Diodes Incorporated CEO Discusses Q2 2012 Results - Earnings Call Transcript

| About: Diodes Incorporated (DIOD)

Diodes Incorporated (NASDAQ:DIOD)

Q22012 Earnings Call

August 8, 2012 5:00 pm ET

Executives

Leanne Sievers - Executive Vice President of Investor Relations, Shelton Group

Dr. Keh-Shew Lu - President and Chief Executive Officer

Richard White - Chief Financial Officer, Secretary and Treasurer

Mark King - Senior Vice President of Sales and Marketing

Analysts

Steven Chin - UBS

Harsh Kumar - Stephens Incorporated

Steve Smigie - Raymond James

Suji De Silva - ThinkEquity

Gary Mobley - Benchmark

Vernon Essi - Needham & Company

Christopher Longiaru - Sidoti & Company

Shawn Harrison - Longbow Research

Tristan Gerra - Baird

Vijay Rakesh - Sterne, Agee

Operator

Good afternoon, and welcome to the Diodes Incorporated second quarter 2012 financial results conference call. At this time, all participants are in a listen-only mode. At the conclusion of today's conference call, instructions will be given for the question-and-answer session. (Operator Instructions) As a reminder, this conference call is being recorded for replay purposes, Wednesday, August 8, 2012.

I would now like to turn the conference over to Leanne Sievers of Shelton Group Investor Relations. Leanne, please go ahead.

Leanne Sievers

Good afternoon, and welcome to Diodes' second quarter 2012 earnings conference call. I am Leanne Sievers, Executive Vice President of Shelton Group, Diodes' Investor Relations firm.

With us today are Diodes' President and CEO, Dr. Keh-Shew Lu; Chief Financial Officer, Rick White; Senior Vice President of Sales and Marketing, Mark King; and Director of Investor Relations, Laura Mehrl.

Before I turn the call over to Dr. Lu, I would like to remind our listeners that management's prepared remarks contain forward-looking statements, which are subject to risks and uncertainties, and management may make additional forward-looking statements in response to your questions.

Therefore, the company claims the protection of the Safe Harbor for forward-looking statements that is contained in the Private Securities Litigation Reform Act of 1995. Actual results may differ from those discussed today, and therefore, we refer you to a more detailed discussion of the risks and uncertainties in the company's filings with the Securities and Exchange Commission.

In addition, any projections as to the company's future performance represent management's estimates as of today, August 8, 2012. Diodes assumes no obligation to update these projections in the future as market conditions may or may not change.

Additionally, the company's press release and management statements during this conference call will include discussions of certain measures and financial information in GAAP and non-GAAP terms.

Included in the company's press release are definitions and reconciliations of GAAP net income to non-GAAP adjusted net income, GAAP net income to EBITDA and free cash flow, which provide additional details. Also throughout the company's press release and management's statements during this conference call, we refer to net income attributable to common stockholders as GAAP net income.

For those of you unable to listen to the entire call at this time, a recording will be available via webcast for 60 days in the Investor Relations section of Diodes' website at www.diodes.com.

Now, I will turn the call over to Diodes' President and CEO, Dr. Keh-Shew Lu. Dr. Lu, please go ahead.

Dr. Keh-Shew Lu

Thank you, Leanne. Welcome, everyone, and thank you for joining us today. I am pleased to report that revenue in the second quarter grew 10% sequentially. Trading volume improved demand across all our geographies and the end-markets as we continue to gain market share.

The quarter benefit from the launching of new projects for our products used in smartphones and the tablets. Well, Diodes is very well positioned. As you may recall, we achieved, strong and seasonal result last quarter. It proved to be the low point in the demand cycle. These are both market growth as we saw in market share gains and it served as the basis of continued growth in the second and third quarters.

Additionally, margins improved in the second quarter as we began to slowly shift our mix to higher margin products while also maintaining from our new product initiatives and the manufacturing efficiency is important. When the demand and pricing environment improves, we can continue to transition available capacity to higher margin products to further enhance our product mix and the margins.

At the end of the quarter, we completed the construction of our Chengdu facility. We have begun the process of obtaining final acceptance of the buildings and are now installing power which may take nine to ten months. We play to close our (inaudible) and move it to the new facility and start production in next year.

More equipment additions to the building would be met in (inaudible) market requirements. This facility would be an important asset for our future growth and expansion. As we get through the second half of 2012, we are approaching the challenging environment cautiously. As we began to see demand moderate in tune and the growth in China has proven to be softer than expected.

That said, we still expect to achieve continuous growth in the third quarter and have met target capital expenditure in our Shanghai facilities to increase capacity for specific package and products. We remain focused on increasing design win activity, capitalizing on the introduction of new products and overall efficiencies.

With that, I will now turn the call over to Rick to discuss our second quarter financial results and the third quarter guidance in more detail.

Richard White

Thanks, Dr. Lu, and good afternoon, everyone. Revenue for the second quarter of 2012 was $159.2 million, an increase of 10% over the $144.7 million in the first quarter of 2012, and a decrease of 6.2% from the record quarterly revenue of $169.8 million in the second quarter of 2011. Revenue was up sequentially due to continued improvement in demand across all of the company's geographies and end markets.

Gross profit was $41 million or 25.8% of revenues in the second quarter of 2012 compared to $33.7 million or 23.3% of revenue in the first quarter of 2011 and $55.6 million or 32.8% in the second quarter of 2011. Gross profit margin improved sequentially due to a greater mix of higher margin products, combined with the benefit of manufacturing efficiencies.

Total operating expenses for the second quarter were $32.7 million or 20.6% of revenue including a $1.4 million gain on sale of assets. Without consideration of the gain in the second quarter, operating expenses were $34.1 million or 21.4% of revenue compared to $30.4 million or 21% of last quarter. This compared to $30.3 million or 17.8% of revenue in the second quarter of 2011.

The increase in operating expenses above our guidance was due primarily to an approximately $1 million bad debt reserve or about $0.02 per diluted share related to an Asian distributor that was terminated. Without consideration of the gain on sale of asset, and this bad debt reserve, operating expenses would have been 20.8% of revenue in the second quarter.

Looking specifically at selling, general, and administrative expenses for the second quarter, SG&A was approximately $24.8 million or 15.5% of revenue compared to $22.1 million or 15.3% of revenue in the first quarter of 2012 and $22.6 million or 13.3% revenue in the year ago quarter.

Investment in research and development for the second quarter was approximately $8.2 million or 5.2% of revenue compared to $7.2 million or 5% of revenue in the first quarter of 2012 and $6.5 million or 3.8% of revenue in the second quarter of 2011. We continue to increase our investment in R&D to further advance our new product initiatives. Total other income amounted to $250,000 for the second quarter.

Income before income taxes and noncontrolling interest in the second quarter of 2012 amounted to $8.6 million compared to income of $6.2 million in the first quarter of 2012 and $23.4 million in the second quarter of 2011.

Turning to income taxes, our effective income tax rate in the second quarter was 10%, which was within our guidance of 7% to 13%.

GAAP net income for the second quarter was $6.7 million or $0.14 per diluted share, compared to GAAP net income of $4.9 million or $0.10 per diluted share in the first quarter of 2011, and GAAP net income of $18 million or $0.38 per diluted share in the same quarter last year. The share count used to compute GAAP diluted EPS for the second quarter was 46.9 million shares.

Second quarter non-GAAP adjusted net income was $6.4 million or $0.14 per diluted share, which excluded, net of tax, approximately $800,000 of non-cash acquisition-related intangible asset amortization costs and a $1.1 million gain on the asset sale. We have included in our earnings release a reconciliation of GAAP net income to non-GAAP adjusted net income, which provides additional details.

Included in second quarter GAAP and non-GAAP adjusted net income was approximately $2.3 million, net of tax, of non-cash share-based compensation expense. Excluding share-based compensation expense, both GAAP and non-GAAP adjusted diluted EPS would have increased by an additional $0.05 per diluted share.

Cash flow from operations for the second quarter was $16.8 million. Net cash flow for the quarter was a negative $8.4 million, due mainly to a $9.5 payoff for the short term line of credit. Free cash flow was a $4.5 million increase including $12.3 million in capital expenditures.

Turning to the balance sheet. At the end of the second quarter, we had approximately $168 million in cash and cash equivalents. Working capital was approximately $373 million. At the end of the second quarter, inventory was approximately $138 million, a $4 million increase from the approximately $134 million in the first quarter of 2012.

Inventory days improved to 105 in the second quarter compared to 118 days last quarter. Inventory in the quarter reflects a $1.8 million increase in raw materials and $1.6 increase in finished goods, while work in process remained relatively flat.

At the end of the second quarter, accounts receivable was approximately $150 million and AR days improved to 83 compared to 86 last quarter.

Capital expenditures in the second quarter totaled $15.2 million and $31 million for the first six months of 2012. CapEx in the second quarter included $1.4 million for the Chengdu building construction. Excluding this amount, CapEx was 8.7% of revenue, compared to 5.2% of revenue last quarter.

For 2012, excluding the Chengdu building expenditures, we expect CapEx to be at the lower end of our 10% to 12% of revenue model. Depreciation and amortization expense for the second quarter was $15.6 million.

Turning to our outlook, As Dr. Lu mentioned, we are approaching the second half of the year cautiously but remain focused on executing our profitable growth model. We expect revenue in the third quarter to increase to a range between $162 million and $170 million. We expect gross margin to be 28% plus or minus 2%. Operating expenses in the third quarter are expected to be 21.4% of revenue plus or minus 1%. We expect our income tax rate to range between 7% and 13% and shares used to calculate GAAP EPS for the third quarter are anticipated to be approximately $47.2 million.

With that said, I will now turn the call over to Mark King.

Mark King

Thank you Rick, and good afternoon. As Dr. Lu and Rick mentioned, revenue was up sequentially, driven equally by all regions across our end markets. Growth was led by computing business coming off of a seasonally low first quarter. Consumer also grew sequentially due to strong increases from smartphone and tablets partially offset by weaknesses in LED TVs which we expect to rebound in the third quarter.

We also achieved broad-based growth in the industrial markets in North America and Europe following solid increases last quarter across all regions. POS sales were up 13% sequentially while OEM sales were up 6%. Distributor inventory was down 1% and global inventory was in line and under three months.

Turning to global sales. Asia represented 77% of revenue, Europe 12% and North America 11%. Our end market breakout consisted of consumer representing 32% of revenue, computing 27%, industrial 22%, communications 16%, and automotive 3%.

Our achievement of solid revenue growth in the quarter was primarily driven by new products as we further benefit from new product initiatives and increased content with customers. We continue to make significant advances on our SBR and MOSFET products, specifically in solutions for portable, power and lighting and we also saw strong gains on bipolar transistors in the quarter.

We achieved record revenue for our CMOS LVOs made further advances with our LND controllers for DVS applications and grew our logic products by 3x as we gained additional revenue and design momentum. Overall, design win activity remains strong across all regions and we have a solid pipeline going into the second half of the year.

In the second quarter, our discrete product introductions totaled 54 new products across 14 product families. Diodes once again proved its commitment to penetrating high growth, high volume applications with product releases focused specifically on the portable segment.

We are targeting a wide range of devices including smartphones, handsets and tablets by leveraging our packaging expertise to create new wafer level chip sale package platforms. These efforts further reinforce our position in miniature package devices and confirms Diodes' leadership in power density and space savings.

The launch of our family of WLCSC MOSFETS is an important milestone in Diodes' development of both wafer and packaging level technology. These devices are developed specifically for the portables market, in particular for smartphones and tablet PCs.

We anticipate significant adoption of these devices and ramping volumes in the second half of the year. Diodes will use this technology as a springboard to further develop product families across our entire discrete portfolio in the coming quarters.

Other notable launches in the period that showcase our packaging expertise and in space constrained portable devices include low VF Schottky in the tiny DFN0603 package, a low VF SBR bridge rectifier in the ultra small DFN3030 package, BJT in the miniature DFN1006, a functional array (inaudible) for wireless charger applications and a range of dual ultra miniature BJTs and switching diodes in the SOT963 packaging.

In addition to our strong design wins for the portable segment, we also achieved significant wins in computing, LED TV, solar, consumer goods and automotive applications confirming Diodes' position as an innovative broad based supplier of discretes.

Turning to analog new product introductions, we released 28 products across four product families. New products highlights include the expansion of our line of Hall Effect switches with the release of the AH1892. This device is the market's smallest Omnipolar Hall sensor and offers user selectable sensitivity and a micro power sleep mode making it very attractive for portable battery operated equipment such as cell phones, ultrabooks and tablets.

Further expanding our support of the consumer market, we also released the AP9060, an overvoltage clamp designed to protect the latest generation of power management units for portable applications such as smartphones and USB On-The-Go enabled handheld devices. Also on the consumer products space, we have continued design momentum for our LDO USB powered switch and standard linear products as well as major wins for our DC-DC convertors and cable modem systems.

Leveraging our strong system level knowledge and support of the satellite receiver and set top box market, we released the ZLPM8000 series of devices. These cost effective feature rich and highly efficient devices offer reliable and innovative LNB power management and control solution within the set top box. New product acceptance and early revenue was very promising across our satellite products during the quarter.

Turning to our logic products. We released two new families of LVC devices to compliment and deepen our range of single, dual and multi gate LVC products. These devices support a wide array of computing and consumer applications. We are seeing continued market interest for our standing logic portfolio and secured two significant design wins in support of tablet applications that will ramp in the back half of the year. We are very pleased with the progress we have made on this new product family and are encouraged by the large volume design opportunities we have secured for these products today.

As we look through the third quarter, we expect to continue to grow revenue and gain market share in spite of the market environment. We remain focused on ramping new projects for our products used in smartphone and tablets and also expect a benefit from the rebound in LED TV. We believe our profitable growth model will continue to produce above industry average returns and produce consistent value to our shareholders.

With that, I will open the floor to questions. Operator?

Question-and-Answer Session

Operator

(Operator Instructions) Your first question comes from the line of Steven Chin from UBS. Please proceed.

Steven Chin - UBS

Nice job on navigating the tough macro environment currently. A couple of questions on your end markets. Just particularly, the industrial end market that you earlier mentioned. North America and Europe were pretty healthy and strong and that growth there was pretty broad. Can you talk a little bit more about how your products are positioned in those two regions in particular? Also how Asia was faring was well, again positioning the high end versus low end products that is practical into battery powered power management products?

Mark King

Well, the industrial market, I would say, in our high end product area is okay and I think it is really pretty broad based. Everything from security and smoke to climate control and various other industrial type of things. It is pretty broad based when you look at the size of the accounts of North America. If you look into Asia, it is pretty much power based and it's very, probably they are focused on the adapter base for portable markets.

Steven Chin - UBS

Got it. Also how are the trends for telecom and automotive business going to Q3?

Mark King

I think that telecom business seems a little bit softer. Again, our exposure is pretty broad based in that and really roughly only 16% and automotive appears pretty strong but obviously that’s our strongest segment. I mean our smallest segment.

Steven Chin - UBS

Just one last question, either for Rick or Dr. Lu. Just in terms of the CapEx, that you are spending on Shanghai in terms of the capacity new packaging types. I understand that that’s mainly for new products. Once we get through the high demand season in Q3 and start to enter Q4, will that capacity be somewhat idle going to Q4 because of the products seasonality or do you see products where you expect to be in a fairly steady demand through the year? Thanks.

Dr. Keh-Shew Lu

Yes, basically it would be very steady mainly because those are our new product. We have been doing a lot of design win and therefore we will continue within that capacity demand will continue and we mainly to continue putting the capacity. If you know what we tried in the past, we have been trying is smaller and thinner and other one is better power efficiency.

So those product that we are putting up is our like power diode (inaudible), like SOT323, those kind of based in or very power efficiency and those are our future and with the agreement for that kind of product will continue. So I don’t think the capacity will be idle.

Operator

Your next question comes from the line of Harsh Kumar from Stephens Incorporated. Please proceed.

Harsh Kumar - Stephens Incorporated

Yes, Dr. Lu, the softness you talked about in China and also the macro environment. How confident are you guys about the ability to shift the mix up given the conditions that exist?

Dr. Keh-Shew Lu

Okay, I think I might take this opportunity to explain about our GPM percent improvement. If you look at from 1Q of 23.3 GPM percent, to second quarter of 25.8 and now we focus the third quarter 28 plus minus 2. WE are going to continue to improve our GPM percent and lastly I have been talking about the GPM percent affected by four factors.

One is ASP and we are now seeing is that there is no more season ASP decline. Now, it is typically we are running about, I think I have been talking about that in the past, 2% a quarter, there is kind of no more ASP drop. We don’t a see silicon drop like in the past.

Second one is product mix improvement. In the second quarter and the focus in the third quarter, most of our product mix improvement is coming now due to the new product or new projects went to production.

Third one, I think I have been talking about is gold wise conversion. That is because the gold price is stable therefore it is not getting worse but the improvement from that is very slowly due to now we are waiting for the major customer to convert and typically they are very slow and very carefully.

Then the fourth one is our manufacturing productivity improvement or we say manufacturing utilization. Those kinds of area, we continue to see the improvement and cost deduction continue driving the cost deduction and implement that and therefore you are able to cover the ASP drop for us. The improvement we focus.

So I think we continue our effort and we will continue to see these kind of GPM percent improvement in the third quarter.

Harsh Kumar - Stephens Incorporated

Very helpful, Dr. Lu. That was really helpful. Then, Dr. Lu, if I can ask you for your guidance, how booked are you from a coverage angle or what is your backlog, 80% booked, 70% booked, just any help?

Dr. Keh-Shew Lu

Most of our product is not really by the book. Like a lot of stuff, we put in a hub. Our direct customer, they want to put four week or six week inventory in the hub. They use it and then they come to tell us. So we don’t really use in the order or the backlog to drive in our (inaudible).

Mark King

I think our coverage pretty typical in the way it is normally. Quarter in and quarter out.

Harsh Kumar - Stephens Incorporated

Okay, fair enough. Dr. Lu, I noticed that the OpEx creeping up a little bit. You talked about new products and R&D efforts there. Is this the new normal rate that we should think of in the 21% or would you help us out and give us some goal of what we should think long term?

Dr. Keh-Shew Lu

Okay. This is a good question because our motto, still targeted at 20%, okay, of operational cost and we see that and some time its up slightly, some time it will be low and at this time, we, due to some special MES cost, some special R&D cost, our GPM, our R&D supposedly 5% from 1Q. We now at 5.2%. So slightly up and this just, some time you cannot control the MES but we have been driving the product and new projects and new technology.

So I am still stuck at 20% now. Sometimes 21%, could be and I think we focus in third quarter should not be changed.

Harsh Kumar - Stephens Incorporated

Fair enough. One last one for Rick. Rick, most of the companies take out options expenses, stock comp expenses when they do non-GAAP. I noticed now for several quarters you guys have it in there. It's about a $0.20 difference between your numbers and everybody else's numbers. Can you just explain why that happens?

Richard White

Sure. The SEC, back in 2008 sent us a letter and their request was that any recurring expense needs to be not excluded from our non-GAAP reporting. So they specifically said that share based or stock based compensation was recurring on a quarter-by-quarter basis and that we should not that out. So since 2008, we have had our reporting, we talk about the price sense difference between GAAP and non-GAAP, both of them would be higher if we added back this $0.05

Dr. Keh-Shew Lu

Therefore, if you want it, you can just say get without the share based compensation, if $0.19 and then at $0.19.

Harsh Kumar - Stephens Incorporated

That’s fair. Thanks, guys. I will get back in the line.

Operator

Your next question comes from the line of Steve Smigie from Raymond James. Please proceed.

Steve Smigie - Raymond James

Great, thanks a lot. First question. Dr. Lu, your guidance is up about 4% sequential. I have seen some of the comps died about flat and I think Fairchild's maybe up about 2%, if I look at TI and I back out some of the wireless stuff there, analog, by my math, up about 2%. So, I would say, this is a pretty good guide in this environment. Would you say that the guide here, that the nice guide is more a function of share gains or is meaning you knocked competitors out of the slots or is it more just you have been putting out a lot of new products to your R&D investment and so you have been gaining pretty big design wins or some other factor? How shall we think about that?

Dr. Keh-Shew Lu

Well, Steve, thank you for the good comment. We continue to gain the market share. No doubt in my mind. That gain here, actually, is coming from the new products, new design wins and new projects with our customers, okay. So, even the market is now growing as fast as what we expected or everybody expected but due to the new projects, new design wins, we are able to grow faster than everybody else or faster than our competitors and that’s why we gain the market share.

Steve Smigie - Raymond James

Okay. Specifically in some of your commentary, you talked a lot about mobility, a lot about smartphones and tablets. Its been a few years since you started focusing on that but it was, maybe three and half, four years ago it was just totally new business to you but could you give some color, if not a percentage on how much that is of your business or at least talk about, to a certain extent, how much your hear your growth you expect to get from more of these tablet handset products and if you could talk a little bit would you say it is fair to say you are strongly positioned on to leading handset and tablet companies right now?

Dr. Keh-Shew Lu

Well, Steve, I am sorry, (inaudible) I cannot really talking about. How about Mark King, if you can make some comment?

Mark King

I think that the portables market in our early days was not a strength of Diodes when we were growing up. Cell phones was a very big focus of all the broad line semiconductors. So we tried to focus on secondary things at that time was cameras, LCD TV and so forth. So as we progressed and as our scales got much bigger, we have got much more focused into those marketplaces.

So, I think that our entry in those areas is broad based both from products and customer base, okay. I think it is going to be, you look at our consumer number, it is quite strong but it is pretty broad based also. So we don’t really like to talk too much about specific end equipments and percentages of those end equipments and those things but there is obviously volumes in smartphones at various customers.

There is a lot of opportunity in tablets. There is a lot, I guess, sometimes I include crossover between ultrabook and tablets. So that kind of confuses the issue a little bit.

So I think that’s about as granular as we want in that area but if you look at some of the products that we have come out for all those segments. That new hall sensor that I talked about, the 1892. That’s a perfect device for us in that area. So as we have expanded into MOSFETS and as we expanded into hall sensors, and as we start to get into miniature and small and thin, obviously those markets become very key to us.

Steve Smigie - Raymond James

Okay, great. If I could sneak one more in. Could you talk a little bit about how we should we thinking about tax rate in calendar 2013? Is it reasonable to think you would continue at roughly the same 10% tax rate you have been seeing so far this year? Thanks.

Richard White

No, I don’t think so. I think that we will go back. If you look historically, Diodes' tax rate was around 17% or 18% and I would think that in 2013 we will be in the upper 15% to 20% range. That’s our guess right now.

Steve Smigie - Raymond James

Okay. Thanks and congratulations on a good quarter and guide in a tough environment.

Operator

Your next question comes from the line of Suji De Silva from ThinkEquity. Please proceed.

Suji De Silva - ThinkEquity

With the manufacturing transitions you are doing in the backend, is there any gross margin uplift coming as you transition some of the production around your back end facilities in the next few quarters?

Dr. Keh-Shew Lu

We will continue. I think we continue and we will continue our product for activity improvement and cost reduction, okay. What we hope is that activity continue overtaking that ASP decrease. If we continue doing that we will continue ever to show GPM percent improvement.

Suji De Silva - ThinkEquity

All right, that makes sense. For the weakness in China that you saw. Can you talk about which end markets you may have seen that and more so was it broad based?

Dr. Keh-Shew Lu

Well, it's more broad based because when we, in China business we actually two coming from the China business. One is the OEM who builds for global companies. They slowed down some due to the global economy, okay but at the same time, the internal, the domestic consumption has actually slowed down too and therefore we see the China market slow down.

Mark King

In some of our key end equipments, we are starting to see the global players making much stronger position which is pushing back some of the more local Chinese supplier, say in TV, and so forth. So they are trying to make a stand or something but they were seeing a shift whereas the global players are more aggressively building and some of the secondary players are softer.

Suji De Silva - ThinkEquity

Got it, and then my last question. Can you just remind us what the forth quarter seasonality for revenue is typically and whether this year you think it would be a typical year or there are some tailwinds for that? Thanks.

Dr. Keh-Shew Lu

No, excuse me. We don’t really give in the forecast on the fourth quarter, okay. You just need to look at the season similarity typically in fourth quarter.

Suji De Silva - ThinkEquity

Historically what’s that been?

Dr. Keh-Shew Lu

Historically, it's flat or slightly down and somewhere between 0% to 5% down. It is somewhere between that. That’s the seasonality.

Operator

Your next question comes from the line of Gary Mobley from Benchmark. Please proceed.

Gary Mobley - Benchmark

I wanted to start with a question for Mark. Mark, did you say that distributor inventory was down 1% sequentially as of the end of the June quarter? I think you mention inventory in the same channel, distribution is approximately three months, was that roughly flat sequentially or perhaps down or up?

Mark King

No, the inventory was down 1% and so it was down 1% and yes, it's slightly under three months globally.

Gary Mobley - Benchmark

Okay, and so three months you are referring to both hub inventory as pulled by OEMs and then as well as distributor inventory, right?

Mark King

No, I am talking about distributor inventory. We consider hub inventory basically as our inventory.

Gary Mobley - Benchmark

All right, very good. I appreciate the fact that your gross margins are improving roughly 250 basis points sequentially for the first three quarters of the year, but if I look at your revenue expected of the third quarter and call it $166 million, I compare that to what your generating previous years, your gross margin expected in the third quarter is about 500 basis points below prior levels. My suspicion is, you have a lot more capacity now, your utilization is lower. So could you share with us what your quarterly revenue run rate would need to be to be at 100% utilization and if not that explicit number, maybe you can share with us what the utilization rate was for the June quarter?

Dr. Keh-Shew Lu

Okay, if you compare to last year, I think that several things you would need to put in consideration. One is ASP and I think that in second half ASP drop quite dramatically and therefore from that point of view, you lose the GPM percent, okay.

Second thing is the product mix. I think the second half of last year, we took in about due to the under loading we moved our product mix downwards and now we are stable and we gradually improve but not back therefore like in the second quarter last year you had.

Third is gold price. Look at the gold price. Still higher than, first half of last year, okay. It stabilized but not really going down yet, okay.

Then the productivity. We continue our productivity improvement. Now when you are talking about the load in. Yes, we are not fully loaded yet. We still put in capacity to support the high end new product, new packages which is the one we don’t have enough capacity but we are getting 10% to 12% at the high 12%. We have now the capacity expansion capital expenditure is somewhat at the low end of that 10% to 12%.

In that region we still need to continue to put capital so as to support newer package or new projects, okay. Now, we still have capacity to support if the market really turns very hard and we still have enough capacity to support.

Gary Mobley - Benchmark

Okay. Assuming you don’t equip your Chengdu facility at a rapid rate, what sort of revenue run rate on a quarterly basis do you think you can do right now? Do you think you can do $200 million in revenue without adding any additional capacity in Shanghai?

Dr. Keh-Shew Lu

That number, I don’t know. I didn’t go through the calculation yet and if really because the (inaudible) is set by ASP and if the market is low then even the same capacity the ASP is low, the revenue will be low. So it is very difficult to tell us that we have enough space in Shanghai to support if we need to put more capital to support.

So Chengdu, you don’t count in to production until next year because I think in my speech, I talked about now we are putting up power and it will about nine to ten months. Then after the power, we put that equipment. We start the qualify to run it and all this.

You are not really looking for capacity out of Chengdu until second half of next year, and so we have plenty enough space and we have enough capacity to supporting us but I cannot really tell you how much revenue it will support because it really depends on ASP

Gary Mobley - Benchmark

I understood, and the last question for Rick, just to be clear on your operating expense guidance for the third quarter. That 21%, that includes GAAP R&D guide in it as well as GAAP SG&A and then last, it includes the amortization?

Richard White

Yes, that’s right. Those three pieces, right.

Operator

Your next question will come from the line of Vernon Essi from Needham & Company. Please proceed.

Vernon Essi - Needham & Company

Thank you very much. I was wondering if you could go back to the end market discussion and I was just curious what drove the uptick in the computing side and, I guess, for clarification purposes, earlier you made a comment talking about tablets. I am wondering if that’s included in the computing bucket or is that put that in the consumer side?

Mark King

In the consumer side and the uptick is because we had a soft first quarter seasonally. So we just, that was why through the past expense it was the most in the first quarter.

Dr. Keh-Shew Lu

In the computer, and it is hard disk, HDD shortage, in the first 1Q. So if you look at 1Q, hard disk shortage because of the consumer market slowdown and saw an uptick it is really just because it's back to normal.

Richard White

It was the fastest growing in (inaudible).

Vernon Essi - Needham & Company

Okay, and then Rick, just sort of a gross margin related question, but just to refresh me on your CapEx plans. In going into next year, you are going to have to, basically this facility will go online, and I am just curios, do you expect a big change in your depreciation amount on a quarterly basis or would that change much from the $16 million run rate you have been at?

Richard White

No, because the plan is that when we start building out Chengdu with equipment, the equipment that we put in to Shanghai will be minimized and so basically we will shift from Shanghai to Chengdu and so there won't be that much change in the depreciation.

Operator

Your next question comes from the line of Christopher Longiaru from Sidoti & Company. Please proceed.

Christopher Longiaru - Sidoti & Company

Can you talk about inventory on the channel a little bit and where that is, where it was relative at the beginning of when you reported the first quarter?

Mark King

I don’t have the first quarter. Let me see, maybe I do. I don’t have it there. It was down 1%. It was where we expected it to be. It was pretty much POP and POS were relatively flat in the quarter, maybe POS was slightly higher as a percentage. I expect it to continue a decline in this quarter. We think it is in pretty good shape.

North America and Europe, traditionally, run at between 3% and 4% and East Asia runs at 2% to 2.5% and so it is probably it is at 2.4% and North America and Europe at the usual spot. I think we are in pretty good shape there.

Christopher Longiaru - Sidoti & Company

Just in terms of, what was utilization?

Dr. Keh-Shew Lu

On what?

Christopher Longiaru - Sidoti & Company

What was the fab utilization?

Dr. Keh-Shew Lu

The fab utilization is (inaudible) and especially old fab is actually quite good because some of the new products went up coming from our old fab. So fab utilization is not an issue. We typically are using like 80% is the growth from about the full. We consider 80% is in the good or normal level. We are back to that.

The assembly, like I said, it still depends on different package. The high end or newer package which is we are fully loaded and we still need to put in the capacity to support those rent. Now the commodity of that growth, the package, like commodity to start turning (inaudible), those kind of packager we are under ordered because we really don’t want to be building those kinds of products.

Mark King

Our objective is to round those up. Have got to move them up the chain.

Christopher Longiaru - Sidoti & Company

All right, that’s all I have. Congratulations on the results in the tough environment.

Operator

Your next question comes from the line of Shawn Harrison from Longbow Research. Please proceed.

Shawn Harrison - Longbow Research

Mainly a lot of clarifications but I guess when looking at distribution in the September quarter, I don’t think you commented in terms of what you would expect them to be with inventory. It looks like the decline in your inventory distribution has been waning or that decline has been lessening. So would you expect no further inventory draw down at distribution in the third quarter?

Mark King

I think that North America and Europe will stay relatively in this range and I think we will see some draw down in Asia but I feel pretty comfortable. We are not kidding. We are not seeing a big pressure on our inventory. We think our inventory is in pretty good shape. From the third quarter in Asia, I think our inventory is in the right place and I think that our inventory for North America and Europe is in the right place for pretty much awkward.

Shawn Harrison - Longbow Research

Okay, and then second, I was a little bit confused. Maybe I just heard this incorrectly, if the consumer is 32% of sales for the quarter that would imply sales were down. Is that almost high single or double digits year-over-year?

Mark King

What?

Dr. Keh-Shew Lu

I don’t know what?

Shawn Harrison - Longbow Research

The consumer electronics business, it was 32% of sales. I think it was 34% of sales last year.

Mark King

Right.

Shawn Harrison - Longbow Research

I am saying, high single or low double digits year-over-year. So I was just trying to triangulate what was the decline?

Mark King

I will have to run through all those numbers and maybe we can get back on that.

Dr. Keh-Shew Lu

Because we don’t have that reading of consumer has went down or something.

Shawn Harrison - Longbow Research

Okay, I mean, I am just going after the facts provided last year, so maybe I have something wrong. Then, I guess, two follow ups.

Pricing environment is actually I just want to confirm that you think it is back to normal or a little bit less than normal. So we shouldn’t have expected the negativity we saw in the back half of '11?

Dr. Keh-Shew Lu

The ASP deduction?

Shawn Harrison - Longbow Research

Right, yes.

Dr. Keh-Shew Lu

Yes, it is slightly better than the normal season or normal quarterly ASP reduction.

Shawn Harrison - Longbow Research

Okay, and then finally, for Rick, trying to get my model in terms of SG&A. The 21.4%, that implies a GAAP $35.5 million of SG&A from the September quarter, at the mid point of your guidance which would be up maybe $1 million sequentially. So I am just trying to figure out where the inflation in the SG&A would be? Or R&D?

Richard White

Remember that we let R&D go up based on the revenue. So since the revenue is going up, the R&D is going to go up. We do have a small increase in SG&A. Whether that occurs or not, we don’t know but we are trying to be conservative.

Shawn Harrison - Longbow Research

So you will be running R&D somewhere in the mid 80 to an SG&A of $25 million to $26 million?

Richard White

Right.

Dr. Keh-Shew Lu

Our motto actually is R&D running above 5% of the revenue and that’s our goal and we continue doing that and our SG&A, firstly, our motto is 15% of our revenue and we are slightly higher now.

Richard White

So we have SG&A at 15% and I have plus the amortization of intangible costs.

Shawn Harrison - Longbow Research

And then, one final question. In thinking about the new designs. Is the mix of new designs that you are winning, you are putting up in the market and things that you win is that share different than your end market mix right now. So is it much more based within the consumer electronics versus the sort of revenues that we are seeing?

Mark King

I think it is pretty broad based. I think it will be very, very hard to, I think it would be relative to the same split we are in now. We are very, very diverse and we have, there is, obviously, some very big ones and then, there is, obviously, just a multitude of smaller more medium sized. So I would say that when it all comes out, we have been relatively consistent in our market mix for a period of time and I would say that we will continue in this direction.

Operator

Your next question comes from the line of Tristan Gerra form Baird. Please proceed.

Tristan Gerra - Baird

So it looks like utilization is no longer having a negative impact on gross margin. If we assume a somewhat weak environment with deploying maybe flattish or up slightly even in the next few quarters, when do you think you will get back to the type of product mix that you have in Q2 2011?

Dr. Keh-Shew Lu

All I can tell you would be, really if the market is very hot, then since last year when the market started to slowdown, market is not really that high or demand. We are gaining the market share but if you look at the growth rate, year-over-year, from semiconductor or from our time, our same point of view. It is not really growing, okay.

If the semiconductor same, go back to that 10% growth or same, go up to 10% then we will be able to cover on that number and then when we see that then you can see the GPM would be improved dramatically. But the market is not growing.

Mark King

If the market improves on a slight basis, so we will be able to continue to grind through changing this mix up and that should drive us towards those margin improvements that you are looking for. We are very focused on what we are trying to sell and where we are trying to sell and we have a lot of new products initiatives that is going to sell up what we believe is somewhat of a lower value products that we have out there.

If there is no market out there that says we need to aggressively attack those lower end products because we see a big price increase then naturally our mix under this will round into a better mix overall which should be positive and drive us towards where you would like to see us go.

Dr. Keh-Shew Lu

Albeit moderately, we want to focus more on the growth instead of just look in the GPM percent. As has already been mentioned that over and over again, our priority is growth, gaining the market share and we will continue doing that. We did that and we will continue doing that.

Tristan Gerra - Baird

Great, that’s very useful. Then, could you remind us what the mix is currently of analog versus discrete and what would be your target by end of next year?

Dr. Keh-Shew Lu

Well, sorry, we really never disclose this number and the reason is we use this should have same capacity. They are using the same kind of package. So we sometimes prioritize based on the need, based on the customer, based on growth. So it is very difficult for us to dive in to separate analog versus discrete or reverse it. So we just don’t separate those businesses.

Tristan Gerra - Baird

Okay, and so directionally though is it a fair assumption that that mix is going to improve and is the R&D increase that you are guiding for Q3, how much of that is just a one time item versus an improvement in mix? In terms of investing into a higher margin products?

Dr. Keh-Shew Lu

When I was talking about, sometimes due to the MES because MES is very expensive, okay. We are talking about 400,000 and 800,000 more in the quarter. Two, three of MES set will make that difference. Therefore it is very difficult to make the R&D exact number we try to guide because some times they use more for the (inaudible), but my motto is 5% of our revenue go to R&D, and that’s our goal.

That’s us our motto and we try to do that. Now sometimes you might be 0.2% more, like I said, 0.2% is probably $300,000. $300,000 one or two MES set. We introduce some new produce so many new product a quarter. It is very difficult to control and I don’t want to because try to set (inaudible) and slow down the new products.

New products is the number priority.

Mark King

One other thing is, that just because it is analog it does not mean it is more margin too. Most discrete and analog both have equal opportunities for higher margin products.

Dr. Keh-Shew Lu

Because it has taken it in its way we are winning it.

Operator

Your next question comes from the line of Vijay Rakesh from Sterne, Agee. Please proceed.

Vijay Rakesh - Sterne, Agee

I was just wondering, just housekeeping questions here. What was your sell-in versus sell-through on your mix on revenues?

Mark King

POP and POS were pretty much flat. I mean they were equal.

Vijay Rakesh - Sterne, Agee

Oh, no, I meant does that recognize all revenues on sell-in?

Mark King

Sell-out.

Vijay Rakesh - Sterne, Agee

Sell-out, okay.

Mark King

No, it is sell-in.

Richard White

Sell-in.

Dr. Keh-Shew Lu

Sell-in.

Vijay Rakesh - Sterne, Agee

Then I know you mentioned POS was coming down to the point of sale was coming down. So just, are you bringing that in the guidance because in respect of selling in and the point of sales is coming down?

Mark King

No, I said, POS was up 13% quarter-over-quarter.

Vijay Rakesh - Sterne, Agee

Right. No, for the out quarter. For the September quarter guide.

Mark King

I don’t expect POS to decrease in the quarter.

Dr. Keh-Shew Lu

We don’t give the guidance.

Mark King

Our POS should be in line with our guidance in that directionally.

Vijay Rakesh - Sterne, Agee

Got it, okay. Then last question here, when you look at the masses and you said ASP is coming in soft but what is the other mix, what are the leeway on the gross margin line in trying to get back to that last year margin levels?

Dr. Keh-Shew Lu

I said at the beginning of the call, I make it four factor effect on margins. One is ASP and I said still continue going down but it's not as worse as second half of that year. It is going down better and that we typically see 2% a quarter type of ASP drop.

Second thing is product mix and I said, product mix actually improve due to majority, due to our new product, new project to ramp up the production.

The third one is gold. Gold conversion is steady but it is not really increased significantly because now we are waiting for the major customer to convert and major customer typically very, very slow to convert, to the gold wire.

Then the fourth one is productivity improvement from our making function and I said, those is really continue improving and that’s why we are able to change our GPM percent from 23.3% in 1Q to 25.8% in 2Q and now we are now guide another 2.2% up plus minus 2% and those is because our effort on manufacturing improvement.

Operator

You have a follow up question from the line of Tristan Gerra from Baird. Please proceed.

Tristan Gerra - Baird

Hi, just a quick one. Have you talked about the cost savings of Chengdu once it's ramped in versus Shanghai?

Dr. Keh-Shew Lu

I don’t think we are talking about that yet because Chengdu won't be ramped up until, like I said, second half of next year. So we see a one year wait. We know there labor cost will be low but since they are capacity at the beginning would be lower, so the cost may not be as good as HK but the labor cost would be cheaper. So we do not really do any comparison yet.

But from long run, yes it will be a major manufacturing facility for us and when they get the same or bigger capacity, then they can be more cost effective.

Tristan Gerra - Baird

Are the labor cost in that region lower than in Shanghai?

Dr. Keh-Shew Lu

Right now, the labor today?

Tristan Gerra - Baird

On equity.

Mark King

And more stable.

Tristan Gerra - Baird

Great.

Dr. Keh-Shew Lu

Because, the Shanghai, you know most of the people coming from inland and Chengdu most people coming from the province. The Sichuan province.

Mark King

That’s what they say.

Operator

Ladies and gentlemen, that concludes today's Q&A. I would now like to turn the conference over to Dr. Keh-Shew Lu for closing remarks.

Dr. Keh-Shew Lu

Thank you for your participation today. Operator, you may now disconnect.

Operator

Thank you. Ladies and gentlemen, that concludes today's conference. Thank you for your participation. You may now disconnect and have a great day.

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