Diodes Inc (DIOD) 2011 Q3 法說會逐字稿

Good afternoon and welcome to Diodes' Incorporated third quarter 2011 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 today, Tuesday, November 8, 2011. I would now like to turn the call over to Leanne Sievers of Shelton Group Investor Relations. Leanne, please go ahead.

Good afternoon, and welcome to Diodes' third quarter 2011 earnings conference call. I'm Leanne Sievers, Executive Vice President of Shelton Group, Investor Relations firm. With us today are Diode's President and CEO, Dr. Keh-Shew Lu, who is joining us from Taiwan today. 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'd 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. 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, November 8, 2011. Diodes assumes no obligation to update those 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 including financial information and 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 and GAAP net income to EBITDA, 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' web site at www.diodes.com. Now I'll turn the call over to Diodes' President and CEO, Dr. Keh-Shew Lu. Dr. Lu, please go ahead.

Thank you, Leanne. Welcome, everyone, and thank you for joining us today. Revenue in the third quarter was $161 million, a decrease of 2% over the prior year and 5% sequentially. We've continued to see broad weakness across growth markets that began in May and accelerated throughout the third quarter. Especially in the consumer and computing market with the exception of (inaudible) and the Smartphones. In spite of this softness we were still able to execute on our strategy of gaining market share by shifting our product mix to lower margin product to best utilize our installed capacity. As reflected by the 10% growth in our year-to-date revenue over the prior year.

Gross margin in the third quarter was 28% of revenue. In addition to our shift in product mix, gross margin was also impacted by a weaker than normal price environment as well as a significant increases in the gold prices. In response to the weaker market environment, we have implemented cost reduction actions that include the delay of investments, hiring freeze, a reduction in factory overtime, as well as temporary reduction in travel. We had today about $30 million of CapEx but still invested approximately $20 million during the quarter, including $10 million for our Chengdu site expansion. Our primary goal is to (inaudible) efficiency at our packaging facility in order to avoid slowdown of our ongoing productivity improvements. Even with the hiring freeze we continue to maximum the duration of our operators and equipment.

During the quarter we used excess capacity to build finished goods inventory and prepare for a 3-day shutdown for the Chinese National Holiday which occurred during the first week in October. Looking beyond the current market environment, we continue to increase our investment in R&D to further advance our new product initiatives, maintain design win momentum and position Diodes for additional market share gains in the future. We have the additional capacity available to take advantage of upside potential and return to our historical growth level as the market improves. We remain committed to our business model and our focus on generating income return for our shareholders. With that, I would now turn the call over to Rick to discuss our third-quarter financial results and the fourth-quarter guidance in more detail.

Thanks, Dr. Lu, and good afternoon, everyone. Revenue for the third quarter of 2011 was $160.6 million, a decrease of 2% over the $163.1 million in the third quarter of 2010. And a decrease of 5% from the $169.8 million in the second quarter of 2011. The decrease in revenue was due to the general market slowdown on a global basis causing larger than normal pricing degradation. Gross profit for the third quarter of 2011 was $45.2 million or 28.1% of revenue, compared to $61 million or 37.4% in the third quarter of 2010. And $55.6 million or 32.8% of revenue in the second quarter of 2011. The decline in gross profit margin was due primarily to pricing, a significant increase in gold prices, and a shift in product mix to lower margin products in an effort to maintain full capacity utilization at our Shanghai packaging facilities. Total operating expenses for the third quarter were $31.8 million or 19.8% of revenue, which was slightly below our model of 20% of revenue.

Looking specifically at selling, general, and administrative expenses for the third quarter, SG&A was approximately $23.4 million or 14.6% of revenue, which was above the 14% of revenue in the third quarter of 2010 and the 13.3% of revenue last quarter. Investment in research and development for the third quarter was $7.3 million or 4.5% of revenue which was comparable to the $7.2 million or 4.4% of revenue in the previous year period and an increase compared to the $6.5 million or 3.8% of revenue last quarter. Diodes continues to invest in R&D efforts to further advance new product development and design in order to capture additional market share in the future. Total other expense amounted to $2.3 million for the third quarter. Looking at interest income and expense, we had approximately $316,000 of interest income on our cash balances and approximately $1 million of interest expense primarily related to our convertible senior notes.

During the third quarter, we recorded approximately $2 million of non-cash amortization of debt discount related to the US GAAP requirement to separately account for a liability and equity component of our convertible senior notes. Also included in total other expense was a foreign currency gain of $460,000. Also included in other expense was a $1.2 million non-cash loss associated with the decrease in fair value associated with Eris stock investment. This investment is recorded based on the stock price of the underlying stock and on the Taiwan-to-US dollar exchange rate since the investment was made in Taiwan dollars. During the quarter the Eris stock price decreased and the Taiwan dollar fell. Income before income taxes and non-controlling interest in the third quarter amounted to $11.1 million compared to income of $27.4 million in the third quarter of 2010 and $23.4 million in the second quarter of 2011.

Turning to income taxes, our effective income tax rate in the third quarter was 3.2% due mainly to a change in profitability by country. It was within our updated guidance of 0% to 6%. GAAP net income for the third quarter was $10 million or $0.21 per diluted share compared to GAAP net income of $21.2 million or $0.46 per diluted share in the third quarter of 2010, and GAAP net income of $18 million or $0.38 per diluted share in the second quarter of 2011. The share count used to compute GAAP diluted EPS for the third quarter was 47.1 million shares. Third quarter non-GAAP adjusted net income was $12.1 million or $0.26 per diluted share, which excluded net of tax, $1.3 million of non-cash interest expense related to the amortization of debt discount on the convertible senior notes and $800,000 of non-cash acquisition-related intangible asset amortization cost. 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 the third-quarter GAAP and non-GAAP adjusted net income was approximately $2.4 million net of tax of non-cash, share-based compensation expense, and $1.3 million loss net of tax in fair value associated with the investment in Eris. Excluding share-based compensation expense, both GAAP and non-GAAP adjusted diluted EPS would have increased by an additional $0.05 per share. And excluding the loss in fair value, both GAAP and non-GAAP adjusted diluted EPS would have increased by an additional $0.03 per share.

Turning to the balance sheet, at the end of the third quarter, we had approximately $125 million in cash which reflects the redemption of $134 million of our convertible senior notes. Working capital was approximately $311 million. At the end of the third quarter, inventory was approximately $139 million, an increase of approximately $10 million from the second quarter. This increase was due to a $14 million increase in finished goods and a $1 million increase in raw materials, partially offsetting a $5 million decrease in work in process. Inventory days increased to 105 compared to 100 days in the second quarter of 2011. Accounts receivable was approximately $139 million and AR days were 81. Capital expenditures were $19.5 million during the third quarter which included $9.6 million for our Chengdu site expansion. Excluding this amount, CapEx was 6.1% of revenue compared to 18.4% in the second quarter. We consider Chengdu to be a long-term strategic project, so we are continuing with our site development regardless of the short-term economic environment. We invested $10 million in the quarter and $15 million year-to-date.

As Dr. Lu mentioned last quarter for our production facilities, we delayed approximately 40% of our second half non-Chengdu CapEx due to market conditions. Year-to-date, excluding Chengdu, we have invested a total of $59 million in CapEx which represents about 12% of revenue. For the full year, excluding Chengdu, we expect CapEx to be at the low end of our targeted range of 10% to 12%. Depreciation and amortization expense for the third quarter was $16.1 million. Cash flow from operations for the third quarter was $17 million. Our cash balance decreased $166 million due primarily to $134 million used for the retirement of our convertible senior notes, $14 million used for the investment in Eris Technology Corporation, and $20 million in capital expenditures including Chengdu. Free cash flow was a negative $7.8 million and included $10 million in CapEx for the Chengdu infrastructure.

Turning now to our outlook. In terms of fourth-quarter guidance, we expect revenue to range between $140 million and $150 million or down 7% to 13% sequentially. We expect gross margin to be 25% plus or minus 1.5%. Operating expenses are expected to remain approximately flat with the third quarter on a dollar basis. We expect our income tax rate to range between 17% and 23% and shares used to calculate GAAP EPS for the fourth quarter are anticipated to be approximately 47.2 million. With that said, I will now turn the call over to Mark King.

Thank you, Rick, and good afternoon. Our revenue in the third quarter declined sequentially due primarily to weakness across our global markets particularly in Europe and North America. The global economic issue continued to weigh on markets and overall demand especially in the consumer and computing markets, resulting in larger than normal declines in pricing. However, as Dr. Lu mentioned, we continue to see strength in smartphones and tablets. Distributor POP was down 11% sequentially as distributors began to reduce their stocking targets going into the fourth quarter. Distributor inventory was up 5% but could begin to climb in Q4. Global POS was down 3% in the quarter.

Although the current environment is causing customer end products to move slower into production, design win activity remains at high levels in all regions for both new and existing products. In terms of global sales, Asia represented 75% of revenue, Europe 13%, and North America, 12%. Our end market breakout consisted of consumer representing 34% of revenue, computing 27%, industrial 20%, communications 16%, and automotive 3%.

Now turning to new products, traction remains strong as we continued to execute on our new product initiatives. We reached another record quarter for synchronous MOSFET controllers as well as our USB power switches. We also continued to gain momentum on our LED drivers, DC to DC converters, CMOS LDOs, as well as our standard linear product line. And although the demand is being constrained by current market environment, we continue to focus on new product introductions in order to expand content at key customers and drive our future growth as the market improves.

Looking specifically at our Discreet product line, we continue to make solid progress in delivering value to our customer base in a wide range of applications. We introduced 66 products across 9 product families. Diodes achieved another record quarter for our synchronous MOSFET controllers as more customers are changing to synchronous control to meet the latest standards from Energy Star. We introduced 2 new synchronous controllers, one targeting the notebook adapter market and another targeting set-top boxes and power over ethernet markets. The design wins continue to expand, and we are engaging with an increasing number of potential customers on these products.

Also during the quarter, Diodes announced the expansion of the Diostar product family targeted for LED lighting applications. We now have 2 versions available, ultra low VF performance and very fast switching that allows for reduced power loss and higher efficiency. These product releases were complemented by a number of other products that confirmed Diodes' position as a leading provider of high-volume performance devices. New design wins in the quarter for our Discreet product line include major gains in portables, computing, industrial and automotive lighting marketplaces.

We released the first new SBR solar by-pass diodes specifically designed to simplify manufacturing concerns of solar panel makers producing the next generation of Modules. The new product is highly efficient with a maximum package height of only 0.75 millimeters, enabling it to be directly mounted within the solar panel and removing the need for separate junction boxes. Now turning to analog, we released 50 new devices across 7 product families. New product highlights include the expansion of our synchronous DC to DC converter product line with new 2 amp and 3 amp devices. These products are developed for consumer electronic applications that require ultra-efficient voltage conversion such as LED TVs, LCD monitors, and set-top boxes. We also continue to expand our CMOS LDO portfolio with the addition of a full line of 1.5 amp adjustable regulators as well as a family of low-power, high-accuracy devices intended for battery operated consumer products.

Revenue in our power management segment also remained strong in which we set a new revenue record in our USB power switches. During the quarter we secured major design wins in notebook and desktops as well as LED TVs and Blu-ray DVD players. Also during the quarter, we released the industry's smallest full featured single-chip fan motor driver. This highly integrated device is designed for driving single-coil, brushless DC fan motors and is offered in a miniature, low-profile DFN package. In the low-power DC fan market the demand for low noise and high performance provides an expanded opportunity for our recently launched integrated drivers. We have seen 3-fold increases in new sockets over the past few quarters.

We also continued to make advances in our standard linear product line with the release of the ZXRD060, a dual-adjustable shunt regulator that offers excellent temperature stability. These devices were specifically developed to be compliant with the new high-speed serial Thunderbolt interface, which is an emerging standard targeted at the consumer products market and is being backed by several major consumer electronic providers. In addition to several design wins from early adopters of Thunderbolt, we secured major standard linear design wins for both consumer and industrial applications.

Now turning to our Logic products, we continue to expand our footprint in the Logic market as we gain traction on our new Dual Gate devices introduced last quarter. Design win activity and product introductions remain very solid even though some customer projects have been delayed due to the current environment. We still expect this product segment to be a key contributor to our growth next year. In summary, we continue to believe that Diodes is well positioned to manage through the current market environment as we proactively prepare for improving conditions and demand. We have additional capacity available and have -- also have a high level of new product and design win activity that will enable us to capture additional market share in the coming quarters. Traction remained strong on a large number of new products, and we continue to have a solid position with our key customers. With that I'll open the floor to questions. Operator?

(Operator Instructions)

Steve Smigie, Raymond James.

Great. Thanks a lot. First question is just related to overall revenue. It seems like between 2 quarters you were down 15%, I mean between Q3 and Q4, versus some comps were down more significantly. I'm going to attribute that to you guys being more aggressive about going out and chasing business, that's maybe a little bit through price. I was wondering if that's the case. And then what does that suggest about Q1, would Q1 potentially be an up sequential quarter? Thanks.

Steve, we don't really give the Q1 outlook at this moment. And the Q1 really be very uncertain for us. Okay. You have -- you hear from some people, they said, well it's (inaudible) but some people talking about because the Chinese New Year this year is coming from -- is coming at the end of the part of January and, therefore, some of the manufacturing do have strong view up for Chinese New Year in December, and so, you know, January is basically the Chinese New Year. We don't really know what will be happen.

Okay. So--

And then the other thing is Thailand flood, we don't know what will be the effect. So it's very unclear for 1Q right now.

Okay. Thank you the for that color, appreciate that. In regard to the pay down of the convert does that mean that going forward there's essentially no interest expense and no intangibles amortization?

Yes, that's exactly right.

All right. Great. And last question was just with regard to overall CapEx, Dr. Lu, you guys were sort of the -- one of the first to take stuff off when things got worse, one of the first to add stuff back as things got better last time. Sounds like you're still a little bit cautious on CapEx, although I would say it does sound like you're still going forward with the Chengdu investment, so you must be a little bit short-term nervous, but it seems like in the immediate term you still feel pretty good that there's going to be a decent ramp to the business. So is that fair?

Well, because Chengdu investment is a long term. It can not be affected by the short-term market environment. If you know our strategy from in the past, it's a short lead time to adding the equipment at the existing facility, therefore we are able to, when the market's up, we are quickly at the capacity. When the market's down, we took a -- put the capital expansion on hold. But at Chengdu we are building the (inaudible), building the building, and then we put in these -- the facility, the money need to be put in and then start to put in equipment. Therefore, whenever -- well, therefore, after we finish this facility then we can go back to, when we put the equipment we can control by the market environment. But at this moment what -- we are building the facility, that portion cannot slow down. And that's a long-term project.

Okay. Great. Thanks a lot, guys. Appreciate it.

Harsh Kumar, Morgan Keegan.

Good afternoon, guys. A couple of questions. Dr. Lu, is there possibility or room for operating expense control beyond what you've got it to which is flat from current levels? And then I have one more.

Well, I don't think -- yes, that's a possibility. But I don't think now's the time we are taking that. Okay. I think we could let people go and put the R&D on hold, but I don't think now is the time to do that. We still believe short term, yes, we have a term now, but from middle term next year, we still go after for market gain, and we still go up to share gain. Therefore, we don't want to cut down any R&D, okay. And for the people, the headcount, I don't think now is the time because we've put the hiring freeze, but we believe we can bite the bullet and get through this downturn without reduced headcount. Other than attritions, normal attrition would take it down, that's why we put a hiring freeze but I don't think I want to take any action yet because I think now is probably -- I won't know, but I think this is probably the worst. But like I said, 1Q we are not very clear, but at this moment, I don't feel we need to do that.

That's very helpful Dr. Lu. That's actually consistent with a couple of other companies. So let me ask you in terms of inventory, do you think this slowdown in your revenues is inventory driven more or demand driven more? And if it's inventory driven, how much excess inventory do you think is left to be addressed?

I don't believe it's inventory driven. I more believe it's demand driven. It's demand, in general, demand soft.

Okay. Great. Thanks, Dr. Lu, thank you.

Suji De Silva, Thinkequity.

Hi, guys. Want to ask first on visibility, what's the turns implied in the guidance? How well are you booked to that guidance?

I'm sorry --, what --

How well are you booked to your guidance? What are the turns implied in the guidance?

Mark, you want to answer this?

Yes. I think it's pretty normal turns. Pretty normal turns rate that we're at at this point in the quarter. So when we're making this guidance at this point, we're looking at where we're turning and what our expectations are.

Okay. Then for the pricing, can you talk about what the decline was, like for like, and what kind of pricing pressure are you seeing in the bookings for next quarter, as well?

We're seeing, in the commodity product areas, we're seeing significant amount of price decrease. I don't think we have a specific -- we don't really give the specific quantity but more than normal. And possibly with some of the change in demand, it's affected the mix a bit, too. So the ASP decline looks a little greater as we chase it with some of that commodity product that's lower priced. And yes, it's a competitive marketplace. But we're used to a competitive marketplace. And any time that it gets slow, you're certainly going to see some make-up for the price decreases that did not occur over the last 4 quarters.

Okay. And then last question, you've held up revenue pretty well here. Can you talk about the dynamics in the lower margin business versus the higher margin business just demand wise looking ahead to the fourth quarter? Thanks.

Yes. I think that there's -- I think there's a softness in demand that's causing more people to react with better prices. And so, I think the general demand in that product area is the same now. We might go after certain areas that we hadn't participated in in previous quarters. So maybe that's why that's up for us relative to some of the other products.

Okay. Thank you.

Thank you.

Gary Mobley, Benchmark.

Hi. I wanted to dig down into some of Mark's commentary about customer inventories and distributor inventories. Mark, could you help us reconcile the fact that distributor point of purchase you said was down 11% quarter-over-quarter. Distributor inventory was up 5% quarter-over-quarter and global point of sale was down 3%. You didn't --

Yes, when you put all this together, you get some timing issues. Okay, so if you look at it, generally within the next month, some of that -- that correction gets -- it gets corrected in the next month following the quarter. So I think we've already seen some of that correction in October. So that those numbers don't look so -- so they balance better. But clearly people were expecting a better period so they built their inventories up. Now they're cutting their -- they're not seeing the business base going into the late third -- in the late third quarter and early fourth quarter as they expected. So now they're changing their profile and cutting their inventory drastically. So I think you'll start to see the numbers, probably you'll see the inventory going down further in the fourth quarter, and the numbers will look different the other way in the fourth quarter.

Okay.

So the channel is definitely rationalizing its inventories at this point. So if there's any inventory correction, it's in the channel and not in the end customer.

Okay. And perhaps putting it in terms that most of us are familiar with, could you talk about the weeks of inventory that both your distributors and your end customers may be carrying, you know, now versus perhaps by the end of the fourth quarter.

We don't really track our customer inventories because our customers generally do it. They expect us to deliver so they don't carry a lot. So Diodes' inventory is right at about 105 days. And distributor inventory -- I know the Asia's running at about 3.4 months, and probably North America and Europe is running at about 120 days. So maybe 4 months which is a little -- it's actually not that -- it's actually not that high. It's to the old profiles, but they had gone -- the industry had shifted to a little tighter inventory control and now they're a little out of whack. They're about -- they're a little bit out of whack, but I expect them to correct that this quarter.

Okay. And Rick, could you go back over your comments regarding the Eris loss in the quarter. What was the exact EPS impact for the quarter?

Yes, it was $1.3 million. Basically we're treating that as a fair value investment. So based on what the stock price does, we either take a gain or a loss on that investment. Plus, the investment was made in Taiwan dollars so we also are impacted by the exchange rate changes. And in the third quarter, the stock price went down, and the Taiwan dollar fell. It was about 50/50 of the $1.3 million for stock price versus exchange rates.

Okay. What was the exact EPS impact?

EPS is about $0.03, right?

$0.03, right.

$0.03.

All right. Very good. Thanks, guys.

Ramesh Misra, Brigantine Advisors.

Hi, good afternoon folks. In regards to inventories, clearly you're building die bank inventory, built a fairly large amount last quarter. Should we expect that to go down in the December quarter? Is that the peak of your inventory build, or will you continue to focus on maximizing factory utilization?

You were talking about the die bank, the wafer bank inventory. We actually slow down the wafer output. Therefore, I would expect that wafer inventory should be reduced.

Okay. And what about the total inventory, Dr. Lu?

Oh, the total inventory, the -- I think we already see some deduction and will continue control that. But to finish good, I'm prepared for the Chinese New Year and prepare for the -- you always have people that don't come back after the Chinese New Year. And so if I have excess capacity, I'd probably -- let me -- yes, excess capacity, I'd probably continue to produce as long as they don't hire the people, as long as they don't put in excess overtime, I'd let them continue build up because prepare for short month of February, Chinese New Year shutdown, and we're going to lose, some people don't come back, the manpower reduction due to the attrition during the Chinese New Year. I'm prepared for those.

Okay. That actually feeds in to my next question. The employee issues that you had earlier on in the year, how well do you think, do you perceive them to be resolved, and do you expect any lingering issues?

It's already resolved. I would say by end of September, I think our productivity due to the -- the new workers has already recovered. Yes. So 4Q -- that's why in my speech I said we do not want to cut down the output because we want to continue that ongoing productivity improvement. And that's why I said if that improvement give me more capacity, just go ahead, do it and prepare for Chinese New Year, for the short months, for all this next year. And therefore, I just go ahead. So I might have -- in the first quarter, we have finished good could be higher a little bit, but I don't want to slow down the productivity improvement.

Got it. And then just a quick followup on the prior questions about your SG&A expenses. Clearly, revenues are coming down. So wanted to get a sense of what part of it is variable and what part is fixed. So -- I'm a little perplexed that you don't have better flexibility in reducing the marketing G&A expenses as your revenues come down.

Well, let's look at several things. Number 1, R&D. R&D, you have 2 portions, 1 is the manpower which is the fixed cost. Another 1 you can thrown around is reduce the new product but I don't want to slow down the new product development. So that portion I just keep constant. Don't increase the people, and I don't want to slow down new product development. Okay.

For SG&A, you can deduce by deduce the people. I want to continue this design win because we have been very successful, the design win we need it for us to gain the market share. We have been continue gaining market share, and I think in our announcement, we already say quarter, or year-to-date, year-to-date, in the third quarter, we actually grew 10% from last year. So you can see we continue gaining market share and, therefore, do not slow down the design wins. So the way I'm doing now is -- another variable would be the accrual for the bonus. And accrual -- but I think in general people still doing a good job. It's a market environment. It's not because people don't do a good job. So we still need to accrue certain amounts for the bonus.

Okay.

So those portions, you just cannot or do not want -- I just don't want to reduce it. Okay, the only one I reduce right now is just encourage everybody taking a vacation. So, and those are the portion and travel, that kind of things we are doing. My point is we are not at the stage we want to be a major force of reduction, work force reduction. I don't think we are in that stage.

Okay. All right. Thanks, Dr. Lu.

Stephen Chin, UBS.

Hi, thanks for taking my question. First one is for either Mark or Dr. Lu. Just in terms of how the -- I guess in your conversations with customers, I was wondering if the specific booking orders that has stabilized yet, or if that is still seen to weaken to a certain degree? That's my first question.

I think it's stabilized. But Mark, do you want to say, comment?

Yes. I don't think that they're really giving very much long-term outlook. First of all, from a customer standpoint, it's not to their advantage to make us comfortable because then we'll be less aggressive with our price. I think that it's pretty much stabilizing, we're starting to see the demand. But we're not really seeing much into -- we're not seeing much beyond this -- the next 2 months, and everybody's a little uncertain about where the demand will be around the Chinese New Year. I mean, there's concern about product, and there's concern about slowing people down because then people won't be prepared for it. But there's not a lot of visibility into that point.

Okay. That's very helpful. And then just kind of overlaying the comments earlier about what you're doing with capacity utilization rates, it sounds like you're seeing output on the back end that was steady to maintain the activity level achievements. And so just kind of depending on how you push those through, will any additional inventory build-up that you have, is that assuming that's basically an indication of a reasonable recovery going to next year and that we don't have a repeat of -- of late 2008, early 2009, is that the right way to think about how you guys are positioning yourself?

Well, let me just answer your question in the general terms. Okay. Number 1, okay -- we -- since we put in the hiring freeze, by natural attritions, okay, we still -- we now have a capital equipment capacity more than manpower capacity. So if the market turn, we have the room for gaining more -- putting more output. Number 2, since we are cutting the overtime again, we -- when the market turn, we can use the overtime to make up the need. Therefore when we see -- when we say we fully realized our capacity, I'm more talking about fully realize our manpower capacity instead of equipment capacity, and we have very limited overtime right now to reduce our cost. But when the market turn, we prepare for the market turn. And we still have the equipment capacity, the overtime we can use. So when the market turn, we are able to pick up the upside.

Thanks. Got it. That's very helpful, Dr. Lu. And last question is for Rick. Just on the gross margin side. Is it possible if you could put out some of the relative weighting of the factors that led to the declining gross margin, which means the higher goals cost, the mix, and also the ASPs. That would be helpful, thanks.

Well, we don't normally give that kind of information. But just in general, gold prices went up about 13% from the second quarter. And we use a lot of gold from month to month. Prices were probably the biggest impactor of the whole thing as Mark talked about the move to low margin, lower price product. That has a significant impact on GP and percent because it comes off the revenue and the GPM at the same rate. So it was probably the biggest factor of the 3.

Great. Thanks.

Tristan Gerra, Robert Baird.

You talked about the inventories being in the channel, not at end customers. What type of point of sale assumption are you making for Q4 sequentially that's embedded in your guidance and would you expect channeling inventories to be back to normal level at the end of the year based on the trends that you're seeing, or do you think that there could be a little bit more taking place in Q1?

You know, I think there could be, it could move into Q1 a little bit. But I think that we're getting closer and closer. We're cutting our POP targets this quarter quite a bit. And probably the actual POS -- I don't have the exact figure of what -- where I expect our POS. Probably at the lower end of -- maybe the higher end of our guidance. I don't -- I didn't really look at it from a POS perspective at this point. But I think I can see the trend based on our ship rates and so forth of inventory against POS improving already.

Okay. That's useful. And then what do you need to see to switch the mix back to higher end product? Because, the mix impact of the weakening demand really started to take effect for you last May, late May. Do you need to see a sustainable recovery trend, or is there any other threshold that you're looking at in terms of moving back to mix up?

I think it all -- You want that one, Dr. Lu?

Okay. I think (inaudible) is we fully utilized our existing capacity. So we have in store capacity and we are using that to support the higher-price mix product, and then when we have excess capacity, we call down the lower GPM to out there for the commodity product. So, if that capacity there, instead of them sitting idle, well, we go out there for the product mix, go out there for the commodity. And that's been our strategy anyway. So whenever we start to have growth in the higher GPM product, then we start to reduce number of the commodity product we sell. So it just depends on the capacity utilization.

Great. That's very useful. Thank you.

Brian Piccioni, BMO.

Hi. A couple of questions. You mentioned that you don't know the Thai flood impact for Q1, fiscal 2012. Do you have confidence that your outlook for the fourth quarter has that fully baked in at this time?

I think so.

Okay. Well, that was quick. Sorry?

Because when this Thai flood come in or happening, they still have inventory, they have the inventory in the PC manufactions, so basically in the 4Q, you probably don't see that much effect from our customer point of view because they have their inventory, okay. But, after in going to the 1Q, how is the recovery? I don't think people very clear.

Okay.

Therefore in 4Q, I think we already factor in -- we already see it, we already play in. And our customer is already play in.

On a follow-on base as somewhat unrelated note, but it's been gone over earlier in the call, when I look at the gross margin outlook for the fourth quarter, given the revenue level, it's more or less in line with -- the gross margin itself is more or less in line with what you posted in the second quarter of fiscal '09 when revenue was considerably lower. And when you had similar revenue levels in the second quarter of fiscal '10, you had a much better gross profit margin. And I -- I understand -- I guess what I'm working towards is I'm trying to figure out for a longer term model what we could do. And I understand you can't forecast the price of gold, but I thought that you were moving vigorously to copper and that sort of stuff so how can we think of gross margins evolving with revenue levels?

Okay. Yes, we aggressively convert our copper, convert the gold product to the copper. And they have a several factors affect the conversions. Number 1, the gold price in 2Q to 3Q actually dropped faster than our conversion rate. I think Rick ought to give you the gold price, dropped significantly from 2Q to 3Q. And that is hurting us on the GPM line because our conversion rate cannot be that fast.

Number 2 is we still have -- a lot of our major customers, they don't want to change the product during the model year. So for the new product, we give them the copper, they design in with the copper product, no problem. But trying to ask them to change the current model, current product and current model who are using the gold, they are kind of resistant. Especially in this tender period when the demand is soft. We cannot force them to convert. So we kind of delayed that major customer conversion only to the new model. So from long-term, after the old models gone, when they start to ramp up the new model, they all will be in the copper. So for the long term, I think you can play in we will significantly reduce the gold product -- gold line product.

Okay. So I guess what it is, is you've converted the -- you've done the process engineering but there's still a heavy mix towards gold. And that's going to take design cycles on behalf of your customers to alter that, basically.

Yes, we do -- we are qualified, number one. We already do the PCN, Product Changing Notes, to all our customers for the second tier, it is easier to say, well, we need to convert. But for the major customer, you need their approval to convert. And typically the major customer, which is our big volume one, they typically are hesitant to change during the middle of the model year. Okay. And so any new design, yes, we already give them the copper and then we need to convert. So, it just takes time.

Okay, great. Thank you.

Harsh Kumar, Morgan Keegan.

Dr. Lu, A quick simple followup on taxes. A lot of the companies that have reported sort of lower guidance have had much lower taxes. I'm wondering why yours shot up -- are you just trying to make up for the tax for the year, or is there something else going on geographically in the mix?

I'm going let Rick answer this.

Yes, so basically what happened in the third quarter, the tax rate has been going down generally throughout the year. The issue is that you do your taxes based on a year-to-date basis. For instance, in the first quarter, you estimate your tax rate for the year, and you accrue at that level. Second quarter, you do the same thing, and you accrue for that on a year-to-date basis. The problem was that in the third quarter, the tax rate dropped, but we had already accrued the first half of the year at a higher rate. And so the third quarter dropped to 3.2% because we adjusted the accruals that we had in the first half. And then in the fourth quarter, you go back to your standard rate.

You got it. Got it. Great. Thank you, guys.

Okay.

Thank you.

Vijay Rakesh, Stern, Agee.

Hi guys. Just wondering on your sales, what's the distributing OEM and distribution and how much is selling versus sell-through?

It's all sell-in, and it's about 55% Dist-D, 45% OEM.

Got it. And the second question was, I know Chengdu is the long-term for you, but is the headcount on Chengdu already done, or is that -- you start to add headcounts onto Chengdu into Q1?

In Chengdu in Q1, we'll finish the drawing, so the building will be done in Q1, and then we will put in the equipment, the power, all those in the Q2 to Q3, and we'll probably start to do the production in the Q3 to Q4 timeframe.

Okay, got it. Good. Thanks a lot, guys.

Joe Wittine, Longbow Research.

Thanks. Most of my questions have been answered. At this point I'll keep it brief. First off, the Shanghai issue, the labor and yield issue that was impacting margins in the prior quarter, I think you said it had 150 BPs of improvement to come. I guess my question is, is that 150 BPs of gross margin improvement already either in the third quarter or already in the fourth quarter guidance?

It's already in the fourth quarter guidance.

Thanks.

And it's in the part of -- the majority is already in the third quarter because we finish -- I think the problem, we already have recover in September, okay. So even the third quarter, they already recover a lot.

Okay, thanks, Dr. Lu. As a quick followup, Mark, in your initial prepared comments when talking about the weaker sales environment, you started off by saying there was weakness, especially in Europe and North America. I thought that was a little bit of a surprising comment given you would expect a lot of the weakness would be in Asia with you guys. So, could you clarify, was that a comment saying that the ultimate end sale of consumer electronics and computing in North America and the European markets will be weak? Or how am I misinterpreting that?

Well, to be honest with you, our numbers were down more in North America and Europe because our POP was down further. And since we're sell-in, that affected us more in those areas.

Okay, how about the inventory cuts in those regions versus in Asia? Was it pretty similar or was it worse in the west, as well?

I think that they're tracking base proportionally.

Okay, thanks, guys.

Ladies and gentlemen, that concludes the Q&A session. I'd now like to turn the call back over to Dr. Lu for closing remarks.

Well, thank you for your participation today. Operator, you may now disconnect.

Thank you. Ladies and gentlemen, that concludes the presentation. Thank you for your participation. You may now disconnect. Have a great