, good afternoon. Thank you for taking my question. I guess, first question, Alan, can you share with us what you think is appropriate target inventory in I guess this depressed environment and where you think we'll be exiting Q4 given the cut to utilization that you're targeting?

Alan Campbell

Yeah. So we have -- we reduced inventory, our own in-house inventory, by $10 million in the third quarter. We also reduced distribution inventory by another $8 million. As we've hit the brakes from a utilization standpoint, our current thought process, we'll reduce inventories further in-house by $15 million to $20 million for the fourth quarter.

C.J. Muse – Barclays Capital

Very helpful. And then I guess as a follow-up, can you share with us a targeted interest expense for calendar '13 given the downtick we saw in Q3?

Alan Campbell

Yeah. So, our current interest, if you look at the third quarter, our current interest is running about $125 million per quarter or $500 million a year. We did execute on the transaction in the third quarter which will save us another $10 million. So, obviously, in the absence of doing any other transactions, the annualized interest will be in the $490 million type range.

C.J. Muse – Barclays Capital

$490 million, great. Thank you very much.

Operator

Thank you. Our next question comes from Raji Gill with Needham & Company.

Raji Gill – Needham & Co.

Yes, thanks. Just a question on the new business reorganization. I'm trying to get a sense in terms of the rationale of the organization. What criteria are you using when you're dividing these organizations up? I understand the R&D allocation, but are you looking at which areas you think you have dominant market share, you want to retain market share? Which areas you think you have smaller market share you think you could grow? Which areas you think are in which the end-markets are not as robust? I just wanted to get a better sense of the criteria and the rationale and what is the ultimate purpose there? Is there opportunities that you would start to divest other segments, acquire other businesses to beef up areas? Any color there would be helpful.

Gregg Lowe

Okay, thanks. There's really four criteria that we use as we did the whole strategic analysis and they were really pretty straightforward. And maybe just as a preface, I know and you're probably all aware, when you do a strategic analysis, you can kind of get lost in the forest for the trees. And so I think it was really important for us to have a pretty clear vision as to what we were looking for, and that's where these four criteria came out.

The first one is, what are the differentiators that we bring in these different product areas? What do we do unique and what do we have special, and so forth? The second question after we spent some time on that was, to what markets can we apply that? What market value that? And then the third was, what are the dynamics of those markets? Are they concentrated markets, are they growth markets, are they shrinking markets, and so forth? And then the final question is, can we see ourselves leading in that particular market segment or product segment. Can we be a number one type player in that space?

It's really these four criteria that we looked at. It's not like there was a spreadsheet and we spelled it all out. It was really a lot of discussion and thought and analysis that went through that. And I think that's what really drove the rationale for why we've decided what to do.

I think that's -- that was a process that included a lot of constituents, certainly business managers across the company, but it took input from customers, it took input, you know, I've met with various different distributors that had their take on where we're unique and differentiated and where they think if we plowed some more money in, it would help them drive our resales in various different markets and so forth. So it was really those four criteria that drove that.

Raji Gill – Needham & Co.

That's helpful, Gregg. And just a follow-up on that, more specifically in terms of the segments and the categorizations, which areas do you think you're stronger, which areas do you think you're weaker? Any details on kind of the -- how you look at each individual segments now under this new categorization?

Gregg Lowe

We have very solid positions and market shares in the, you know, certainly in the microcontroller space, we've got a number two position. In automotive microcontrollers we've got a very solid position as well, number two. In the RF space, we're the leader in RF power amplifiers. A very strong, number on position in networking; we've got a very, very solid position as well, basically the leader in that space. So there's certainly four areas, four of the five areas where we're either number one or two today.

Raji Gill – Needham & Co.

Thank you.

Operator

Thank you. Our next question comes from Franklin Jarman with Goldman Sachs.

Franklin Jarman – Goldman Sachs

Great. Thanks for taking my questions, guys. Just with regards to the realignment, I wanted to go about it a separate way. From a manufacturing perspective, how much fabrication overlap occurs across each of these new segments? Is there a way to segregate the production at this point?

Alan Campbell

Well, the production is up. It's actually segregated or separated today, Frank. If you look at most of the internal capability that we have, it's focused in the microcontroller space, it's focused in the analog, some of the RF space, to a lesser extent, because of the technology in networking. So it's pretty well aligned today and we don't anticipate major changes from that as a result of this direction.

Franklin Jarman – Goldman Sachs

Got it. That's helpful. And then just one other question. You had mentioned that, as part of the realignment, there will be some projects ramping down over the next few quarters or years. Is there a way to quantify your revenues that we should consider lower focus and sort of revenues that could ramp down based on this realignment?

Gregg Lowe

I think -- well, a couple of things. I don't know that we're going to go into that level of detail. What I would tell you is, I mentioned it earlier, this -- we're going to first off continue finishing up any projects that are associated with customer commitments and so forth. That's part of the reason why we've got a charge as well associated with that. Those projects will be finishing up by the second quarter of next year. And those projects that are in design and wrapping up in the second quarter of next year will actually be ramping into production in the years to come.

So what is most likely going to happen with the revenues associated with these products is they will drift upwards for the next couple of years because we've got design wins that are going into production. As we stop developing new products in those spaces, we would then obviously see design win momentum turn around. And so we would anticipate then that they would gradually decrease beyond a couple of years from now.

Franklin Jarman – Goldman Sachs

Okay, great. Thanks. That's helpful. That's all.

Operator

Thank you. Our next question comes from Robert Parish with Citi. Mr. Parish, your line is open. Sir, you may want to check mute feature.

Glen Yeung – Citi

Can you hear me?

Alan Campbell

Yes, we can.

Glen Yeung – Citi

Oh, hey. It's Glen Yeung. I don't know who that other person is. Okay. Maybe they have someone new working for us. Maybe this question first thinking about, maybe to you, Gregg, about manufacturing. I'm just trying to understand, as you think about your business going forward, how important is manufacturing to the company, in two ways, one, in terms of, do I need leading-edge manufacturing? And then, two, do I even need to own my own manufacturing facilities at all some number of years down the road?

Alan Campbell

I think it varies, Glen, obviously by business or by product group I would say. The fact is that we do have the 8-inch facilities and today probably 65% to 70% of our revenues are generated from those three facilities. These are facilities, however, that [had kept] 90nm technologies. So as we mentioned earlier that as we think about some of the new products, and we'll take networking as an example, there's not a need to utilize our existing facilities.

So the manufacturing strategy really is a balanced strategy based on the diversification of the portfolio that we currently have. And it is a good strategy because these factories are pretty much depreciated as you know and can throw off cash while leveraging or utilizing them. So it really is a balanced strategy between the portfolio that we have.

Glen Yeung – Citi

Ultimately it sounds like no change though. Is that the right way to read that?

Alan Campbell

Yeah, there'll be no change in that strategy.

Glen Yeung – Citi

Okay. And then Alan, maybe you might have said this before and I apologize if you did, but do you have any breakeven quarterly revenue run rate as a function of all these changes?

Alan Campbell

Sorry, Glen. Can you give me that question again? We didn't hear it.

Glen Yeung – Citi

Sorry. Do you have any break-even revenue run rate as function of all the changes you're making in your business?

Alan Campbell

Yeah, the breakeven will decline somewhat. We've said that we're running about a breakeven below $4 billion; it's really about $3.9 billion. As a result of some of these changes, there will be cost coming out of $35 million to $40 million. So breakeven will go down slightly. But this is really more of a story and a message of growth of revenue and margin expansion as opposed to reducing the breakeven from cost denominator management.

Glen Yeung – Citi

Okay. And then just one last question which is, when we were doing due diligence at the IPO, one of the themes that came out was that the legacy of Freescale was valuable to your customers. And now that you're undergoing changes, have you talked to your customers? What's their response been? And do you sort of exit any legacy businesses that might have picked off somewhat?

Gregg Lowe

Well, I think the legacy is important and it remains solid today. As I mentioned, I've been -- by the time November is over, I'll have been to China three times, Japan a couple of times, Europe three times, meeting with customers. In fact, I'm just coming back from Japan, I got back yesterday from the Freescale Technology Forum there. And we had over 3,700 customers visiting our technology forum in just a two-day period. It's an absolute all-time record in terms of customers coming in. I met with a whole bunch of them as you can imagine during that timeframe. And in fact I was in a meeting yesterday with a customer that talked about first meeting with Motorola SDS people 25 years ago and designs and so forth.

So I think that heritage and legacy remains -- is very, very important to our customers and remains very important. I think with this change, in some respects we're going to be amplifying the things that this company has been historically very powerful at. Processors, multicore processors and microcontrollers certainly have been a very strong emphasis of the company, the networking products and so forth. And so I think this is, you know, my take and again it's based on real discussion I've had with customers, is they're going to be excited more about the amplification here and how it extends that legacy going forward.

Glen Yeung – Citi

Okay. Thanks, Gregg.

Operator

Thank you. Our next question comes from Steven Eliscu with UBS.

Steven Eliscu – UBS

Yes. Thank you. First question is on -- with regards to both microcontrollers and multicore processors, I mean you've already laid out some pretty well-defined roadmaps with Kinetis, and you just talked -- you just introduced Layerscape. From a customer point of view if I'm looking at your road map based on what you're doing, what do I see that's different? Do I now see a lot more products? Do I see more variations that go into adjacent markets? How should I think about what the results will be that will ultimately drive sale synergies?

Gregg Lowe

There's going to be several things, Steve. One is, from a microcontroller standpoint, we're basically merging all of our various different microcontroller product lines into one single entity that's focused on the general purpose market. And so I think the go-to market message will be much clearer. How the products differentiate from themselves, from each other will be much easier understood. And I think our, as I said, I think our go-to market message will be a lot more straightforward.

The second thing you'll see in both the networking area and the microcontroller area, in fact in all of the areas that we're going to be plowing more investment in, is a relatively sizeable increase in the number of products that'll be released. The number of -- and that could be core platforms, it'll certainly be more variations. So Kinetis, we'll see a boost in its ability to continue driving out lower power variance of the device or smaller or more integrated versions of the devices and so forth. So they'll certainly see an extension of the platform.

I was just up with a customer two weeks ago that is actually looking at designing Kinetis in, and that was the exact message that they were looking for, which is they love the products but they want to put them in more of their platforms. They want to have a single Kinetis platform that will span across more of their own platform. So I think that's the second piece you'll see.

The third thing that you'll see is a relatively sizable increase in our investments in software, more and more of the design-in process or, you know, the customer's ability to use these products is based on sort of software, middleware and the ability for them to quickly ramp into production. So, across both the networking and the microcontroller space you'll see an increase in our investments in software, which will translate from a customer standpoint into ease of use and time to market. I think these three items will be pretty substantially well received by customers in these spaces.

Steven Eliscu – UBS

That's really helpful. And just a related question, when you went through the strategic review, you clearly understood what your strengths are, but you must have also discovered that there were some holes in the portfolio and in terms of being able to affect the change with regards to driving more growth. And are the resources you're now focusing a lot to fill some of those technology holes? And within that, is there a given that you looked at what your strengths are internally, is there now an evolved process for how you do tuck-in M&A to complement what you're doing organically?

Gregg Lowe

Well, certainly we looked at both the strengths and the weaknesses, and to be honest with you I spent a lot of time drilling into the weaknesses and trying to understand where the gaps were and why there were gaps and so forth. There's gaps where we need a certain technology and perhaps obtaining that technology through either licensing or a possible tuck-in thing is certainly on the table and something that we look at. But there are other areas that I think we looked at our capability and we've decided to do something a little different.

Maybe I'll just point out one to kind of help you understand our thinking a little bit. Inside of our analog business a few years ago, we started down a path of developing PMICs, or power management ICs for our microcontrollers and processors. And this makes logical sense because you need to have PMICs for customers. Customers like having PMICs so that they don't have to figure out the power solution themselves. And we sort of started building this capability from within. And as many of you know, PMICs are a lot more difficult to do than many people imagine and I think we've struggled to come up with PMICs that have been competitive and, quite frankly, helpful with designing in our processors.

And so as part of this realignment, we've made the decision that trying to do our own PMICs probably wasn't such a smart idea, and rather are working with very reputable companies that are experts in PMIC to become partners with us and actually develop PMICs for us. So that when we go to the customers and we propose solutions, we can propose a solution that's been created by a company that's got a very reputable capability in doing these PMICs.

So we've launched discussions already there. They're very encouraging. And I think us trying to slug it out on our own was just probably -- it just wasn't our smartest way going forward, and I think working with companies that know how to do PMICs is going to be a smarter choice for us.

Steven Eliscu – UBS

All right. That's really helpful. Thank you.

Mitch Haws

Kim, we have time for one more question.

Operator

Thank you. Our next question comes from Jeff Harlib with Barclays. Your line is open.

Jeff Harlib – Barclays Capital

Just, I know you talked about the demand weakness is broad-based, but automotive, can you just go into a little more detail there given the significant weakness in Europe while U.S. is holding up better? And any supply chain impacts you're seeing in your automotive business?

Gregg Lowe

Well, automotive, at least for the near term, is not what I would call an area of strength. I think a number of automotive manufacturers, especially in Europe, have announced that they're going to have extended holiday periods and plant shutdowns and so forth. I can't remember the exact number, but it was more than a handful, have announced shutdowns. So, near term, we're not anticipating the automotive market being an area of strength for us. What happens in 2013, I can't predict that, but certainly in the fourth quarter, we're not anticipating that being an area of strength.

Jeff Harlib – Barclays Capital

Okay. And just, Alan, just on the inventory reductions, do you expect to be at normal levels by the end of Q4, assuming revenues stabilize, do you have a target in terms of inventory days?

Alan Campbell

That's going to be a function, Jeff, of overall demand, and we'll continue to manage and balance that. Direction, I would say, no, our expectation would be to continue into the early part into Q1 of '13 to manage inventory and get our days down. We are running at 115 days at the moment, as I said, which is higher than maybe we would like to be. But those two sites, there's one that's continuing to manage inventory down, at the same time manage that with respect to demand when demand starts to kick in. So we are a balance of those two issues. But our current thinking is continue to reduce inventory in the short term.

Jeff Harlib – Barclays Capital

Okay. And just last thing, this distribution resales, you said selling was -- you said your sales were flat. How were the resales in the quarter?

Alan Campbell

Our resales were down slightly. I think it was down by 2% to 5% on a resale basis. So, resales were down.

Jeff Harlib – Barclays Capital

Okay. Thanks very much.

Gregg Lowe

To wrap up, I'd like to summarize a few points. First, the Freescale team executed well in a relatively tough third quarter environment. Revenues for the product groups were above expectations, and our overall revenues were slightly above the high end of our guidance. While profitability is not where we'd like it to be, gross margins are 1,100 basis points above the level we saw in the last downturn. Our cash balance is strong and we were able to use the excess cash to take another $100 million out of our debt. So far in 2012, we've taken the annualized interest expense down by $30 million. Q4 is clearly a challenging environment for us in the industry, and we'll manage discretionary spending tightly.

In a little over 90 days, we've completed a thorough review of our businesses aimed at driving growth and improved profitability. We are now implementing that strategy and moving a significant amount of our R&D spend into areas that we believe will help drive those two objectives. We've also begun a strategic redeployment of our sales resources, growing our overall selling resources with an emphasis on Asia. We've assembled a strong management team that is committed to helping deliver growth and profitability that we know we can achieve. And we're at the beginning of the change process, so I'm sure there'll be a lot of issues to tackle. We'll face those issues together as one strong Freescale team.

We look forward to sharing our success as we move forward. Thanks, and have a good evening.

Operator

Thank you for your participation on today's conference. You may disconnect at this time.

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