安森美 (ON) 2006 Q2 法說會逐字稿

Good day, ladies and gentlemen, and welcome to the ON Semiconductor second quarter earnings conference call. [OPERATOR INSTRUCTIONS] As a reminder, this conference call is being recorded.

I would now like to introduce your host for today's conference, Mr. Ken Rizvi.

Sir, you may begin.

Thank you, Matt.

Good afternoon and thank you for joining ON Semiconductor's second quarter 2006 conference call.

I am joined today by Keith Jackson, our CEO, and Donald Colvin, our CFO.

This call is being webcast on the investor relations section of our website at onsemi.com and will be available for approximately 30 days, along with our earnings release for the second quarter 2006.

Our earnings release and this presentation include certain non-GAAP financial measures.

Reconciliations of these non-GAAP financial measures to the most directly comparable measures under GAAP are in our earnings release posted on our website in the investor relations section.

In the upcoming quarter we will present at the Citigroup Technology Conference on September 7th.

During the course of this conference call, we will make projections or other forward-looking statements regarding future events or the future financial performance of the company.

The words “estimate,” “intend,” “expect,” “plan,” or similar expressions are intended to identify forward-looking statements.

We wish to caution that such statements are subject to risks and uncertainties that could cause actual events or results to differ materially.

Important factors relating to our business, including factors that could cause actual results to differ from forward-looking statements, are described in our Form 10-K and other filings with the SEC.

The company assumes no obligation to update forward-looking statements to reflect results, changed assumptions or other factors.

Now let's here from Donald Colvin, our CFO, who will provide an overview of the second quarter 2006 results.

Thanks, Ken, and thanks to everyone who's joining us today.

ON Semiconductor Corporation today announced that total revenues in the second quarter of 2006 were $375.3 million, an increase of approximately 12% from the first quarter of 2006.

During the second quarter of 2006, the company reported record net income of $67.5 million or $0.19 per share on a fully diluted basis.

This included approximately $3.3 million or $0.01 per share of restructuring, asset impairment and other charges.

Second quarter 2006 results included approximately $2.4 million associated with stock-based compensation expense, primarily due to our adoption of FAS-123-R, share-based payment.

During the first quarter of 2006, the company reported net income of $40.4 million or $0.12 per share on a fully diluted basis.

First quarter 2006 results included approximately $1.9 million associated with stock-based compensation expense, a $2.3 million gain reflected in other income.

On a mix-adjusted basis, average selling prices in the second quarter of 2006 were up approximately 1% from the first quarter of 2006.

The company's gross margin was 40.8%, up approximately 560 basis points compared to the first quarter of 2006.

This was due to a combination of increased sales volume, improved mix, increased factory utilization, improved pricing and the effect of a review in depreciation life of manufacturing equipment.

In the second quarter, the company reassessed the overall depreciation life of the company's manufacturing equipment.

Following this analysis, the company changed the estimated depreciation life of its manufacturing equipment consistent with the expected useful life of this equipment.

This change, which affects results only for the second quarter of 2006 and future periods, reduced depreciation by approximately $7.5 million and increased gross margin by approximately 200 basis points during the second quarter.

EBITDA for the second quarter of 2006 was $96.8 million compared to EBITDA for the first quarter of 2006 of $76.9 million.

During the second quarter of 2006, the company grew cash and cash equivalents by approximately $43 million from the end of the first quarter of 2006 to a record high in the company's history of $295 million.

At the end of the second quarter, days sales outstanding remained flat at approximately 49 days.

Internal inventories increased by approximately $20 million to approximately 80 days. $10.3 million of this internal inventory increase during the quarter was a result of the Gresham fab acquisition.

Distribution inventories in dollar terms increased slightly, as anticipated, to approximately 11 weeks, in line with our model.

On a unit basis, however, inventories in the distribution channel remained flat at approximately 10 weeks.

Much of the dollar increase was due to improved pricing and mix.

Cash capital expenditures during the quarter were approximately $103 million.

Approximately $81 million of our cash capital expenditures were related to a purchase of the Gresham fab.

Now I would like to turn it over to Keith Jackson for additional comments on the business environment.

Thanks, Don.

During the second quarter of 2006, our largest end market was the consumer end market, which represented approximately 24% of second quarter 2006 product sales.

Growth in this end market was primarily driven by a ramp in platform builds related to gaming consoles, mp3 devices and TVs.

Computing, our second largest end market, grew on a dollar basis and represented approximately 21% of our second quarter product sales.

We expect to see continued growth in our computing revenues in the back half of 2006, driven by a ramp of new products about the Vcore trench MOSFETs, gate drivers and DDR memory controllers.

The wireless end market represented approximately 17% of product sales during the quarter and fell slightly on a dollar basis, primarily due to slower industry growth in the low end of the handset market in the second quarter.

We continue to grow our design wins in the wireless end market with our portfolio of analog switches, EMI filters, over-voltage protection products and TVS devices and currently expect to see growth in this end market as we enter the seasonally stronger second half of the year.

The automotive end market grew slight on a dollar basis in the second quarter and represented approximately 16% of product sales.

The industrial end market grew sequentially and represented approximately 14% of product sales, primarily due to increased sales in the automated test equipment market, and networking represented approximately 8% of product sales in the quarter.

Sales on a direct billings basis to our largest OEM customer, Motorola, represented approximately 8% of total sales in the second quarter.

Our top five OEM customers, excluding foundry services, on a direct billings basis for the second quarter were Delta, Delphi, Motorola, Samsung and Siemens.

Foundry service revenue represented approximately 3% of second quarter sales.

On a geographic basis, our contribution this quarter from product sales in Asia, excluding Japan, increased by 100 basis points to approximately 58% of sales.

Product sales in the Americas decreased by approximately 100 basis points and represented approximately 22% of second quarter sales.

Product sales in Europe remained flat at approximately 16% of sales and sales in Japan were flat at 4% of sales.

Looking across the channels, sales to distribution channel increased by approximately 100 basis points to 48% of product sales.

Direct sales OEMs decreased by 300 basis points to approximately 38% of product sales and the EMS channel increased by approximately 200 basis points to 14% of product sales.

Even though much of our design activity is carried out directly with OEMs, the product fulfillment has been increasingly done with the EMS channel.

We also estimate that approximately 20% of sales through distribution were for third party logistical services.

During the second quarter, revenues broken out by our historical product line categories were as follows -- power management and standard analog represented approximately 31% of product sales.

MOS power devices represented approximately 19% of product sales.

High frequency clock and data management represented approximately 7% of product sales and standard components represented approximately 43% of product sales.

Beginning in the third quarter, we expect to break out revenues based on our four new market-based divisions, the automotive and power regulation group, the computing products group, the digital and consumer products group and the standard products group.

Now I'd like to provide you with some details on the progress we've made.

As many of you know, in May we closed our purchase of LSI Logic Corporation's Greshman wafer fabrication facility.

We are excited to welcome the Gresham employees to our family and believe the Greshman facility provides ON Semiconductor a platform to extend our portfolio of high-performance analog and power products.

During the second quarter, we began to provide foundry services to LSI Logic as part of our wafer supply and test agreement with them.

As we move into the third quarter, we expect to expand our foundry service revenue associated with the Gresham facility, as well as continue to qualify ON products for production at Gresham.

We are on track with our integration plans at Gresham and anticipate revenue from ON Semiconductor-generated products out of Gresham by the first quarter of 2007.

On the computing front, we are beginning to see traction with our next generation analog controllers and trench MOSFETs.

In the latest generation of desktop computing platform, we have won analog controller and trench MOSFET business at three major OEMs and several Asian ODMs.

These wins will ramp in the third quarter.

We are also engaged with and are gaining traction with other market-leading OEMs and Asian ODMs in this space and expect to expand upon our recent success.

Going forward, we look to accelerate the success we're enjoying as a result of our focus on strategic accounts by creating four market-based business units.

Beginning in the third quarter, we have created a digital and consumer products group, a computing products group, an automotive and power regulation group and a standard products group.

We believe this new organizational structure will enable ON Semiconductor to continue expanding the development of innovative power solutions for customers in these key markets.

Now I'd like to turn it back over to Donald for our other forward-looking guidance.

Donald?

Thank you, Keith.

Now the third quarter 2006 outlook.

ON Semiconductor recognizes revenue through a distribution channel on a sell-through basis.

Based upon product booking trends, backlog levels, anticipated foundry service and estimated turns levels, we anticipate that total revenues will be approximately $405 to $415 million in the third quarter of 2006.

Backlog levels at the beginning of the third quarter were up from backlog levels at the beginning of the second quarter and represented over 90% of our anticipated third quarter 2006 revenues.

We expect that average selling prices for the third quarter will be approximately flat sequentially.

Gross margins in the third quarter are expected to decline slightly to approximately 38%, primarily associated with an increase in lower-volume-- in lower-margin foundry service revenue.

In the third quarter we believe that distribution inventory will remain relatively flat on a global basis at approximately 11 weeks and on a unit basis we expect distribution inventory to also remain flat at approximately 10 weeks.

For the third quarter we expect cash capital expenditures of approximately $50 million.

Of this approximately, $15 million is related to a final payment to LSI as part of the purchase of the Gresham facility.

For the third quarter we expect total operating expenses of approximately 17% to 18% of sales, with SG&A at approximately 10% to 11% and R&D at approximately 7%.

We anticipate that net interest expense will be approximately $11.5 million.

Beginning in the first quarter of 2006 we are required to expense stock-based compensation.

This is in accordance with the State of Financial Accounting Standards number 123-R, share-based payment.

We currently expect this expense to be approximately $2.5 million in the third quarter of 2006 and this expense is included in our guidance.

This is a pre and post-tax adjustment-- adjusted expense.

We expect the fully diluted share count to be approximately 336 million in the third quarter of 2006, which includes approximately 323 million of common stock, approximately 7 million shares related to options and approximately 6 million shares related to our convertible bonds.

Further details on share count and EPS calculation are provided regularly in our 10-Qs and 10-Ks.

With that, I would like to start the Q&A session.

Thank you, sir. [OPERATOR INSTRUCTIONS] Our first question is from Michael Masdea of Credit Suisse.

Your question, please?

Yes.

Maybe, Donald, can you give us more clarity on how much the LSI impact was?

There was some of it in the press release, but any more details on both this quarter and next quarter how much LSI is impacting the various P&L lines?

Well, I think, we'd-- obviously, we don't want to become a proxy for LSI and give precise numbers, Michael, as you can imagine.

I think we are looking at something in the approximate range 2%-3% of revenue, I believe, this quarter and this should significantly increase next quarter, more than double, I believe, it's on track to do.

So, I mean, that gives you a flavor.

Obviously, the mix of revenues is something that's dynamic.

I think it's fair to say that we've always said that the LSI revenue as a foundry service revenue is less profitable, less in a margin basis than our normal business.

So that's why-- primarily the main reason, coupled with a little bit less, low inventory growth in the third quarter, that's why we're anticipating a lower gross margin.

But I think you will understand that we don't want to become a proxy for LSI and start to give very precise numbers and try and forecast rates of their foundry revenue.

That's fair.

What about on the spending side around the EPS impact for the last quarter.

Is there any more detail you can get on that or--?

Well, I guess we have never been in the habit of giving marginal EPS by customer.

I don't think anyone gives that.

LSI is a valued customer, so, again, I will be a little bit evasive in replying to you there.

So, again, I think you'll understand.

All right.

Just trying to get at how you did on your core business versus what we were thinking.

Well, I think it's fair to say we had a good quarter this quarter on our core business and I'll let Keith jump in with some more comment.

And what is fair to say is our core business is performing well.

We had over 40% margin on a consolidated basis.

The foundry revenue is under our core business margin, therefore, without the foundry it would have been even better.

Our core business will grow, the third quarter over the second quarter and our core business gross margin remains very healthy.

Yes, Mike, I would also remind you of the guidance we gave at the time of the purchase.

We were not expecting EPS impact from the foundry business and in the second quarter there certainly was no substantial EPS impact.

So, again, I'll just go back to what we set the anticipation for.

It really was not a big part of the earnings plan.

Yes, and I guess from what Donald said, I mean, your gross margin, even when you strip out your operating margin, your incrementals, when you strip out all the-- the impact of depreciation, it's still pretty impressive.

Walk us through what were the biggest kind of pieces of the-- of the profitability improvement.

Okay.

So I think we spelled out different things that helped us and, in all fairness, you're right you strip out the depreciation, we had an inventory build, which you can say gave us a help.

I don't know how much I would attribute to that, certainly a cent.

We had very, very good manufacturing activities and that helped too.

We're using less outside foundry and more internal.

We had a good mix, particularly good strong mix in our high-frequency and analog, so certainly that was-- we could attribute 1 to 2 points of gross margin on that.

So it was a combination of very good manufacturing activity, good internal source manufacturing, keeping the plants humming along over 90% capacity utilization and a good mix of analog and high-frequency products.

Great.

Just last question for me, really.

On the PC side you made a comment about expecting some continued growth.

I thought you said the back half of the second half, is that-- is that correct?

And you're looking at really later in the year this year for PCs or is that just me mishearing a little bit.

Yes.

No, we expect our PC revenues, computing revenues, in the second half to be stronger than the first half.

We started to see some of that expansion in Q2.

So we are expecting to see better PC and, again, most of that, Michael, is more product participation on our part, not necessarily a change in the end market.

Your next question is from John Barton of Cowen.

Your question, please?

Thank you very much.

Just to followup on the last one, if I can.

Any indication you can give us with respect to how we should think about incremental gross margin for those dollars coming in from foundry services?

Again, very-- very difficult to simulate.

As I said to Michael, we're not going to give margins by customer.

I think we did disclose when we-- when we announced the deal that we had a two-year take-or-pay agreement, which was just under $200 million.

So assume $200 million, which would be $25 million a quarter.

We also said that it was more front-end than back-end loaded.

So there was more revenue up front and, as Keith mentioned, we also stated we did not see that having any negative impact on EPS this year.

So, I mean, that's the big parameters that we would like to keep with.

I think if you look at the rates we're running in the second quarter, we don't expect the LSI business to be less than the contractual amount in the third or the four quarter from the visibility that we have today, so I think we've given some pretty indications of what that business is costing and what the revenue it generates.

Fair enough.

Keith, could you give us kind of an update on where you stand from a game console perspective?

And a couple things that I'm curious about is, obviously, what we saw, some tremendous design win success with the Xbox 360, some of which were multi-sourced sockets, some weren't.

How are you doing at maintaining [inaudible] in that box and any indication you can for the next major game console launches, please?

So in the game consoles that ramped here over the last few quarters, we continue to maintain good share and good content per box.

So those actually we expect Q3 to provide some growth quarter-on-quarter, as well, in that area.

So keeping good share and we see those builds building in the third quarter.

Relative to the new game consoles, we certainly believe that we've got good analog power design wins in those consoles, which will represent growth as we enter the fourth quarter.

Great.

Thank you very much.

Our next question is from Craig Ellis of Citigroup.

Your question, please?

Thanks.

I'll start with a clarification.

Don, can you just clarify on the asset life revaluation, did you utilize all the benefit from that in the second quarter or is there incremental benefit on the gross margin line in the third quarter, as well?

Good question.

The-- it's a change in accounting estimate, Craig, and what we did is we reviewed what other companies are doing, how long we're using the equipment for and we got comfortable on-- only on the manufacturing equipment that we could extend the life.

We had already in a range 5 to 10 years and we extended it all to 10 years.

So it was-- it was not retroactive, it was effective from the first of April.

So there will be no incremental changes going forward.

So that is now baked into our guidance and into our projections.

Okay.

And then just followup on the gross margin and the outlook, some more clarification there.

If I assume that the Gresham facility doubles as a percent of revenue to that customer, it still seems like the base business is going to grow, based on your guidance, a little bit above mid single digits and so it would seem like there would be potential to offset the incremental pressure from the Gresham business on the gross margin line.

Is there anything else that's happening from a mix or other standpoint that we should be thinking about as we think about gross margin mechanics into the third quarter?

I think you've managed to chart it out pretty well.

I think not so much above 5.

I think we'll see low single digits for the core business rather than above 5, maybe a wee bit higher there, I think it's fair to say and as far as the gross margin is concerned, I think the-- we're looking at-- in the third quarter, specifically to Michael, we have grown inventory by $10 million on our core business in the second quarter and we don't plan any inventory increases in the third quarter--

Okay.

--either internally or in distribution.

So a little bit less manufacturing activity with the offset in absorption rates there, explain all, as far as I can make out, all the delta in the gross margin.

Okay, great.

And then lastly, great job on the top line and we'd expect to see SG&A tick up on that, but it was up a little bit more than I thought, I think about 8% sequentially.

Anything that was a one-time item on the expense line in the quarter that wouldn't be recurring in the third quarter?

Well, we do have-- we do have kind of goals and profit-sharing type bonus program for the whole company and that is something that pays out more with better results.

So as you have generously remarked, the results in the second quarter were good, so the payment was good.

So I don't think that really you can classify that as one-off.

We don't anticipate the results in the second half to be such that they're going to drive the bonus down.

That's good.

Lastly, Don, for you, you had analyst day goals for $400 million in quarterly revenue, 40% gross margins.

You guys did a nice job of getting there in the quarter.

Any update to that?

I think we said we-- we've obviously-- we got there on our guidance but we got there on our guidance because of we have this foundry business and when we first gave that-- that objective at the beginning of last year, we weren't counting on foundry business to take us there.

So I think we are very happy with our core business going above 40%, but our core revenue did not get to $400 million.

So I think we have said officially that we see ourselves getting to that core business revenue in the $400 million range more next year than this year.

And, again, from the guidance we're giving, the market outlook, it's not impossible if we have a real snap-back in the fourth quarter like we had last year, but right now I think it's probably more reasonable to predict that we will meet these objectives next year.

Our next question is from Ramesh Misra of C.E. Unterberg.

Your question, please?

Good afternoon, guys.

Good job on the quarter.

My first question was in regards to pricing.

You said it was up.

How much of that was because of mix and how much was it on kind of-- kind of an individual part basis?

Yes, we try and give numbers as close as we can to approximate the actual change in prices, not the change in mix.

So that 1% was really as close a we can get to approximating the change in actual price.

Okay.

All right, great.

In terms of materials pricing trends for you, have you-- have you seen any inflation in that regard happening in Q2 and is that something you're watching out-- concerned about in Q3?

Yes.

Yes, the biggest headwind we've had basically on margins this year has been raw material pricing.

Metals, particularly up dramatically over the last six months, polysilicon also having some impact, but primarily metals for us and oil-based supplies.

So it has been a big headwind.

We've had to run very hard to get ahead of that in our manufacturing cost reductions, but certainly that remains a big factor in-- in increasing margins.

Okay.

And then, Keith, at your Gresham fab do you anticipate or have you made any toolfit changes?

If I remember correctly, I don't think the Gresham facility had any in-house implant.

Yes, we will be continuing to make some small changes there.

There's nothing radically planned, but certainly we have as our product base ramps from-- on semiconductor power-base products definitely use less metallization, less lithography, if you will, and more of the epi and implant.

Okay.

I don't think it'll be substantial or significant in the short term.

Okay.

And then one more question for you, Keith.

In terms of-- can you just give a dollar amount for the depreciation last quarter and where do you see it next quarter?

I think we said-- I think we said we saved-- this is off the top of my head.

I think we said we saved $7 or so and the total depreciation after that was like $17.

So it's like $24 or $25 and I think last quarter it was similar.

Okay.

And a comment on lead times and that'll be it.

Lead times remain basically 12 weeks.

Certainly they have not been expanding as we went through Q2, so in general long-- longer than we would like them, but-- but not-- not getting worse.

Our next question is from Craig Hettenbach of Wachovia.

Your question, please?

Yes, can you discuss what fab utilization was in the quarter and what you expect going into Q3?

Yes, I can.

Fabs were running approximately 90% last quarter and I would expect something fairly similar here in the third quarter.

Okay and then in the handset market you mentioned the weakness in the low end.

Do you have any type of visibility as to when you would expect a snap-back in that business in terms of what you're seeing for orders there?

Yes, I don't know about snap-back.

We definitely have seen order patterns that are greater in the second half than the first half, but the concept of snapping back is probably pretty aggressive.

Most of that backlog got adjusted in the second quarter and I think represents fairly normal seasonal growth as opposed to, perhaps, some more aggressive growth by our customers anticipated prior to that.

Okay.

And then in prior calls you've discussed the dollar content in Xbox.

Have you discussed any-- the content potential in the Sony PlayStation 3 for you guys?

We haven't give any specific numbers that.

That is not yet public information from our customer, so we're going to probably hold off on that.

Got it.

Okay.

Thank you.

The next question is from Chris Caso of Friedman Billings.

Your question, please?

Yes, hi.

Thank you.

I just-- going back to the depreciation question, can you clarify how much additional depreciation was added on from the Gresham fab?

And I guess-- I assume you guys weren't depreciating that for the whole quarter?

No, I think-- let me-- I have to work through it. $80 million of equipment over 10 years is $8 divided by 4 is $2 and multiplied by 2-- by 0.5 is $1.

So we're at $1.

Okay and that goes up to about $3 or so, going forward?

Yes. $2.

It'll go to $2.

To about $2?

Okay.

And also we depreciate-- to be totally factual we depreciate the workflows in process and the IP over 5 years, so it's probably $2.2 or $2.3, but--

That's fine.

--I don't think you're going--

My model's not quite that accurate.

I didn't think so.

But the-- but you're not-- the depreciation is constant.

You're not depreciating as you turn on equipment or anything like that?

No, no, no.

We're depreciating it straight out of the box.

Okay.

And just clarify with the PC market, the growth you guys saw in the second quarter was probably a little bit different than a lot of the folks.

I guess we'd assume that some of the VRM-- VRM11 components and then some of the other stuff that you're doing new started shipping there in the second quarter ahead of the platform?

That's correct.

We started seeing those builds in the second quarter and so as I mentioned on the earlier question it really is more content change for us, more share, if you will, than any indicator of the end markets changing dynamically.

And I guess as you look into the third quarter, that's-- you'd probably make a similar comment?

I guess maybe if you could comment on-- from a sort of underlying market standpoint?

Yes, I-- I mean, I do think the second half will see more computers built.

So I mean I think there'll be more seasonal approach and that is very normal.

So I do think that'll happen, but I think we will grow faster than that rate because of our additional content.

Okay.

And then back on the production side, I know that one of the reasons the lead times are as high as they are is because of constraints mainly on the back end.

Could you comment on where those constraints are now and is that getting better or worse as you go into the second half?

Yes, the constraints are still there.

We're still running over 90% utilization, even with the capacity that we've been adding this year.

I would anticipate actually we get a little bit better in the second half than we have been in the first half.

So, again, I think we'll start seeing those lead times come in sometime during the second half.

One thing that's interesting for us when we look at business, lead times and all the rest that's encouraging is that our pricing still remains pretty stable and you saw our guidance we're up 1%, pretty flat going into Q3 with over 90% of the backlog on the books.

So, I mean, that's a comforting sign.

And also what's good is that our units are not-- have not changed dramatically from Q4.

So we've seen the benefit of better mix and a better pricing environment.

So it's not like we've been shipping in [inaudible] and where we were really short was in certain packages where we have added that additional capacity, but that's also helped us change our mix to higher-margin products while keeping total units pretty flat.

Okay.

And just one final one and I know it's a question you guys have been getting since the beginning of the year, but with the lead times as high as they are, the potential for double orders or customers trying to put additional orders in.

I know you guys have been trying to manage that.

Any sort of update there on either what you're seeing or what you're doing to prevent that from happening?

Yes, we-- again, there's some of the channel that we have a big impact on and from a total dollars of inventory, the two biggest ones are what we do internally and with our distribution partners.

And we've actually been working very well with them to re-profile their backlog to make sure they're getting the products they need without over-shipping there and, frankly, we're feeling pretty comfortable.

As we mentioned earlier about 10 weeks of units in the channel is historically fairly low.

So we're actually feeling good about the bulk of the inventory situation out there.

Clearly would not have the same kind of visibility into the OEM side, but, frankly, the distribution piece is over half, so we're actually feeling pretty good.

Just a lot of questions whenever I've been on the road have been 2004, they say it's a 2004 repeat.

And so I think to pick up from Keith's point there, units of inventory is at 10 weeks.

I think at the same period at the end of the second quarter in 2004 we got to 16 weeks.

And as far as dollars of inventory, we came in just over 11 weeks, exactly in line with our plan and we were, of course, at 14 weeks at the end of the second quarter in 2004.

So I think, again, these are pretty good indicators that as far as our actions to control inventories, we're doing our best and it's working.

Okay, thank you.

The next question is from Mark Edelstone of Morgan Stanley.

Your question, please?

Hey, guys.

Nice job on the quarter overall.

Thanks, Mark.

Just to start, I guess, Keith, clearly you had some pretty nice upsides in the second quarter in the core business.

Can you just talk about where some of those upsides came from when you look at the end markets?

I guess, again, we got a little stronger participation out of computing than we had initially anticipated.

As you know, some of those platform ramps had been pushing.

We did see them start in the second quarter.

The tester business in-- largely in Japan, as it turns out, but the automatic test equipment sector certainly performed very well with some upsides there.

And the gaming, consumer, mp3 platforms and televisions, et cetera, held very strong for us.

So all of those sectors, I think, were positive for us in the second quarter.

Just to follow up there, clearly we're starting to see in the industry a little bit of a slowdown, I think, on the back end at this stage.

What's your sort of read as you look at ATE for the rest of the year.

Does that look like that business can hold in here or does it look like that might need to pull back a bit?

At this point we think ATE's holding in there.

I don't have anything that indicates to me it should be weakening.

There's still a lot of demand out there for-- for units and for additional unit testing, so in general I'd say that should be holding up in the second half versus the first.

And then just-- I don't know if you have any overview on the EMS sector, but that was a pretty good portion-- or pretty big driver for you here in the second quarter and we've definitely seen some inventory build there kind of across the whole EMS sector.

Do you think-- is that all, do you think, geared up to basically drive or support end demand or is there a risk of inventory build in that sector that maybe is not showing up in distribution this time around, but is showing up in that sector instead?

Yes.

No, we-- we're watching that carefully.

We do expect our EMS partners to grow in the third quarter over the second.

We have built some inventory there specifically for that purpose and, again, we've got better visibility than we've had before in their end customers.

So we actually feel pretty comfortable with the EMS piece.

The only real piece I have little visibility into is the OEM sector.

Remember, a lot of our EMS guys pull the stuff out of special reserved inventory in distribution.

So the EMS sales has no incentive to build up their own inventories and we estimate, I think, Keith, something like 20% of our distribution inventory is actually reserved for the EMS guys.

So when we give a distribution numbers, they'll include that reserved inventory for the EMS market.

Understood.

And just this last question for you, Donald.

On the backlog comment where you're more than 90% booked now for the third quarter, does that include the foundry piece or is that just specifically on your production specifications.

That was the-- I think what we did say is our backlog improved in both the core and the foundry business going into third quarter.

But when you talked about like the quarter fill that you have at this stage, is that for--?

That applies to both of them.

Okay, great.

Thanks a lot, guys.

Nice job.

Thanks.

Our next question is from Chris Danely of JPMorgan.

Your question, please?

Thanks, guys.

Good quarter.

Can you give us your expectations for gross margin trends after Q3?

Well, I think we've-- although there's a temptation to do that, we're resisting giving more than a quarter's guidance for obvious reasons.

I think everyone will agree, including analysts, it's very difficult to forecast more than one quarter and so if we start giving gross margin, Chris, then we'll be-- we might as well give the P&L and you know that will get it into-- into a vicious circle.

Sure.

How about just giving us some sort of update on the long-term gross margin target, then?

Well, I think what we said when Craig was asking the question, we stated that we believe that the $400 million and 40% is something that we can reach next year and-- on both revenue and the gross margin and that we also stated that our core business performed at more than 40% gross margin in the second quarter and then we don't see-- we see that continuing in the third quarter as part of the 38% guidance that we gave.

So that's pretty detailed.

Also, Keith mentioned that we see the second half seasonally stronger than the first half and we see growth in the third quarter, but I think it's too early to call the fourth quarter revenue.

I will leave it to people closer to the markets like yourself.

Sure.

And, Keith, can you just run us through your expectations by end market for Q3?

Yes, again, you're wanting the end market expectations or our sales into those end markets?

Both would be great.

We do believe in the wireless handsets and computing that the end markets themselves will grow third quarter over second and that our content will grow in both of those sectors, computing significantly faster than the market itself because of the content change.

The consumer-- the wireless handset side we should be growing pretty much in line with the change that you would expect there.

For the automotive market, typically Q3 is not a growth quarter.

We are not expecting that to grow for either us or the industry.

The industrial sector I'm not looking for a lot of growth there, but I would think that would be fairly constant quarter-on-quarter.

And have I missed any?

Networking also not a lot of change.

So really the growth we're expecting quarter-on-quarter will be in computing and in the handset business.

Okay and then so in Q2 pricing was up, I think, 1%.

I know you guys are expecting to be flat in Q3.

Is that a function of mix or is there something else going on out there?

Am I just looking into it a little--?

No, I think that's pretty much not a function of mix.

I think that's pretty much the pricing environment.

Certainly the perceived shortages in the industry are starting to come a little bit better in balance and so, I mean, we actually see pretty much very little change from a-- from a pricing pressure perspective quarter-on-quarter.

Got it.

And then last question, on inventory.

Your deferred income to disties went up a little bit or a little bit more than that and your own inventory went up.

It sounds like you guys want to keep your inventory and distie inventory flat in Q3.

Will you seek to bring those down in Q4 and I guess what sort of inventory level should we be looking at as a comfort level for you guys on both distie and internal?

Well, I think the deferred income went up because we've got a richer mix and that richer mix, I think, in the end-- we had that at the end of the first quarter and I think Michael Masdea asked a question on it and I think someone drew the inference that it would help our margin in the second quarter as it was sold through.

So I think that was a pretty reasonable thing.

So having good mix in distie is good for margin and, again, that's a positive thing for us going into the third quarter.

Looking forward towards the end of the year, we believe that there will be a reduction in distie inventory in the second half and that's what we're planning to achieve.

We got down last year to something like 10.5 weeks at the end of last year and so we'll try to get as close as that as is reasonably possible.

So we would expect our distie inventory to be relatively flat in Q3 and fall in Q4 and it should fall because the distribution-- distributors themselves will want to clean up their balance sheets for the year end like they did last year.

So that is something that we anticipate happening in the fourth quarter.

As far as our internal inventories are concerned, you're right.

They did grow but we're trying to make sure we've got the parts to meet the demand in the second half and we will-- we have not planned any more growth in internal inventories, which is why in our margin guidance we assumed we would not grow inventories in the third quarter and that's why-- that's one of the main reasons why we took our gross margin guidance down.

We would expect that to probably slightly fall in the fourth quarter and our target is certainly to get it somewhere in the mid 70s in days and I think it's just 80 days now if you exclude the Gresham.

So we'd like to try to get it down by four or five days.

Got it.

Thanks, guys.

Really good quarter.

Thanks.

Our next question is from Robert Burleson of ThinkEquity Partners.

Your question?

Hi, guys.

Nice quarter.

Just a couple of quick ones.

On the strength in PCs that you guys are seeing from-- from the uptake of your products there, how much of that is predicated on a strong adoption for the new dual core platforms that are rolling out?

It's tied pretty closely.

So basically our ramps there are going to be matched up with the ramps of the dual core.

It's not exclusively that, but certainly there's a significant portion tied there.

And do you have a sense of what the product mix is there, the kind of PCs that are being launched?

Is there still a lot of legacy kind of single-core products being launched for back to school or is it pretty much converting over to dual core at this point?

It seems to be following a relatively traditional ramp plan from a-- from a platform changeover perspective.

You're seeing some very nice growth in the dual cores and the-- the past platforms trailing off at the same time.

So it's not-- I mean, obviously, the new stuff is growing much faster and the old stuff is falling off.

And then just quickly on the-- the pricing issue, should we be concerned that we haven't been seeing the normal sort of secular quarterly declines in ASPs and that something like that could kind of start to crop up here, maybe not in Q3 but in Q4 as the back end loosens up and we see what I believe will be maybe a little bit below seasonal norm for-- for PCs and handsets?

Yes.

I mean, always we look for that.

Frankly, the way we've modeled our business every year is the long-term average for ASP in our type of business has been around 8% per year.

In years that have some strong growth that can go to 0 or slightly positive.

The-- but since 2001 we have not seen anything that even approximates that 8%.

So, frankly, I guess where I'm headed with this is we're expecting a more muted pricing environment in both directions as we look forward.

So, yes, I think at some point in time we do get back into declines, but I think they're still in the 1% to 2% range is kind of the range we'll see when supply exceeds demand.

And then just quickly on your wireless business, the 17% of revenues, on the stuff that's not Motorola, how much of the slowness do you think is slowness for emerging market handsets versus actual share losses by those customers?

Yes, I understand what you just asked.

We-- we service all of the major manufacturers and, of course, most of the-- the ODMs in Asia, as well.

And so I do believe the expectations for the year were pretty high as everybody thought they were gaining share.

I think most of that has been adjusted in the current backlogs.

I think it reflects much better the real end market growth at this stage and certainly there are share shifts, but I guess my point to you is I think that at this stage it's not-- it's not us having more or less sales due to share change, it's pretty much the market itself has just been adjusted to the end market demand.

Our next question is from Steve Smigie of Raymond James.

Your question, please?

Great.

Thank you.

Could you please just comment a little bit on what sort of innovations product-wise you might be able to have now that you have the Gresham facility?

Any sort of pie-in-the-sky opportunities there or anything?

Yes.

Actually, I don't know about pie-in-the-sky, but our basic plan there is to accelerate the development activity for portable power applications.

So basically being able to get better integration into those portable consumer applications and also looking at a pickup in our automotive sector where those processes will give us more ability to integrate more functions.

So in both cases, we're looking at kind of accelerating the development in ASSPs, application specific standard products in both automotive and portable.

The computing piece will also move there, but I don't know that that represents a delta in activity.

Okay.

Could you just talk a little bit about how your cost structure looks with this facility, let's say, when you get past the period where you're doing the foundry revenue?

And is it-- you've always seemed to have a pretty low cost structure, how does that impact that?

I mean, do you create higher-value-added products but a little bit higher expense now?

Yes, I understand what you're asking.

Basically, kind of two thought concepts for you.

One we should be able to generate higher margin products out of that factory, both because the costs are better than the foundries that we're using today.

So, in other words, kind of phase one is move some of that foundry revenue internally and we'll get better performance from that perspective.

But also, from the value, if you will, of the content as we do more of these ASSPs, we'll be capturing more content with higher ASPs.

So in both cases, I think we get a lot of leverage from a margin model going forward.

Finally, if you could-- I hope I didn't miss it, but could you just talk about linearity just in the core business through the quarter and into the-- into this quarter?

I think the-- we've seen this quarter performing-- shaping up reasonably well.

There's obviously-- there's always some uncertainty in the point that we have a pretty big September as always, as you would expect.

But I think what's fair to say is that July shaped up okay and that compared to July of last year it's significantly more attractive.

I remember sitting here in this room last year and we were off to a pretty [inaudible] start and, as a matter of fact we finished the quarter okay, but it was very, very back-end loaded.

So it certainly would appear to be shaping up less back-end loaded than Q3 of last year and with July off to a good start and July revenue still not closed but indicating a significant increase over July of last year.

So the trends are not discouraging.

And how did it look through-- through Q2?

Q2 we had a-- we had a pretty linear-- I'd say more linear, still with a strong-- strong June and we had some pretty nice pleasant pull-through at the end.

It's always a bit of a scramble when you're on a sell-through model.

So I think it's fair to say that it closed with a bit of a bang.

So it was quite-- the last week was a lot stronger than the weeks before.

But that's what you have to live with when you're on a sell-through model.

Thank you very much.

The next question is from Tristan Gerra of Robert Baird.

Your question, please?

Hi, guys.

You've mentioned in the past your expectation in terms of second half revenue over the first half and if we look at this year and excluding Gresham, what type of percentage can you talk about?

I think what we-- what we have said is when we looked at the unit basis normally the second half is up 5% to 10% over the first half.

And I think as far as the guidance is concerned for the third quarter we're still tracking in line with that model.

But I don't-- I think it's still premature to call the fourth quarter, but that's what the facts seem to show.

Apart from 2004 we saw unit growth of 9% to 10% second half over first half.

And revenue might not have grown the same because there was ASP movement.

So, again, we-- we don't see that model being broken, but a lot depends what's going to happen in Q4 and I hear people questioning strength of certain markets and things.

Time will tell.

The-- certainly the PC space, as Keith said, offers lots of hope for strong growth in the second half, especially stimulated by price war and more penetration in many markets overseas.

So we'll just how to see how it shapes up.

Now in the PC space, have you quantified or can you help us understand what type of mix notebook revenues could be at the end of the year and perhaps quantify by how much you think it can outpace the PC revenue growth this year versus last year based on your market share gains?

I don't really have any numbers I can give you, Tristan.

It's something we can look at, but I really couldn't give you-- we haven't calculated those numbers at this point.

Sure, I understand.

And then last question, what was the ECL as a percent of sales in the quarter?

I think we stated that the ECL business performed well and I think we got it up to just between 6% and 7%.

Great.

Thank you.

Our final question today is from Craig Ellis of Citigroup.

Your question, please?

Thanks.

I just wanted to cycle back on the Gresham facility.

You outlined some of your longer-term plans, Keith, but as you've been in operating the facility for the last two months, any-- anything surprising from a capabilities standpoint there, either on the positive or negative side?

Oh, we've been very pleased with what we've seen.

The facility's running very well.

It was, as we expected, a high-quality team and a high-quality facility.

So we've been very pleased.

I don't know that we've had any significant surprises in either direction, but certainly it's met all of our expectations.

And your products will start coming out in the first quarter?

Yes.

Okay.

Thanks, guys.

Ladies and gentlemen, this concludes the conference for today.

Thank you for your participation.

You may now disconnect.

Good day.