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Conexant Systems, Inc. (NASDAQ:CNXT-RETIRED)

F3Q08 Earnings Call

July 31, 2008 5:00 pm ET

Executives

Karen Roscher - Senior Vice President and Chief Financial Officer

D. Scott Mercer - Chief Executive Officer

Christian Scherp - President

Analysts

Allan Mishan - Oppenheimer & Co.

Sandy Harrison - Signal Hill Group LLC

Blayne Curtis - Jefferies & Co.

Sanjay Devgan - Morgan Stanley

Eric Rubel - MTR Securities

Operator

Welcome everyone to the Conexant Systems third quarter 2008 conference call. (Operator Instructions) I would like to introduce Karen Roscher, Senior Vice President and Chief Financial Officer for Conexant Systems, who will chair this afternoon's conference call.

Karen Roscher

Good afternoon, everyone, and welcome to Conexant's third quarter fiscal 2008 earnings conference call. Joining me today are Scott Mercer, our Chief Executive Officer, and Christian Scherp, our President.

Scott will begin today's call; I will then review our third quarter financial results. Christian will provide a business perspective and review, and Scott will return with our outlook for the fourth fiscal quarter. We will then open the call for questions.

Please note that our comments today will include statements relating to future results that are forward-looking statements as defined in the Private Securities Litigation Reform Act of 1995. Actual results may differ substantially from those projected as a result of certain risks and uncertainties, including but not limited to those noted in our earnings release and those detailed from time to time in our SEC filings.

The financial information we will discuss today is based in part on non-GAAP financial measures. The company believes that these financial measures, which we term core financial measures, provide an enhanced understanding of our underlying operating performance. A reconciliation of core to GAAP measures is included in our earnings release, a copy of which is available on our website at www.Conexant.com.

I will now turn the call over to Scott.

D. Scott Mercer

During the third quarter, the Conexant team continued to make outstanding progress across multiple fronts, the cumulative result of our efforts reflected today in the improved financial performance we reported and in our increased guidance for the fourth fiscal quarter.

For the third quarter, we once again met or exceeded our expectations on every major financial performance metric. We also introduced innovative new products targeted at high-growth market segments and we executed a 1 for 10 reverse stock split.

This past April we announced plans to sell our broadband media processing product lines to NXP Semiconductors in a transaction valued at up to $145 million. We expect to close this transaction in August, and we plan to use the majority of the net proceeds to improve our balance sheet by retiring debt. The NXP transaction is consistent with our overall company strategy of improving our business model and generating positive cash flow, focusing our investments on market segments where we either lead or have the opportunity to lead, and establishing a long-term sustainable capital structure.

In June we provided a preview of what our new company will look like when the NXP transaction is completed. We have built leading positions in multiple segments within the markets the new Conexant will address, and we plan to accelerate investments in the sectors that offer the best opportunities for profitable growth.

After the close of the quarter we completed the purchase of Freescale Semiconductor's SigmaTel multifunction printer product lines. This purchase is consistent with our strategy of augmenting investments in new product development, with select acquisitions in the high-growth markets we serve. In addition, the SigmaTel products and engineering resources strengthen our position in imaging, which is a key area of focus for our imaging and PC media team, and also broadens our footprint within our existing customer base.

Before I turn the call over to Karen for review of our third quarter results, I'd like to point out that we had a substantial GAAP net loss for the quarter, driven primarily by the writedown of goodwill and certain other asset associated with our DSL business. These charges reflect the ongoing challenging nature of today's DSL market. One of my primary areas of focus this quarter will be to work with our management team to improve this situation.

Karen Roscher

Before I begin discussing our financial results in detail, I'd like to note that the tables included in our third quarter press release classify our broadband media processing business as discontinued operations as a result of the agreement we signed in April to divest that business to NXP. Because our guidance for the third quarter included the financial results for our BMP business, I will discuss our performance including BMP first, followed by the highlights of our financials excluding the discontinued operation.

In addition, please note that all our earnings per share figures have been adjusted to reflect our 1 for 10 reverse stock split, which was executed on June 27.

Including BMP, third quarter revenues of $171.1 million were slightly above the high end of our previously provided guidance range.

Core gross margins for the quarter were 47.1% of sales, which exceeded the top end of our guidance range by 160 basis points. This improvement was driven by higher than expected revenues in our imaging and PC media product lines and the favorable sales mix in our broadband access business.

Core operating expenses of $69.6 million were below our original estimates, even with the impact of executive separation costs during the quarter. We are continuing to execute on our cost reduction initiatives and this remains a key focus area for our team.

Core operating income in the third quarter was $11 million. Other expenses of $7.8 million primarily reflected interest expense related to our debt, partially offset by interest income generated from our cash and investments.

Core net income for the third quarter was $2 million or $0.04 per diluted share based upon approximately 49.5 million average shares outstanding. This compares to our guidance of a net loss of $0.06 to $0.17 per share.

Excluding the discontinued operations associated with our BMP business, third quarter revenues were $115.6 million and core gross margins were 50.6%. Gross margins excluding BMP declined on a sequential basis because of less favorable product line mix.

Core operating expenses without BMP were $46 million, which resulted in core operating income of $12.5 million. Net income from continuing operations was $6 million of $0.12 per diluted share.

Our GAAP results included a number of additional non-cash expense items, resulting in a net loss on a GAAP basis of $149.9 million or $3.03 per fully diluted share.

As we have discussed in the past, we continue to conduct a candid and thorough assessment of the future prospects for each our businesses' products and projects to enable us to deliver the best possible return to our shareholders. As a result of this ongoing assessment, we recorded an asset impairment charge of $120.4 million during the third quarter which was primarily related to the writedown of all goodwill associated with our broadband access product line.

In addition, as a result of the pending sale of our BMP business to NXP and the associated reclassification of the results of this business as discontinued operations, we recorded a net loss from discontinued operations of $23.5 million. $4.7 million of this loss was related to operations and the remainder was related primarily to asset impairment charges.

Now turning to the balance sheet, at the close of the third quarter our cash and cash equivalents totaled $134.6 million, a sequential decrease of approximately $29 million. This decline was due to the reclassification of $29 million to restricted cash related to standby letters of credit associated with one of our vendors.

Accounts receivable represented 42 days, up from 38 days in the previous quarter.

Inventories declined by $1.5 million sequentially to $36.7 million during the quarter, and inventory turns increased to 6.2 compared to 6.0 in the prior quarter.

I would now like to turn the call over to Christian for a review of our businesses.

Christian Scherp

I would like to spend a few minutes talking about third quarter business and product highlights, focusing only on imaging and PC media and broadband access, which will comprise our ongoing businesses when the broadband media processing transaction closes.

Excluding BMP, our imaging and PC media business accounted for approximately 55% of our total revenues in the third quarter. This business is comprised of four segments - imaging, video, audio and modem. The total available market for our imaging and PC media products is more than $2 billion today, and it's expected to grow to about $3 billion over the next several years. We are either number one or number two in each of these segments, and we are working to expand our presence.

With our acquisition of Freescale's SigmaTel multifunction printer business, we significantly broadened our product offering in our imaging business. Our leadership position now ranges from semiconductor solutions for fax platforms to integrated solutions for the high-growth multifunction printer and digital photo frame market segments.

The acquisition also broadens our footprint with our existing customer base, which will provide a foundation for future growth. The combined imaging IP and our extensive firmware and software stacks uniquely positions us to successfully address the increasing demand for printers that feature higher print speed and quality.

Our kind architecture also enables us to support the trend to host independent PC printing and will allow us to capture additional share as mobile printing spurs future demand.

The total addressable market for imaging solutions is approximately $900 million today.

During the quarter, we won critical designs for next generation fax products and also introduced the latest member of a family of highly integrated solutions for fax platforms with advanced voice capabilities. We have already secured a major design win with a global T1 OEM for this next generation solution.

In our video business, we are focused on providing solutions for PCTV applications and for video surveillance, a segment that is experiencing rapid growth. During the quarter, we introduced a new family of broadcast audio/video decoders for PCTV applications. These products are generating significant customer interest worldwide, and we expect to earn revenues within the next two quarters.

We also introduced two new products targeted at PC-based video surveillance systems with digital video recording capabilities. These new products can be used with our latest video decoder to form a complete 8channel industry standard digital video solution for real-time video surveillance DVI applications. These solutions offer unmatched video quality and the lowest available cost per channel. Customer interest has been high, particularly in Asia-Pacific and Europe, where the majority of DVR-based video surveillance systems are developed.

We are also making good progress in our audio business, where our strategy is to utilize our extensive IP portfolio and our core expertise in voice processing and coding technologies to deliver integrated products for markets that are growing rapidly.

During the quarter we secured notebook design wins at major PC OEMs with our current HD audio solution. In May, we introduced the industry's first family of speakers on a chip solution with Class D amplifiers. Class D amplifiers provider higher audio performance at lower power consumption. Our highly integrated new audio products are targeted at virtual PC sound systems, speakers, notebook docking stations and voice over IP speakerphones. We have already won designs with a leading speakerphone provider and with a top tier PC OEM for a new multimedia sound platform. Interest in our new audio solutions is high, and we expect to continue winning designs with a variety of manufacturers.

And of course we remain the world's number one supplier of analog modems. These products are used in desktop and notebook PCs, set top boxes, digital TVs, point of sale systems and other industrial applications, and our team is committed to expanding our leadership position.

Turning now to our broadband access business, we continue to be a leading supplier of broadband access system and chip solutions, which accounted for approximately 45% of our revenues without BMP in the third fiscal quarter. During the quarter our team worked to accelerate new product introductions in the fast-growing DSL/CPE residential gateway segment. We have also delivered several new features, such as VDSL/CPE bonding and support of IPTV deployments by AT&T and other carriers. Bonding increases bandwidth capacity and extends network reach, which allows service providers to deliver offerings such as IPTV to a wider subscriber base and to expand revenue-generating potential.

We have now delivered more than 8 million [inaudible] and are currently shipping more than 1 million [inaudible] ports per quarter. Recent design wins included CPE data router with a major OEM and a next-generation VDSL to a central office line card with a major telecommunication OEM. In addition, we remain the sole silicon provider of VDSL solutions for AT&T's U-verse IPTV network, which added more than 13,000 new subscribers per week in the June ending quarter and remains on track to have more than 1 million subscribers by the end of this calendar year.

Demand for our highly integrated ADSL2plus residential gateways with [inaudible] land functionality grew strongly throughout the quarter, with shipments surpassing 1 million units. These advanced solutions offer cost and performance advantages for triple-play voice, video and data applications, and enable operators to quickly and cost-effectively scale advanced gateways across a large base of users. We continue to be the number one provider of these solutions in China, and our products are now being used in consumer equipment being deployed throughout Western Europe.

During the quarter, we also continued to gain traction with our high-density, low-power ADSL2plus chipset for central office applications. These 16-port and 24-port solutions enable operators to improve power efficiency and have been qualified at major OEMs that must adhere to the European Union's newly mandated lower power consumption requirements. In addition, we are also winning designs in applications where ADSL2plus is being used to provide the last mile access connection to multi-dwelling housing units.

I would now like to turn the call back over to Scott for our fourth fiscal quarter business outlook.

D. Scott Mercer

In June we provided fourth quarter fiscal - fiscal quarter guidance for our company without our broadband media processing product lines. I'm pleased to report that we now expect to deliver even better financial results than we anticipated a few months ago.

For the fourth quarter we anticipate revenues in a range of between $120 and $125 million, including a modest revenue contribution from the SigmaTel acquisition. Previously we expected revenues in the range of between $115 and $120 million.

We anticipate that fourth quarter core gross margins will be between 51.5 and 52.5% of revenues, up from our previous expectations of 49.5% to 50.5%.

As a result, we expect fourth quarter operating income will be in a range of between $14 and $16 million, resulting in core net income of $0.13 to $0.17 per share, up from our previous EPS estimates of $0.08 to $0.12.

Karen Roscher

That concludes our prepared comments today. We're now ready to open the lines for the question-and-answer session.

Question-and-Answer Session

Operator

(Operator Instructions) Your first question comes from Allan Mishan - Oppenheimer & Co.

Allan Mishan - Oppenheimer & Co.

Can you give us an idea about how some of the subsegments performed on a sequential basis? I'm specifically thinking of ADSL, VDSL and analog modem.

Christian Scherp

As you know, we are in general not providing details at the moment on a segment level. I can say, though, that, for example, if we talk about the analog modem business, as we all know, the PC business and the underlying strength of the PC business was certainly a phenomenon that we saw last quarter. So we saw strength certainly in that market segment.

In the DSL segment overall, as we mentioned, we are continuously on track to particularly support the AT&T rollouts here in North America with the U.S. program, so we certainly saw strength in that business as well.

ADSL is really regionally driven, and we see differences there from region to region.

Allan Mishan - Oppenheimer & Co.

And can you give us an idea about which businesses are driving the growth in the coming September quarter?

Christian Scherp

Yes. In the coming September quarter, as Scott mentioned, there is a small contribution from the SigmaTel acquisition, but overall the core of the growth will come from the imaging and PC segment overall and from our business there.

Allan Mishan - Oppenheimer & Co.

And then how do you expect your gross margins to look? Should they bounce around seasonally as the PC business goes up and down or should they stay in this range of 51.5% to 52.5%? How do you think about that?

Karen Roscher

From that perspective, we would expect to see a little bit of bouncing around, depending upon how heavy we are seasonally within the PC modem space. So that's what was responsible for the change from last quarter to this quarter and then also giving us a bit of a boost going into the fourth quarter.

Allan Mishan - Oppenheimer & Co.

And then I guess in the first half of the year it generally would trend lower on the lower PC shipments?

Karen Roscher

Correct.

Christian Scherp

Even though, as you know, the seasonality, if I can just make one comment there, the seasonality in the PC business is certainly not anymore what it used to be, let's say, three to five years ago.

D. Scott Mercer

And I'd just add that our exposure in the PC business grows really quarter by quarter to the mobile segment with our IPM product line. So that's obviously a higher gross segment within the overall PC [segment].

Allan Mishan - Oppenheimer & Co.

And then how are you expecting the OPEX to trend over time? I mean, have we hit a point where it won't decline further or are you continuing to drive that lower?

Karen Roscher

We're going to continue to focus. We're not going to lose our focus on controlling the costs and managing that down and addressing overall infrastructure. But, as you may have gotten a flavor from this call today, the shift is going to be in driving growth for the businesses going forward.

Allan Mishan - Oppenheimer & Co.

And last one from me is what would you estimate the analog modem penetration rate is in notebooks today for the total market? In other words, what percentage of notebooks that ship today have analog modems in them and how do you see that going forward?

Christian Scherp

So the attach rate at the moment is healthy in the notebook space.

Allan Mishan - Oppenheimer & Co.

Can you care to throw a number out there or a range at least?

Christian Scherp

Well, it's certainly about 50%. It depends. You know, it's very difficult to say because it really depends a little bit on the manufacturer and then also on the skews. But it's certainly healthy, and that's certainly a trend we also see moving forward.

Operator

Your next question comes from Sandy Harrison - Signal Hill Group LLC.

Sandy Harrison - Signal Hill Group LLC

I can appreciate you guys are still kind of getting your hands around some of the acquisition stuff and what it looks like. I was just wondering if you could, for modeling beyond the September quarter, what you guys, when you say modest, is modest $1 million, $500,000, $2 million? You know, just trying to get an economies of scale. And then what a run rate business would be or what we could start to think about as we model out on a little bit longer term.

D. Scott Mercer

I think that, you know, we're not going to get specific. It's going to be a very modest revenue contribution. We literally just closed the transaction an hour before this call so, you know, we have people on the ground getting ready to go.

But that an acquisition, as I said in my remarks, which, you know, that was a product segment we were already participating in. We had a road map in that area. This acquisition really allowed us to pull in products which fit where we were going in our road map very well and accelerate our revenue growth in that area. We were going there in any event. This will just accelerate our participation.

Sandy Harrison - Signal Hill Group LLC

And then as you look at lining this up and some of the other products that you've got and as you define what the company's going to look like going forward, do you think you've got enough of the product sort of in the pipeline that you need or is there some other investment in R&D? I guess that kind of [links up] with the prior question. Is there any additional R&D that you guys could see coming up on a more strategic basis which would cause R&D to spike up or to move forward, or do you think you're sort of in position and now it's simply continuing to execute on what you've got laid out there?

D. Scott Mercer

I think it's a combination of both. Let me explain that a minute.

I think that if you look at our organic R&D, you know, you won't see great expansion there. We have very robust roadmaps in many of our product segments that we're pretty happy with, and we're real happy with our execution in most of the businesses right now.

Where you will see some increases in R&D and we're constantly on the lookout for augmenting our product portfolio, either in adjacencies or places we can accelerate growth, and so you will see us be looking to bolt on other businesses and engineering teams that will come along with them.

So that's where you'd see R&D growth going forward.

Sandy Harrison - Signal Hill Group LLC

Outside of any seasonal impacts that are going to come and go, is there any other events that you guys could see taking place that would sort of add to or we should be thinking of as far as when we start modeling out longer term?

D. Scott Mercer

Well, I think just generically. There was nothing to mention on the call; we only give guidance a quarter at a time. Every management team around the world is constantly looking at the overall economic conditions and the consumer spending drive, and we're driven a lot by consumer spending. So we're cautiously optimistic, but we continue to keep our eyes on that.

Operator

Your next question comes from Blayne Curtis - Jefferies & Co.

Blayne Curtis - Jefferies & Co.

Christian, you talked about strength in PC. I just want to make sure that was modems as well as audio that you were referencing?

Christian Scherp

That is correct.

Blayne Curtis - Jefferies & Co.

And then going forward, can you talk about the drivers within imaging? And I wondering if you can quantify PC modems as a rough percent of the mix - you've done that before - and kind of how you replace that revenue with the growth drivers.

Christian Scherp

Yes. So to your first part of the question, Blayne, certainly the strength in the PC segment, and particularly in the notebook segment, is driving for us audio business as well as modem business. So you're absolutely correct there.

Then with respect to our modem business overall. As we talked about, our modem business makes up about roughly 20% of - our PC modem business makes up about 20% of our IPM business overall. And we see overall certainty strength and additional opportunity for us in the imaging segment, particularly here with the acquisition of the SigmaTel MFP and digital photo framing business.

Blayne Curtis - Jefferies & Co.

And then just, to that point, the SigmaTel acquisition, can you talk about the timing of design cycles? I believe they're fairly lengthy. And the strategy is to sell the SigmaTel product. Is there any integration strategy or how shall we think of the timing as you go after new design wins there?

Christian Scherp

You're absolutely correct, so design-in cycles and then MFP platforms, I would say about two quarters longer than, for example, in the PC space.

Now what you have to consider is that the SigmaTel team is very successful at the moment by not only shipping revenue but also, you know, winning designs on an ongoing basis. So some of those designs will ramp over the next couple of quarters, obviously.

We started the integration process literally today, as Scott mentioned. The deal just closed literally, you know, an hour before this call today, but we are obviously very focused on integrating that business and making it a substantial part of our imaging business moving forward.

Blayne Curtis - Jefferies & Co.

And then if you look at your guidance, it looks like you're guiding OPEX of a few million dollars, spending the majority of that for the acquisition. Can you talk about particularly the photo frame business, whether you're keeping that, whether there's any cost reductions you could do, and just talk about how you can drive OPEX with that acquisition.

And then, Karen, just in general, whether there's still some long-term opportunities out there as you kind of consolidate facilities and that sort of thing.

Christian Scherp

So let me comment quickly on the photo framing business, and then I will hand over to Karen to answer your part on the OPEX question.

We are committed in driving up the business in the digital photo framing business. We believe this is a very exciting market segment, a market segment that is targeted to grow more than 50% over the next several years. And we have very exciting products on our road map here.

Now on OPEX?

D. Scott Mercer

Let me just comment overall on that. We're doing a lot of benchmarking these days, and we made a lot of progress over the last quarters on the OPEX front. As Karen mentioned, we're obviously going to continue to be diligent in that, but the long-term solution here as we see this, from our analysis we're getting relatively competitive to the rest of our peer set on the OPEX side. The real growth that we're focusing on here is building the top line, building the gross margin dollars and percentage, and increasing [OPIC]. And that will take, as we bolt on additional R&D, etc., some additional OPEX to get there, but we're focusing on the total P&L at this point.

Operator

Your next question comes from Sanjay Devgan - Morgan Stanley.

Sanjay Devgan - Morgan Stanley

Just a quick question regarding your broadband access business. First off I was wondering if you can kind of give us from a general sense how you're kind of seeing the business, particularly in Asia, if you could just give us some commentary around that.

And then I guess as a follow up, specifically, if you're talking VDSL, there are two major deployments, I guess, currently in the world today, one in North America and one in Japan. You're obviously entrenched in North America, but as you look at the Japanese market, I was wondering if you can talk about the opportunities there specifically and what you're doing to try to engage with the leading providers there?

Christian Scherp

Yes. So these markets in Asia, this is certainly one of the major markets, geographical major market segments for us. And we see continuously strength in the business in Asia, not only in deployments in Asia but also with our Asian manufacturers that then deploy in Europe, largely in Europe or in South America, for example.

Now the growth in Asia is not as strong anymore as it, let's say, used to be six months ago. But the business is certainly still, you know, from a pure port and CP unit point of view, is still growing from our perspective in that territory.

Now with regards to VDSL, you're absolutely correct. There are two large deployments. It's in North America with AT&T with us, and in Japan largely at NTT at the moment, which is with one of our competitors. Now what you really have to take into consideration is that, you know, the current deployments are really endtoend deployments meaning that, you know, if an operator engages, he will have to buy the central office and the consumer premise equipment from one vendor. So the current deployments and designs are from that perspective, certainly from my perspective, so to speak, locked in for us here in North America for the other supplier in Japan.

Now where things are interesting, of course, is in Europe. And at the moment, there are some deployments in Europe, for example, at Deutsche Telekom, but we are obviously working on those opportunities as we speak. But they are not in deployment; they are in field trial stages at the moment largely.

Operator

(Operator Instructions) Your next question comes from Eric Rubel - MTR Securities.

Eric Rubel - MTR Securities

Karen, you mentioned restricted cash movement during the quarter. Could you give some more color about that with respect to the certain vendor?

Karen Roscher

I'll give you a little bit there, Eric. I guess it's not surprising given the current macroeconomic situation that companies are looking at ways in which they can manage their financial positions, so we see this situation not really as a connection specific action but rather an action by one of our vendors to respond to this environment and what we're seeing right now.

So we expect as we go forward especially with the closure of the NXP transaction that this will be a short-term issue. And most importantly for us is that this will in no way impact our ability to run our business, fund our business and do the investments that we need to, as you saw from the SigmaTel acquisition that we closed today.

Eric Rubel - MTR Securities

So it's sort of related to inventory around the media processor business?

Karen Roscher

It's one of our major suppliers, yes.

Eric Rubel - MTR Securities

Then you also talked about bond repurchase in the quarter with proceeds. Can you give us a sense of how a transaction would roll out and timing?

Karen Roscher

Certainly. What we're thinking about at this point in time is that once we close the transaction here in August, pending our Board approval, we would come out with a tender offer at par to be concluded within this quarter.

Eric Rubel - MTR Securities

If I could review for a minute any other potential asset sales that you might be able to - could you update us on where you might be with any other asset sales? I was thinking particularly in reference to the wireless LAN assets.

D. Scott Mercer

Nothing more to discuss at this point on that, Eric.

Eric Rubel - MTR Securities

Then could you discuss the purchase price for the Freescale SigmaTel acquisition?

D. Scott Mercer

Yes. That was $16 million, Eric.

Eric Rubel - MTR Securities

And do you have information on what the revenue run rate for that business was over the last 12 months?

D. Scott Mercer

Of course we do.

Eric Rubel - MTR Securities

Sorry. Could you share it with us?

D. Scott Mercer

No.

Eric Rubel - MTR Securities

Then one last question and I'll go. The guidance for the quarter, it assumes some of the SigmaTel business. If you were to have a whole quarter of SigmaTel, can you tell us what the OPEX associated with those 50 engineers would be?

D. Scott Mercer

I'll just tell you that this quarter they won't - this quarter being the fourth quarter, we'll end up - they will not contribute to earnings this quarter. They'll be slight drag on earnings.

Operator

There are no further questions in queue.

Karen Roscher

That concludes our conference call today. We look forward to updating you on our performance again next quarter.

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Source: Conexant Systems, Inc. F3Q08 (Qtr End 06/27/08) Earnings Call Transcript
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