International Rectifier's CEO Discusses F1Q13 Results - Earnings Call Transcript

Nov. 1.12 | About: International Rectifier (IRF)

International Rectifier Corporation (NYSE:IRF)

F1Q13 Earnings Call

November 1, 2012 5:00 PM ET

Executives

Chris Toth – IR

Ilan Daskal – EVP and CFO

Oleg Khaykin – President and CEO

Analysts

David Wong – Wells Fargo

Bill Ong – B Riley & Company

Mark Delaney – Goldman Sachs

Chris – FBR

Ramesh Misra – National Securities

Terence Whalen – Citi

Stephen Chin – UBS

Steve Smigie – Raymond James

Alex Gauna – JMP Securities

Operator

Good afternoon. My name is Madison and I will be your conference operator today. At this time, I would like to welcome everyone to the International Rectifier First Quarter Fiscal Year 2013 Results Conference Call. All lines have been placed on mute to prevent any background noise. After the speakers’ remarks, there will be a question-and-answer session. (Operator Instructions) Thank you.

Mr. Chris Toth, you may begin your call.

Chris Toth

Thank you, Madison. Hello and good afternoon. We all welcome you to the International Rectifier conference call. On the call today are Chief Executive Officer Oleg Khaykin and Chief Financial Officer Ilan Daskal. I trust you’ve all seen copies of our press release, which was published about an hour ago. If not, the press release can be found on our website at investor.irf.com in the Investor Relations section.

Before we begin, I would like to remind you that except for historical information the matters that we will be describing this afternoon will be forward-looking statements that are dependent upon certain risks and uncertainties, including factors such as orders received and shipped during the quarter, the timing and introduction of new technologies and products, general semiconductor industry conditions, and the overall economy and financial markets. In addition to these risks, we refer you to the risk factors included in our press release that we issued about an hour ago and in our most recent SEC filings.

I would also like to mention that in addition to reporting our GAAP financial results, we began presenting supplemental non-GAAP financial data. A reconciliation of the non-GAAP to GAAP measures set out in our release and in our discussion today can be found in our press release and on our website. We believe providing non-GAAP measures combined with our GAAP results provides a more meaningful representation regarding the company’s operational performance. Our non-GAAP presentation and EPS calculations exclude certain items such as restructuring and severance charges, amortization of acquisition-related intangibles, and certain discrete tax items, among others.

Our non-GAAP presentation and EPS calculation include stock-based compensation expense. We also began publishing a table that includes our stock-based compensation as allocated to our cost of sales, R&D, and SG&A.

Lastly, I would like to highlight the following upcoming events. On Wednesday, November 7, we are planning to attend the 2012 Wells Fargo Technology, Media and Telecom Conference in New York. And on Tuesday, November 27, we will be attending the 2012 Credit Suisse Technology Conference in Scottsdale, Arizona.

Now Ilan will discuss our most recent financials. Ilan?

Ilan Daskal

Thank you, Chris. Good afternoon and thank you all for joining us. For the first quarter of fiscal 2013, IR reported a revenue of $252.5 million, which was a 6.4% decrease from the prior quarter and a 16.6% decrease from a year ago. IP revenue was $2.1 million in the quarter, and included a one-time patent sale of $1.7 million.

Gross margin on a GAAP basis was 27.9%. Non-GAAP gross margin was 28.3% and excluded $500,000 of accelerated depreciation and $400,000 of inventory write-offs associated with the closure of our El Segundo facility. Overall, the GAAP net loss was $28.8 million, or $0.42 per fully diluted share for the quarter. This compares with a GAAP net loss of $68.2 million, or $0.99 per fully diluted share in the prior quarter, and a GAAP net income of $22 million, or $0.31 per fully diluted share in the prior-year quarter.

Non-GAAP net loss was $13.9 million, or $0.20 per fully diluted share for the quarter. The non-GAAP net loss excluded $500,000 of accelerated depreciation, $400,000 of inventory write-offs associated with the closure of our El Segundo facility, $9 million of severance payments, amortization of intangibles of $1.7 million, and a net tax charge of $3.3 million. This compares with a non-GAAP net loss of $10.5 million, or $0.15 per fully diluted share in the June quarter, and a non-GAAP net income of $25.4 million, or $0.36 per fully diluted share in the September quarter of last year.

Moving on to our operating expenses. For the September quarter, R&D expenses were $33.4 million, which represented 13.2% of revenue. SG&A expenses were $47.3 million and represented 18.7% of revenue. The reduction in SG&A and R&D expenses from the prior quarter was the result of actions to reduce our fixed costs. Amortization of acquisition-related intangibles was $1.7 million.

During the quarter we recorded $9 million in severance charges. These charges appear in the asset impairment restructuring and other charges line item on the income statement. GAAP tax for the quarter was a $7 million expense, partly as a result of a deferred tax provision of $3.3 million. Excluding this discrete item and adjusting for net tax effects on one-time items, our non-GAAP tax expense for the quarter was $3.7 million, mainly due to foreign tax accruals.

Turning to the balance sheet. Total cash, cash equivalents, and investments were $367 million at the end of the first quarter, which included $1.6 million of restricted cash. Last week we entered into a $100 million senior unsecured credit facility. Our cash position remains strong and at this time we have no plans to draw on the facility. The rates were very attractive for an unsecured facility and provide us with further financial flexibility to increase our capital structure efficiency.

During the quarter, inventory decreased by $11.2 million to $283.5 million. Weeks of inventory increased slightly to 20 weeks due to the lower revenue. In the September quarter, we generated $6.5 million in cash from operating activities. Cash capital expenditures for the quarter were $22 million or about 8.7% of revenue.

Free cash flow was negative $15.4 million. Depreciation and amortization expense was $22.7 million, and stock-based compensation was $5.7 million. During the quarter, we purchased about 300,000 shares of our stock at a total cost of $5.2 million. We are currently at about 69.1 million shares outstanding.

Now moving on to our outlook. We currently expect revenue for the December quarter to be between $215 million and $230 million. For this projected revenue range, we currently estimate gross margin to be between 22% and 23%, primarily due to low factory utilization in the December quarter and revenue mix.

We expect R&D expenses to be between $32 million and $33 million. SG&A expenses are expected to be about $46 million. Amortization of fixed acquisition-related intangibles is expected to be about $1.7 million.

For the December quarter, we expect approximately $2 million to $3 million in restructuring and other charges resulting from the resizing of our manufacturing facilities and other cost reduction efforts. Other expense net is expected to be about $1.5 million.

GAAP tax for the quarter is expected to be between $2 million to $3 million benefit as a result of a release of tax reserves of approximately $4 million to $5 million. Excluding this discrete item, our non-GAAP tax expense for the quarter is expected to be about $2 million, mainly due to foreign tax accruals.

And finally, for the December quarter, we expect our cash capital expenditures to be about $24 million. Capital expenditures are expected to be about 10% of revenue for the full fiscal year.

Now, Oleg will give you the latest update on our business. Oleg?

Oleg Khaykin

Thank you, Ilan. Though we executed well in the September quarter and relative to our guidance, end market demand has continued to weaken. In view of these uncertainties, OEMs and distributors remained hesitant to restock inventory despite being at relatively low levels.

As such, orders in December quarter have not shown signs of improvement, and we expect a challenging quarter. We understand the headwinds we are facing, and we are taking decisive actions to address the situation.

To accelerate the return to profitability, we initiated operational restructuring to reduce our fixed cost base and reduce operating expenses. I will cover the progress of those activities in greater detail shortly after the review of our September quarter results.

Geographically, demand in Asia was relatively strong in both high-performance computing and automotive. However, that strength was more than offset by significant weakness in the appliance and industrial end markets, as customers continued to work down their finished goods inventories in the face of lower end-market demand.

The Americas remained stable. Automotive was slightly up and the industrial end-market was slightly down, as customers continued to reduce inventories. Europe continued to be weak, running well below normal levels due to weak industrial demand. And finally, Japan decreased significantly across both the industrial and appliance end-markets. Many of these products are sold into China and are feeling the effects of the Chinese slowdown.

Moving on to our business units. The enterprise power business unit revenue increased 13% to $37.8 million, in line with our expectations for strong seasonal growth. Growth has been driven by strength in high computing – high-performance computing and server markets.

For the December quarter, however, even with the recent share gains, we are unable to offset the overall weakness in the computing market and expect enterprise power revenue to decline significantly.

Our power management devices business unit decreased 12% from the prior quarter. The decrease was mainly due to weak demand in the industrial and high volume consumer and computing end markets. We currently expect this trend to continue into the December quarter.

Our energy-saving products business unit revenue decreased 13% compared to the June quarter. Overall demand continues to remain very weak, mainly as a result of high level of finished goods inventories and slow consumer demand in the appliance end markets, particularly in China.

For the December quarter energy-saving products revenue is expected to continue to decline. Our current expectation is that China demand is bottoming out and would likely start to recover somewhat after the Chinese New Year, boosted by depletion of inventories and seasonal strength and appliance build. Our automotive products business unit revenue decreased 1% from the prior quarter, mainly due to seasonal – normal seasonality. Design win activity remains robust, particularly in our latest automotive IGBTs.

We continue to see design wins in hybrid and electric vehicles, where our technology is used in electric powertrain components. For the December quarter we expect automotive to be slightly down, mainly as a result of weakness in Europe and holiday shutdowns. Although the overall automotive demand is declining in Europe, we expect the drop to be somewhat offset by the continued ramp of our new products. Lastly, our HiRel business unit decreased 4% compared to the June quarter, in line with our expectations.

For December we expect revenue to remain stable; however, gross margin is expected to be lower over the next two quarters due to sales of higher-cost inventory and product mix. Overall, bookings and our backlog continue to be strong for all of our HiRel market segments. And we continue to see steady growth – steady, slow growth in our business, with margins in the 50% plus level over the long run.

Now an update on channel inventories. During the September quarter POS decreased 8% compared to the June quarter. Sell-in versus sell-through during the September quarter was about in equilibrium, and channel inventory increased to 12.5 weeks. While elevated on a weekly basis, total channel inventory dollars remain low. In the September quarter we took active measures to mitigate – to manage the trade-off between utilization and inventories.

As a result, we lowered utilization and were able to reduce our inventories even in the face of declining revenues. In December, we will continue to manage the balance between factory utilization and inventory reduction. As part of that effort we are planning to run our factories at their lowest utilization levels since March 2009, and expect these inventory reduction efforts to weigh in on our gross margins.

At this point, I would like to turn to the operating restructuring activities that are focused on reducing our fixed costs and operating expenses with the short-term goal of returning to profitability. On the manufacturing side, the closure of our El Segundo fab is on schedule and is expected to be completed by the end of the March quarter in 2013. Upon completion we expect to save approximately $10 million per year. The resizing of our Newport, Wales, fab remains on schedule.

The actions associated with this facility are expected to come in two phases and save a total of $16 million per year when completed. We expect the first phase to be implemented by the June quarter in 2013, resulting in annualized savings of approximately $5 million. The remainder of this six-inch fab is expected to close by the middle of calendar 2015, resulting in additional annualized savings of approximately $11 million.

We also launched measures to refocus and streamline our backend operations. This includes increasing the amount of industry-standard products we outsource for assembly, and focusing internally on automotive and proprietary packages. With these restructuring actions, our internal capacity should be able to produce about $850 million per year, depending on mix.

Coupled with qualification and our additional technologies at our foundry partners, we expect to scale our long-term manufacturing model up to 50% external sourcing on the front end and 70% on the assembly and test. Doing so will allow us to effectively scale our business during an up cycle and significantly reduce the downward margin pressure during a down cycle.

Moving onto our SG&A and R&D cost reduction measures, given the continued weak demand we are taking further actions to reduce SG&A and R&D by an additional $20 million per year. By June quarter of 2013 we expect to be at approximately $75 million in quarterly SG&A and R&D expenses. When compared to our run rate exiting our fiscal 2012, we now expect to save approximately $40 million in SG&A and R&D expenses on an annualized basis when our options are completed.

In addition, we are taking necessary short-term measures to curtail spending and limit the impact of lower revenues. These measures include fab and office shutdowns around the holidays and other variable expense controls. In conjunction with the reduction of our operating expenses, we have re-prioritized our R&D to focus on core technology platforms with product launch time frames over the next 12 months.

These platforms include first Digital Power Management, as we continue to deepen our penetration in high performance computing and server end markets, including low-power systems.

Second, high-voltage IGBTs for products in the automotive, industrial and appliance end markets. While appliance and industrial goods are currently depressed, we continue to believe in the secular trend towards energy-efficient variable speed motors, and we believe that that trend remains intact. Penetration rates remain low, and as such we believe the market opportunity continues to warrant ongoing investment.

Third, next-generation low-voltage MOSFETs. IR is currently the market leader in the MOSFETs, and we intend to continue leading the market with the next-generation technologies. Lastly, gallium nitride, as we prepare to rollout our 600-volt products that will allow IR to re-enter the high-voltage switch market.

We believe streamlining our research and development will not jeopardize our near-term ability to innovate or deliver products in a timely manner and will drive our profitability over the long term. In summary, we are facing the challenges in the markets head-on.

We are streamlining our business, following through on options to decrease our inventories and reducing our fixed cost base. We believe these actions will position the company to be capable of achieving a breakeven level at about $240 million in steady-state quarterly revenue and positioning us for sustainable, long-term growth.

This concludes our prepared remarks and we will now open the session to your questions. Operator?

Question-and-Answer Session

Operator

(Operator Instructions) And your first question comes from the line of David Wong.

David Wong – Wells Fargo

Thank you very much. When you said that you expect to emphasize certain R&D projects, can you tell us which R&D projects you are actually going to be pulling out of or de-emphasizing?

Oleg Khaykin

We do not disclose the particulars, but effectively all projects with a revenue timeline time to market that is more than 12 months are going to be pushed out or put on a slower burn rate. And any project technologies with the time to market within 12 months will be either kept on schedule or accelerated. And that mainly includes our MOSFET and IGBT platforms.

David Wong – Wells Fargo

Great. And do you have a minimum cash level on your balance sheet that you expect to maintain over the next several quarters?

Ilan Daskal

So, David, generally speaking, we continue to support our capital allocation model and on a high-level one quarter – equal to one quarter of revenue. That is the minimum level that we will continue to maintain.

David Wong – Wells Fargo

Great, thank you very much.

Operator

And your next question comes from the line of Bill Ong with B Riley & Co.

Bill Ong – B Riley & Company

Yes, good afternoon, gentlemen. Just looking at the automotive business, that business has been fairly steady for the last two years, $25 million to $32 million per quarter. Your margins have been fairly steady, 27% to 32%. The last few quarters it has been down, so can you maybe give – offer some analysis of the gross margins being hit, and then how should the gross margins be on a long-term basis when it starts to stabilize?

Oleg Khaykin

Thank you, Bill. Well, automotive business, both of their silicon and backend operations are largely internal to IR. And as a result when you take down the utilization of the fabs and backend operations they get a significantly greater drag on their margins due to the variances in the factories. So the margins that you see, segment margins, do not really reflect the business fundamentals. Our automotive business unit at fully loaded factory run rates is in the low 30% gross margin. And over time as we cycle out of a lot of legacy products and replace them with the new products, we are moving margins towards the high 30% gross margin.

Bill Ong – B Riley & Company

Great, that’s helpful. And then my last question is as you manage down your inventory levels, as well as low wafer starts, do you have an opportunity for the March quarter to be maybe seasonally better because of how you’re taking things down so aggressively in the December quarter?

Oleg Khaykin

Well, I mean, absolutely, but I guess it largely depends on how the March quarter is going to shape up, because even at today, let’s say, $250 million, $240 million, $230 million revenue run rate, if we were in the perfect mix of inventories, right, just purely supporting that level of revenue, our factories would be running at fairly high-level utilization. And with a further operational footprint restructuring, that would make it even easier. So, I guess, it’s really the question comes in is what is going to happen in March quarter.

As you can imagine, it is always much more challenging to burn off your inventories when your quarter-to-quarter revenue declines. Obviously, when your quarter-to-quarter revenue goes up you get a double wind in your sales. On one hand, your inventory velocity increases dramatically, and on the other hand you scale up your factory utilization at a much greater rate that increases your absorption. So on the way down, you get a double whammy; on the way up, you get a double positive.

Bill Ong – B Riley & Company

Great, that’s helpful. Thank you very much.

Oleg Khaykin

Sure.

Operator

And your next question comes from the line of James Schneider with Goldman Sachs.

Mark Delaney – Goldman Sachs

Yeah, hi. It’s Mark Delaney calling on behalf of Jim Schneider. Thanks very much for taking the question. I was hoping, first, you guys could elaborate a little bit more on your comments about orders not having improved. Is it just that they are not improving but they’ve stabilized, or are they continuing to decline?

Oleg Khaykin

Well, we kind of track orders. I mean, the orders, when you start – we usually start tracking the following quarter at minus 90 days to the beginning of the quarter, so three months in advance. So the orders have been moving up, but not at the rate where we would feel comfortable to give higher revenue guidance. So it’s not – I would not say the orders have been decreasing, they just kind of started low, and they are making their way up, but they have not closed the gap with the prior quarter.

Mark Delaney – Goldman Sachs

Understood. Thank you. As my second question, can you detail how much industry pricing pressure is impacting your gross margins? I know you talked about lower utilizations being one of the primary drivers. I was hoping you could quantify the amount that pricing is having?

Oleg Khaykin

Well, I think, clearly, the spot market pricing is very volatile. And it is mainly impacting the standard products like MOSFETs, where you have – it is almost an option. You have multiple OEMs. They say: I need so many million units over the next three months, and there is, maybe a handful of qualified sources, and you have to decide on a case-by-case basis how much of the rebate or discount you extend.

So I would say you are probably seeing on the MOSFETs anywhere between 2% to 5% rebate. But I wouldn’t say the prices are just dropping on a sustainable basis. It’s really much more on a very short-term contract for, like, one to two to three months outlook. And it is all done very much on a POS basis. We are not really dealing with the brokers or middlemen. We deal directly with the OEMs. And we tell them, say, okay, for this much product consumption over this many quarters here is the rebate that you would get. But it absolutely does not guarantee them a reset in pricing or anything like that going forward.

Mark Delaney – Goldman Sachs

Great. Thank you.

Chris Toth

Thank you.

Operator

And your next question comes from the line of Craig Berger with FBR.

Chris – FBR

This is Chris, in for Craig. Thanks for taking the question. So really quickly, given your guidance, how should we really think about inventories in terms of dollars for next quarter, and how does that sort of progress through calendar 2013? Thanks.

Oleg Khaykin

Well, I mean, we expect during this quarter to continue to work down the inventory and, obviously, it will ultimately depend how much – where the revenue comes in this quarter, but our intent is to do so. And if you think about it, it is much more challenging to reduce your inventory if your quarter-to-quarter revenue is dropping, because then it means you have to take your production by a significantly greater rate down than the drop.

So that is why we are taking our factories to the levels of utilization that have been the lowest since the March quarter of 2009 to maintain the inventory burn. In many segments we are now at the point where the inventory levels are, I would call, normalized. And the only area where we still have excess inventory is in the more of the appliances and industrial products, where the revenues have dropped significantly. That said, any kind of uptick in those markets will pretty much burn off all the inventories pretty quickly.

Ilan Daskal

So, Chris, overall we continue to balance between the inventory burn and the utilization rates. As the market recovers, we will be able obviously to burn a higher level of that excess inventory.

Chris – FBR

Okay, all right. On the China and the ESP segment, what gives you guys – you guys talked a little bit about Chinese New Year and that being a bottom. What gives you guys confidence there? I know there is some seasonality coming out of that, but other than that, what are you sort of hearing there and why do you have confidence that that is actually the end of the bleed? Thanks.

Ilan Daskal

Well, we are in constant contact with our major customers and we’ve been monitoring their finished goods inventories, and little by little – they have taken a lot of bitter medicine in the past nine months or so and slowed down any kind of builds and been burning off inventory.

And coming out of the Chinese New Year, usually most of the appliance – especially air-conditioning builds take place in the February, March, April timeframe, in time to be able to have those products on the shelf at the retail. So from where we are right now – and there is also, obviously, talk of Chinese government providing additional stimulus to spur the domestic consumption upon the change of the government – gives us encouraging outlook that things will improve after the beginning of the year.

Also, as you have probably seen, the most recent China PMI index was for the first time above 50 in – I think it was in last five, six quarters, which is a quite significant outlook for us. It finally seems like it’s going in the – starting to go in the opposite direction.

Chris – FBR

Great, thank you.

Operator

Your next question comes from the line of Ramesh Misra, National Securities.

Ramesh Misra – National Securities

Hi, good afternoon, gentlemen. If this weak macro conditions kind of continue for the next few quarters, in terms of your product portfolio currently and expected product rollouts, which segments do you expect, Oleg, to potentially outperform for IR?

Oleg Khaykin

In the view of near-term visibility, I would kind of – I was going to say being flat is kind of the new growth, right? So in that respect the automotive and HiRel business units are relatively more stable than the other businesses, right? That said, I always kind of think back to the – 2009, and one area where we see an immediate snapback should any kind of market recovery start to materialize is our discrete business unit.

So as much as it kind of has been going up and down, and if you really look over the last few quarters, it dropped a lot and it spiked a lot. It’s very much probably the best indicator for the real-time market velocity. That is one business unit that to the extent market starts to pick up, we will probably see the biggest short-term snapback. And I would say that will be followed by the computing and enterprise. And I think generally the industrial and appliance recovery takes a bit more, because of their longer supply chains where they have to order steel, the motors, compressors, and things like that. So those take a little bit longer to pick up, but I would say discretes and computing usually will be the first ones to snap back, and automotive and HiRel – they kind of remain fairly steady.

Ramesh Misra – National Securities

Okay. In regards to product areas, and gaps in particular in your product portfolio, would you be using this slowdown to focus on those, and can you say what those might be?

Oleg Khaykin

Well, I think I wouldn’t say we have major gaps in our portfolio. I think I would say probably more likely there is maybe a timing of – like, for example, you have a system solution composed of, say, three chips, and two of them are out and one is behind. That’s kind of more likely the situation we are trying to address to really accelerate some of the products that complement one another. And, if anything, what we are trying to do is accelerate the refresh rate of our products that are currently driving the bulk of the growth in design wins.

Ramesh Misra – National Securities

Okay, all right, thanks very much.

Operator

And your next question comes from the line of Terence Whalen with Citi.

Terence Whalen – Citi

Hi, thanks for taking the question. This one relates to – as we think about free cash flow over the next several quarters, what is your outlook for tangible book value over the next several quarters? Thank you.

Oleg Khaykin

Sorry, could you repeat your question? As you look at the free cash flows over the next few quarters what is the tangible book value?

Terence Whalen – Citi

Yes, so what I am trying to understand, Oleg or Ilan, is it seems like the stock is being valued near tangible book value. And I’m just trying to understand as we think about the current state of the balance sheet and expectations over the next several quarters, where do you anticipate tangible book value for the stock being over the next couple of quarters? Thank you.

Oleg Khaykin

It is kind of hard. I wish I could predict where the market is going to go. I would probably not – I’m not the best expert on valuations or predictions, but just looking where we are coming out, clearly we are going to have an operating loss with lower utilization and lower revenue and lower margins. That said, we have obviously depreciation and the stock-based compensation that you add back. And one thing we have done is significantly scaled back or pushed out CapEx expenditures. So I expect our cash to come down over the next couple of quarters, but probably not that significantly. Aside from that, we are not planning to write-off or impair any significant assets beyond what we have already announced.

Ilan Daskal

And, Terence, I would add, obviously, as Oleg mentioned, we cannot predict, obviously, the share price, but we do know and we do look into the leverage that we see in the recovery in terms of our gross margin expansion. And it all depends how robust is going to be the recovery and how soon is it going to be, right? And that is probably the key factor here in terms of the tangible asset book value of the company on the balance sheet. So I would say that from here to correlate it directly to the share price is a little bit difficult.

Oleg Khaykin

Yeah. And in terms of the losses, Terence, you got to look at the – our gross margin utilization, I mean, a lot of it is very much by design. We are keeping our factories running at below their – what would be normal level of utilization for them to burn off inventory rather than keep building excess inventory. So once we achieve this burn and take the utilization back to sustainable level, we should see a very nice leverage on our gross margins and operating margins come on from that. And to the extent revenue starts to go in the other direction, that impact will be even more severe.

Terence Whalen – Citi

That’s very helpful to hear that. My follow-up question is regarding the comment that you made, Oleg, that flat is the new growth. And I definitely understand the origin of that sentiment. And I guess my question for you is: do you feel like the business is appropriately structured for revenue growth, or are there areas that you don’t have exposure to that you need to gain exposure to, to face the sort of new reality of what growth will – what will constitute growth over the next several years? And then I have one last follow-up after that. Thanks.

Oleg Khaykin

Okay, Terence. So I think – let me kind of qualify it. If flat is the new growth, I would say within the timeframe of this quarter is what I’m saying, right? Clearly, I mean, from our perspective we see a lot of growth potential in all of our businesses, even in the one ESP that’s been really pummeled the most. If I look at the new products that we rolled out, such as micro IPM module that takes us into the high-volume industrial segments below kind of 6-ampere range. We actually significantly expanded our market TAM with these products. So to the extent the traditional market starts to recover in combination with our new design wins and new products that address a broader industrial market for fans and motors, we are going to see a pretty nice growth leverage in those markets.

So in terms of the growth leverage going forward, I feel we are in very good position with our current products and technologies. Clearly, I wish we had mobile RF products, because that seems to be the only segment that’s doing well, but that’s not really part of IR’s DNA. We are very much a power semiconductor company, and we do not have smartphone or products of that nature that obviously seem to be faring a lot better in over the last past quarters. But the markets where we are in, I mean, those are the markets that – products and markets that are here to stay. I mean, everybody needs electrical appliances; everybody needs power management; and everybody needs power efficiency. So in that respect I don’t think there is a change in our long-term investment thesis.

Ilan Daskal

And Terence, we continue to focus on the same end markets that we serve. And we target to grow one cycle over the other, and not to try to sweep from one end market to another within the cycle in order just to sustain a certain level. We try to continue to grow within the same end markets that we’re always focused on.

Oleg Khaykin

I mean our approach is if the competition gets tough, we go out and kill the competition. We don’t run to another segment.

Terence Whalen – Citi

Okay. That’s crystal clear. My last question would be in terms of profitability, despite some of the restructuring initiatives, profitability is still going to be pressured. And I think some critics would say maybe this is too small an adjustment or too late. I want to understand how you view that. Do you view you being a little bit later on the restructuring side as maybe what was warranted? And perhaps prospectively to some investors who would potentially like more cost savings, how will you address and balance out those concerns? Thank you.

Oleg Khaykin

I think when I look at it, first and foremost, I look at the structural change to the business, right? And you say, well – I mean, first of all, shutting down a fab or a resizing operation is not a trivial matter, because it actually generates 12 to 18 months of a lot of additional work that you need to do to transfer the products, transfer the technology, and downsizing the operations and things like that. There is only so much an operation can take on before the therapy kills the patient.

That said, when I look at it is I don’t look at my profitability on any given quarter as the absolute. Because I also have to keep in mind that I have inventory burn that I got to execute on. And if I adjust for the inventory burn I have to look at my cost structure as to where would it be had I been running steady-state at the current – at the revenues I have. When I look at that, if I did not have the additional inventories that I got to work off, my factories would actually be running at fairly high level utilization; and at revenue levels like $250 million, we would actually be in the profitability range.

And, as I said earlier, with our measures that we are implementing now, we are looking to take down our breakeven levels to be about $240 million, you know, be capable of running at $240 million revenue as a breakeven point.

Clearly, if things go down, we have a repeat of 2008 or 2009 for a prolonged period of time, then you got to look at much bigger shutdowns. And of course there you have to take much more extreme measures, which obviously will very much change the picture of the Company.

Terence Whalen – Citi

Okay, terrific. Thank you so much.

Chris Toth

Thank you, Terence.

Operator

And your next question comes from the line of Stephen Chin with UBS.

Stephen Chin – UBS

Hi, thanks for taking my questions. The first question is how was linearity in the quarter?

Bill Ong – B Riley & Company

How is what? Stephen, can you repeat it please?

Stephen Chin – UBS

Yes, how is demand linearity during the quarter?

Oleg Khaykin

Demand linearity in our third-quarter? Actually, it was surprisingly linear. One thing that I was encouraged by is actually – normally, you start seeing demand flattening out with one month to go. And we were pleasantly surprised that it is continued through the month of September, which tells me that everybody is very much reacting to – in real-time to the orders that they are receiving.

So in that respect, we have not seen any kind of push-out or massive cancellations that we have seen in the prior quarters, which leads me to believe that most of the OEMs and distributors have reached their equilibrium and they are purely reacting – they are purely in the reactive mode towards their customers’ demand.

Stephen Chin – UBS

Okay. That is helpful.

Oleg Khaykin

Except they are very cautious about getting ahead.

Stephen Chin – UBS

Yes, I completely understand. The other question I had was for your enterprise power segment, you mentioned that there was some element of share gains that helped you in Q3. And I just wanted to better understand the Q4 guidance for down significantly. Is there some reversal of the share gains or is it just inventory digestion or is it seasonality that is leading to the big step-down in enterprise power?

Oleg Khaykin

No. It just that a lot of it, especially PC manufacturers, I mean, their December demand is – just fell off the cliff. It’s very – they have done a lot of building in September and now it’s a lot of wait and see. And we have seen across the board a much lower level of demand. But also even if we see in some of the enterprise, they generally try to build the servers in the September quarter and then the sales generally tries to push them in the December quarter.

In fact, they probably generally pull in the orders from the March quarter to finalize their end of the year market-share positions. And that generally means that in the December quarter you have somewhat lower demand. And actually there is a general seasonality for computing and enterprise sector to be weaker in the fourth quarter. But I think this time around there is also a lot of weakness in the end-market demand that is weighing in on their decisions.

Stephen Chin – UBS

Okay. Got it. And just one last question, if I could. Just in regards to your plans for outsourcing front-end and also test assembly production, in terms of the 50% number you mentioned for front-end wafer production, generally speaking, like what is the gross margin profile for the products that you plan to push on to – down the outsourcing path?

Oleg Khaykin

Well, I mean, you got to look at it both ways. You got to look at the peak of the cycle, and you got to look at it at the trough of the cycle, right? So at the peak of the cycle, the spread between internal and external manufacturing is very little. It is plus/minus zero, maybe a little bit better on some products, a little bit worse on the others. The big difference comes in is that the weaker part of the cycle where you are sitting with a lot of underutilized capacity, and at that point your outsource capacity is purely variable cost. So you get a significant gross margin leverage in a down part of the cycle.

Stephen Chin – UBS

Perfect.

Oleg Khaykin

Does that answer your question?

Stephen Chin – UBS

Yes, it does. Thank you.

Chris Toth

Thanks, Steve.

Operator

And your next question comes from the line of Steve Smigie with Raymond James.

Steve Smigie – Raymond James

Thanks a lot. I just wanted to ask a question about your computing business, your business focused on power management for servers, and to the extent you’re pushing your notebook. You’re starting to see ARM make efforts to get more into notebooks and maybe ultimately even into servers. Can you talk about the extent to which you can transfer your existing power management platforms for server over to ARM solutions versus Intel or AMD solutions?

Oleg Khaykin

We actually have a very good digital power management solution for ARM-based servers. (Inaudible) in many ways we are fairly agnostic. We can reconfigure our products very easily to run with ARM versus Intel. The difference here is the ARM-based processors are mainly used for lighter computing loads like viewing pages or moving content. And really from our point of view – I mean, we love them all equally. Clearly Intel-based servers have higher content, because they are doing heavier lifting and they require more power. So for every Intel chipset we sell – still the same controller, but we sell more power stages. For ARM-based processor you generally require, still require the controller, but you will require fewer power stages as they require lower power for their type of applications. So for us it really doesn’t matter. It is really more going to be a mix of how much content per blade it is going to be.

Steve Smigie – Raymond James

Okay. And then could you talk a little bit with regard to gallium nitride, what the environment is for you in terms of intellectual property, what is the competitive environment like that? And I know you have a lawsuit you are pursuing there. Just update us from that perspective?

Oleg Khaykin

If you go to any IP experts or even a lot of our – a lot of companies who track IP position and you ask somebody – show me what does a gallium silicon IP looks like, I mean, IR I think today has by far the strongest position in the world in that respect. I mean there are some Japanese companies with some pretty good IP, but by and large – I mean – we have been working very diligently from the point of view of filing patents and protecting IP over the past four years to truly position IR as the not only market leader, but then would be the IP leader in that position. Because once the market starts to develop, you can rest assured that it will become a very litigious environment. And IR is committed to aggressively protecting its IP and enforcing its IP position.

So really our legal action that we are pursuing today is very much in line with our strategy to protect our IP position and reassert our rights and protect our intellectual property in the field of gallium silicon.

Steve Smigie – Raymond James

Okay, great. And then last question was just with regards to your aerospace/military business, can you talk about that a little bit in context of where the major growth areas are going to be going forward and what headwinds you see in that business near term?

Oleg Khaykin

Sorry, what are the major growth areas going forward?

Steve Smigie – Raymond James

Yes.

Oleg Khaykin

Yes, okay. So clearly from our perspective we are in several markets. Space is by far our biggest market. And our first and foremost growth driver there is to continue, expand our position in space products. And that is doing more integrated products, not just purely MOSFETs, but also expanding our modules, voltage regulators and other type of products in space applications.

What we also see as a very close adjacent market that in terms of the performance requirements very close to us is what they call a down-hole market which is the deep oil drilling, where you may not need the radiation hardening but you need exactly the same type of performance characteristics when it comes to hermiticity and high-temperature resistance. And so taking our capabilities and know-how from space, we see that as one of the most attractive – we call it a heavy-duty industrial segment for us to expand into.

And the third leg of our growth strategy is the medical type applications where we look at the high-reliability products that go into the implantable devices, such as defibrillators and other type of implantable medical devices.

Steve Smigie – Raymond James

Okay. I think we talked about this a little bit last quarter, but with regard to space, is there no risk of sequestration affecting that in terms of, there are obviously going to be military satellites, so to the extent there is budget cuts, would that affect you?

Oleg Khaykin

Well, I am less concerned about space with respect to sequestration, because the space projects are funded years in advance. All the components are generally bought ahead of time and then the satellite gets built. And the rocket and the launch window is secured against major deposits. So once the project is approved, it’s fully funded. Probably the area – if you do have a sequestration – is going to be much more with the kind of variable, I would say, more military conventional spending rather than launches.

Steve Smigie – Raymond James

Okay, great, thank you.

Oleg Khaykin

At least none of our customers, even though many of them have military businesses where they are worried, they really do not seem to be concerned about space.

Steve Smigie – Raymond James

Okay, thank you.

Chris Toth

Thanks, Steve.

Operator

And your next question comes from the line of Alex Gauna with JMP Securities.

Alex Gauna – JMP Securities

Good afternoon gentlemen. I was wondering, Oleg, you talked about some of the opportunities and being somewhat indifferent between x86 and ARM-based servers. I was wondering if we consider the 64-bit initiatives maybe out there for 2014, 2015, are there any programs that you can see being high-power enough that they are interesting or rival what Intel is doing in x86?

Oleg Khaykin

Well, it’s really probably a better question for the people who know a different architecture and can discuss technical architecture differences within the 32, 64 process. Clearly, 64-bit processor is a more powerful processor. And from our perspective in the end, it’s really largely indifferent, because the way the designer would look at it, depending on which processor they pick for their architecture, they’re going to say: hey, what is going to be my power budget?

And what that is basically going to determine is how many IR power stages they would need to put on the board. So if they have a lower-power design, they may put one or two or three or four. If it’s a high-power design they may go up to eight or more. So really from our perspective, we work with a designer and they basically tell us what budget they want and – power budget they want, and we tell them how many power stages – what kind of configuration for power management they need to put in.

And for us, our digital power controllers scale up and down with great ease between a few power stages to many power stages. So in that respect, we don’t worry so much. We have products that go into super computers which have a huge number of power stages and we have no issues handling them.

Alex Gauna – JMP Securities

So is it fair to say, if I am understanding you correctly, if an ARM-based 64-bit server is doing a similar workload to x86, you’re going to have an opportunity to have a similar number of power stages.

Oleg Khaykin

Well, absolutely, absolutely. I mean, to me it’s really a function of the – what the blade on that server is – what kind of application is it used for. And for kind of light loads that you would have relatively fewer power stages; for heavy loads, you have the Ferraris out there in terms of power management.

Alex Gauna – JMP Securities

Okay. And then, you made a comment about the RF market being the only market. It seems like it’s growing right now. I’m wondering, a similar question around what’s going on in mobile computing. The blurring of the lines between Ultrabooks and convertibles and tablets, are you finding that some of these tablet-type of form factors, ultra-mobiles, get more powerful? There are quad core, even ARM-based solutions out there. Are you starting to see some better or interesting opportunities for you there in the ultraportable category?

Oleg Khaykin

Well, I mean, we clearly see opportunities and we are taking our digital power controller portfolio down to the lower-power applications. And there it’s the same thing, right? I mean, it always will require a power controller. And then it’s going to be really a question does it need one power stage, two power stages or more, depending on the end-market application.

So, clearly, Ultrabooks targeted at a professional market for heavier duty processing will require more. Ultrabooks targeted at a lower kind of more e-mail, web browsing-type consumer space will probably require lower power. But to the extent you want to watch a video, it’s probably going to require more power.

Alex Gauna – JMP Securities

And so, are you starting to see some design wins or activity that’s getting interesting in that tablet type of a convertible form factor?

Oleg Khaykin

I would not say a tablet, but I would say the Ultrabook. Tablet is probably – our solution is still above the power threshold for tablet computers, but for Ultrabooks we actually see a number of opportunities where we are working with customers.

Alex Gauna – JMP Securities

Okay. One last one, if I could. You gave some great insights into what is going on at enterprise computing. I was wondering if you could do the same thing on the industrial side of the house? Is there still an environment of low visibility extending into next year, or do you think we can get some helpful Q1 seasonality on the industrial side, and maybe touch on China as well?

Oleg Khaykin

Well, I think the – when I think about industrial I think of two types – two markets: one is Europe, one is APAC, mainly China, right? So in Europe we have seen industrial demand drop quite significantly, because most of the European industrial goods are really the products that go into the capital goods equipment. And to the extent the economy slows down everybody stops – slows down their buying of capital goods, right?

Alex Gauna – JMP Securities

Right.

Oleg Khaykin

But that said, we actually see Europe as having somewhat stabilized. It is not really getting better; it is not getting worse. It’s kind of achieved its equilibrium run rate.

The area where we still see weakness is very much China, because most of the industrial demand in China is driven by appliances, as well as some of the infrastructure-type projects. And that is the area where we have seen significant decrease in demand.

That said, we have been monitoring and talking to our customers and clearly we have seen them working diligently over the last 12 months reducing inventories. And maybe it is just a lot of their wishful thinking on their side, but they all feel that next year should be a lot better than last year. And at least the only data point I have that points out in the near term is the most recent purchasing index – Purchasing Managers’ Index just came out that shows that for the first time being up a little bit above 50.

So I think time will tell. Clearly ask me that question at the end of January, early February, as we start seeing better picture developing early next year.

Alex Gauna – JMP Securities

Okay. Thanks so much.

Oleg Khaykin

I don’t want to speculate on the government changes and all the incentives, because it is purely going to be a speculation. I want to see the factual data to start coming out in form of orders.

Chris Toth

Thanks, Alex.

Alex Gauna – JMP Securities

That was helpful.

Operator

And our final question comes from the line of Bill Ong with B. Riley & Co.

Bill Ong – B Riley & Company

Just a follow-up housekeeping. What was the utilization rate in September quarter? It was 80% in June. And what was your internal inventory? I understand it was 19 weeks in June.

Ilan Daskal

So the inventory was about 20 weeks and the utilization was in the mid-60s and we project that utilization will be lower in December.

Bill Ong – B Riley & Company

Okay. Thanks so much.

Chris Toth

Thank you, Bill.

Operator

I will now turn the call back over to you, Oleg Khaykin, for closing remarks.

Oleg Khaykin

Thank you. Thank you all for joining us today, and we look forward to speaking with you in person over the next several weeks. Thank you.

Operator

And this does conclude today’s conference call. You may now disconnect.

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