德州儀器 (TXN) 2004 Q2 法說會逐字稿

Good afternoon, ladies and gentlemen, and welcome to the Texas Instruments second quarter earnings release conference call.

At this time all participants have been placed on a listen-only mode and the floor will be open for your questions following the presentation.

It is now my pleasure to turn the floor over to our host, Mr. Ron Slaymaker.

Sir, the floor is yours.

Good afternoon and thank you for joining our second quarter earnings conference call.

Kevin March, TI's Chief Financial Officer, is with me today.

This call will last one hour.

For any of you who missed the release, you can find it on our website at ti.com/ir.

This call is being broadcast live over the web and can be accessed through TI's website.

A replay will be available through the web.

This call will include forward-looking statements that involve risk factors that could cause TI's results to differ materially from management's current expectations.

We encourage you to review the Safe Harbor statement contained in the earnings release published today, as well as TI's most recent SEC filings for a complete description.

Our mid-quarter update to our outlook is scheduled this quarter for September 8th.

We expect to narrow or adjust the revenue and earnings guidance ranges as appropriate with this update.

We will observe a quiet period beginning on September first until the update.

In today's call, I'll review our revenue performance and then Kevin will discuss profit performance and the third quarter outlook.

After this review we'll open the lines for your questions.

Second quarter TI revenue grew 10% sequentially and 39% from the year ago quarter.

Demand was strong across a broad range of products in Semiconductor, Sensors and Controls, and Educational and Productivity Solutions or E&PS.

Semiconductor revenue in the second quarter was up 8% sequentially and 44% from the year ago quarter.

Another strong quarter that we believe reflected further market share gains for TI.

Sensors and Controls revenue grew 2% sequentially and grew 11% compared with the year ago quarter.

E&PS revenue more than doubled sequentially, reflecting back to school seasonality and grew 8% compared with the year ago quarter.

In Semiconductor sequential growth was particularly strong in DSP and analog products for cell phones and wireless infrastructure, in high-performance analog products and in DLP products.

Total analog revenue grew 7% sequentially and 44% from the year ago quarter.

A big factor in both of these comparisons was high-performance analog, which grew 13% sequentially and 64% from the year ago quarter.

The high-performance analog growth was broad based, as is the nature of this product line, but demand was particularly strong in both comparisons for the company's products for digital audio/video applications, as well as for power management products for rate -- for a range of portable electronics applications.

Growth from the year ago quarter was also strong in high-performance or precision linear products.

Total analog growth also benefited in both comparisons from strong growth in analog products used in cell phones.

For the first six months of 2004, analog was about 40% of TI's semiconductor revenue, the same as 2003.

DSP revenue grew 13% sequentially and 53% from the year ago quarter, primarily due to strong demand in wireless.

In addition to wireless, growth in both comparisons was also strong in catalog DSP, digital still cameras and voice over Internet protocol or VoIP applications.

For the first six months of 2004, DSP was about 35% of TI's semiconductor revenue, the same as 2003.

TI's remaining semiconductor revenue grew 4% sequentially and 34% from the year ago quarter.

DLP set the pace with 10% sequential growth, and over 90% growth from the year ago quarter, although all of the product areas, including standard logic, risk microprocessors and microcontrollers grew as well.

Royalties declined about $30 million from the first quarter, with almost all of this due to a single licensees that has recently moved to a semiannual payment schedule and for which we recognize revenue on a cash payment basis.

Blended pricing for commodity logic and linear products shift in the second quarter, increased from the first quarter level as expected.

Turning to specific end equipments, wireless had a growth -- had a strong quarter both in cell phones and infrastructure.

Revenue grew 15% sequentially and 64% from the year ago quarter.

This growth was broad based, with strong demand from multiple large OEM customers for digital based VAN, analog power management chips and OMAP application processors as well as from ODM customers for TI 2.5 G chipset products.

Products for WCDMA 3 G handsets are now an important part of our wireless operations and we have the early lead in this market.

WCDMA baseband modems have emerged as a significant contributor to our wireless growth with about one quarter of the sequential growth in the second quarter attributable to WCDMA digital basebands shipped to our large OEM customers.

On the application processor side of 3 G handsets market analysts IDC attributes two thirds of the rapidly growing market for wireless application processors in 2003 to TI.

Most of these OMAP processors are being used in 3 G WCDMA handsets.

The company's combined strength in modems and application processors have positioned TI as the leader in WCDMA.

Taking the technology combination even further, TI and NTT DoCoMO announced last week that we are extending our current relationship to work together to combine TI's next generation application processor, OMAP2, and a UMTS digital baseband on the same chip.

UMTS is the 3 G technology that is based on WCDMA but is backward compatible with the GSM and GPRS standards which are used by about 70% of the world's cell phone subscribers today.

UMTS is widely expected to be the prevalent worldwide standard for 3 G cell phones.

TI's OMAP application processor is currently used in most of DoCoMo's FOMA 3G cell phones today.

This latest program means that TI will be extending our content in these cell phones to include the baseband processor as well.

Finally, in broadband communications, revenue was about even sequentially and grew 44% compared with the year ago quarter.

Sequentially, revenue growth in VoIP offset a decline in wireless LAN revenue.

Revenue in all product areas increased strongly from the year ago quarter.

At this point, I'll ask Kevin to review profitability and our outlook.

Kevin?

Thanks, Ron, and good afternoon, everyone.

TI's second quarter gross profit was 1.481 billion or 45.7% of revenue, gross margin was up 0.7 percentage points compared with the first quarter and up 8.2 percentage points compared to the year ago quarter...

Gross profit and margin benefited in both comparisons from higher revenue.

Semiconductor gross profit grew by $97 million sequentially to 1.285 billion or a 46.2% of revenue.

Gross profit in Sensors and Controls increased to 112 million or 38.5% of revenue.

Gross profit in E&PS grew to 99 million or 58.3% of revenue.

In the second quarter, we increased the accrual for our TI employee profit sharing plan from the first quarter level reflecting an upward adjustment in our expectations for the company's 2004 performance, about $100 million was accrued in the second quarter, compared with about 30 million in the first quarter, excuse me, 70 million in the first quarter.

Of the 30 million increase, about half was a cumulative catch-up for the first quarter.

Therefore, we expect that profit sharing in the third and fourth quarters will be accrued at about $85 million per quarter.

About 40% of the profit sharing accrual in 2004 should be allocated to cost of revenue with the remainder about evenly distributed between R&D and SG&A.

We expect profit sharing accruals in 2005 to decline significantly.

In 2005, we'll be implementing a new TI employee profit sharing plan.

2004 is a transition year in which the profit sharing accruals are based on a combination of revenue growth and operating margin for the full calendar year.

While this same formula did not result in any profit sharing in the last three years, it is driving the accruals during this planned transition year.

Next year, we will be fully transitioned over to the new plan.

The new plan allows for profit sharing to be paid based upon the company's operating margin for the full calendar year.

A minimum threshold of 10% operating margin must be achieved before any profit sharing is paid.

Profit sharing at 10% operating margin will be 2% of eligible payroll.

Profit sharing will cap out at 20% of eligible payroll when the Company's operating margin meets or exceeds 35% for a full calendar year.

By way of example, if we were to annualize TI's operating performance in the first half of 2004, the new plan would result in a accrual of about 25 to 30 million per quarter compared with the 85 million that the current plan requires.

Turning back to the second quarter, the combination of the lower royalty level, that Ron mentioned previously, and the profit sharing accrual, including the catch-up, negatively impacted gross profit in the second quarter by about $40 million compared with the first quarter, with most of this attributable to the royalty decline.

Operating expense of 889 million increased 41 million from the first quarter, with about half of this due to the higher profit sharing accrual.

Operating expenses as a percentage of revenue declined 1.4 percentage points from the first quarter.

Sequentially, R&D spending of 514 million increased by 20 million and SG&A expenses of 375 million increased by 21 million.

TI's operating profit was 592 million or 18.3% of revenue, up 118 million or 2.1 percentage points compared with the first quarter.

Operating profit grew 467 million to almost five times the level of the year ago quarter.

In those comparisons, operating profit and margin reflect higher gross profit and revenue that is growing faster than operating expenses.

Semiconductor operating profit was 526 million or 18.9% of revenue.

Sensors and Controls operating profit was 77 million or 26.6% of revenue.

And E&PS operating profit was 68 million or 40.2% of revenue.

For TI other income and expense produced income of 38 million in the quarter.

Interest expense on loans was 8 million in the quarter.

The Company's effective tax rate was 29% within the quarter.

Net income was 441 million or 25 cents per share.

Net income grew by 20% compared with the first quarter and almost quadrupled compared with the year ago quarter.

The quarters' results include a -- $19 million of pretax amortization of acquisition-related costs.

Total cash of 5.534 billion increased 41 million from the end of the first quarter and increased 1.351billion from the year ago quarter.

Cash flow from operations was 506 million, up 113 million sequentially.

Capital expenditures of 356 million in the quarter decreased 45 million sequentially.

Capital expenditures in the quarter were primarily for increased assembly and test equipment and for 90 nanometer wafer fabrication equipment within DMOS 6 our 300 millimeter wafer fab in Dallas.

TI's 90 nanometer process is currently in production in our Kilby fab and we expect to ramp the DMOS 6 90 nanometer line into production during the second half of this year.

We now have 17 different products that have been designed in 90 nanometer and are presently in various stages of sampling or qualification.

Depreciation of 363 million increased 15 million sequentially.

Accounts receivable of 1.930 billion increased sequentially by 252 million due to higher revenue and seasonally higher E&PS receivables.

Day sales outstanding were 54 days at the end of the second quarter, compared with 51 at the end of the first quarter and 55 at the end of the year ago quarter.

Inventory of 1.285 billion at the end of the second quarter increased 137 million sequentially as we continued to build inventory to targeted customer service levels, especially in standard products to support customer plans for the second half of the year and to ensure the company's ability to quickly respond to upside demand.

Days of inventory increased to 66 days at the end of the quarter, up from 64 days at the end of the first quarter.

While TI operates with days of inventory below that of many of our competitors, we believe that our inventory level is currently well positioned to meet customer service requirements.

As a result of having achieved our inventory targets, we expect the rate of change in TI's inventory to begin to more closely align with our anticipated shipments.

Most of TI's inventory growth in the second quarter was in the form of variable costs such as products built in foundries or at highly depreciated internal fabs and therefore the growth in inventory had minimal impact on TI's profitable in the quarter.

We expect our inventory targets to adjust over time based upon such factors as our demand outlook, manufacturing cycle times, capacity utilization, and our customers' seasonal considerations.

TI's orders in the second quarter were 3.253 billion, up 1% sequentially.

Semiconductor orders were 2.762 billion, down 2% sequentially.

Semiconductor's book-to-bill ratio was 0.99, down from 1.09 in the first quarter and was the same level as the year ago quarter.

Turning to our expectations for the third quarter, we currently expect total TI revenue to be in the range of 3.200 billion to 3.440 billion.

Semiconductor revenues should be in the range of 2.780 billion to 2.980 billion.

Sensors and Controls should seasonally decline to the range of 255 to 275 million and E&PS should be in the range of 170 to 190 million.

This expected revenue range for semiconductor is less than the robuth growth -- robust growth rates of recent quarters.

It is our belief that in the past few quarters our customers and distributors have replenished their inventories from the very low levels of last year to what are now more normal levels.

As a result we expect that our growth rates will begin to more closely align with our customers shipments in the quarters ahead as their inventory replenishment becomes less of a factor in our growth.

Earnings per share are expected to be in the range of 26 - 29 cents.

We continue to expect the effective tax rate for 2004 to be about 29%.

As I mentioned earlier, profit sharing accruals are expected to be about 85 million per quarter.

For 2004, we expect R&D to be about 2.1 billion, capital expenditures to be about 1.3 billion and depreciation about 1.5 billion.

In summary, we're encouraged -- encouraged about the combination of our focus on high growth markets, our strong product technology and our relationships with some of the world's best customers that continues to result in solid market share gains for TI.

Our semiconductor revenue in the second quarter was higher than it has ever been before and operating property for the company is approaching an all-time record.

Especially encouraging is that we have grown to this revenue level while maintaining capital expenditures below our depreciation levels for the past few years.

As a result, depreciation should continue to be stable.

With stable depreciation and lower expected profit sharing accruals next year, TI is well-positioned to continue to deliver higher levels of profitability as revenue grows.

With that, let me turn it back to Ron.

Thanks, Kevin.

At this time I'll ask the operator to open the lines up for your questions.

In order to provide as many of you as possible an opportunity to ask your questions, please limit yourself to a single question.

After our response, we will provide you an opportunity for an additional followup.

Operator?

Thank you.

The floor is now open for questions.

If you do have a question, you may press star, 1 on your telephone keypad.

If at any time your question has been answered, you may remove yourself from the queue by pressing the pound key.

We do ask that you please pick up your handset to minimize any background noise Our first question is coming from Glen Yeung of Smith Barney.

Thanks.

Good afternoon.

I wonder if you could give us some color on the decline in orders that we saw in the quarter, maybe some thought on what the linearity was there and how July has started in terms of orders?

Okay.

I'll take a stab at it, and, Kevin, if you have anything to add, please chip in.

As far as linearity, second half of the quarter was not as strong as the first half of the quarter.

And generally, you know, probably the only thing I would -- I would use to describe it is -- is along the lines of what Kevin said in his prepared marks -- remarks which are basically we believe that combination of distributors as well as our OEM customers that have been replenishing their inventory levels over the past few quarters have pretty much hit targeted levels and so the part of the -- the growth that we have seen that's associated with that replenishment, and similarly the orders that were associated with that replenishment, have backed off in the second half of the quarter.

And then as far as July, probably no real significant trend -- trend change one way or the other.

And what we've seen is certainly fully consistent with the -- the revenue outlook that we've just provided.

Kevin, do you have anything else to add to that?

No, I think that you said it very well, Ron.

Okay.

Any -- do you have a followup, Glen.

Yeah, maybe just one followup which is just in extending the discussion on inventory.

You know, if you look at your DOIs, they're, by our calculations, almost near the records, not quite as highs that we saw in 2000 and 2001 but pretty high.

And you talk about the fact that you feel comfortable here, you know, as you need to meet customer demand.

And, Kevin, I also noticed that somewhere in an interview you talked about demand outlook being pretty good.

I wonder if maybe you could share with us what you think you are seeing in the end markets for the second half of this year and just sort of reiterate your comfort with inventories.

Well, Glen, as we indicate in the guidance there, we are showing a, you know, growth range that could be anywhere from flat to 7% growth for semiconductor.

And so that -- that generally speaks of our confidence that we'll -- we'll see the kind of growth that's necessary to keep pulling the inventory out of our warehouses for us.

From the end equipment standpoint, we would generally expect that we'll see the kind of seasonal patterns that we've seen in past years, that is where, especially on the back half of the year, where handsets and the wireless area will probably be a little bit stronger in the back half of the year versus third quarter.

And just so consumer electronics will probably begin to step up later this quarter and into next quarter also.

So those are probably the two main things that we noticed last year that would probably recur again this year.

Just from the days of inventory on hand that you were talking about, it is worthwhile noting that our revenue projections, if you look at our range, third quarter versus the same quarter a year ago, are such that revenue will be up anywhere from 26 to 36% versus where it was third quarter a year ago.

And our inventories are presently up about 28% over that same period.

So we feel that we've got a good mix of inventory to support that kind of revenue growth and that is one of the additional reasons why we are quite comfortable with the inventory that we have on hand.

I would also remind you that we have been working for quite a few quarters now to grow our inventory and have continually been behind the increasing rates of demand that we've had.

We've finally to this past quarter gotten our inventories to the kind of levels that we feel much better about for satisfying our customer service requirements.

The -- the one thing I would just add to that, also, Glen is -- is keep in mind over the last, I don't know, few years there probably hasn't been a big swing in mix.

But areas like high-performance analog which are standard products where it is, certainly, we believe more appropriate to carry higher levels of inventory, the high-performance analog revenue has become a bigger part of our mix and, certainly, a more important part of our business.

And -- and frankly, what we've done in terms of inventory positioning, oh, pretty much over the course of the last year has been a big factor in allowing us to grow our high-performance analog revenues at a pretty much consistently faster rate than most of our peers in that -- in that market segment.

So the formula has worked for us thus far and will continue.

That's great color, thanks.

Thank you, Glen.

Next caller please.

Thank you.

Our next question is coming from Michael Masdea of Credit Suisse First Boston.

Nice quarter, guys...

I guess the question, just to followup on this whole supply chain discussion, is it -- would you say it's fair that despite some of the change in the ordering patterns from some of your customers that their build forecasts have not dramatically changed in either direction?

Is that safe to say?

Let me add one thing and then Kevin.

In general, I think that's true.

And what I would say, certainly, the build forecasts, this is not a common on the build forecast, the build forecast, I do not know that we've noted any kind of notable change in terms of customer's plans.

One thing I would note, and you've probably heard this from some of our customers and just analysts in general in the wireless space, if you look at the wireless market in first half of this year, I believe the numbers are pretty much agreed that handset unit shipments were up something like 30% first half of this year, compared to first half of last year.

If you look at TI's wireless revenue, our wireless revenue was up about 50% with the premium relative to the industry numbers really being associated with, you know, what we've talked about for some time now, the fact that our, on average our content per handset continues to grow with these new advance technologies and advanced handsets.

If you carry that market segment into second half, I don't believe most analysts, nor would TI expect that the wireless industry will continue to grow at that 30% year-on-year pace.

And, again, that's not any kind of downtick in customers' build forecast but just, you know, color in terms of -- of that particular end market and generally what I think we, along with both customers and analysts, would expect there.

Do you have a follow-up, Michael?

Yeah.

I guess just on that point, where are we in the whole TI story in terms of product cycles, ASP cycles?

Can you continue, especially in wireless, can you continue to outgrow some of your end markets because you have more content expansion?

I think if you look at, you know, some of the -- some of the content we just talked about which is that WCDMA base band modems are now emerging as a significant contributor to our wireless growth, hopefully this is deja vu all over again for you guys as well as our experience, if you go back to 2.5 G transition from the -- from the 2 G world, where with the 2.5 G handset TI had more content.

We had a better ASP on that digital base band product than we did in the 2 G case and you can correctly assume that that same scenario takes place as you move from 2.5 G to 3 G. And the reality is it is probably even a little better than -- it is actually a lot better than that, because in a 3 G handset, besides just having a more expensive digital base band modem, you also have a separate applications processor which we believe we're very well positioned with our -- with our OMAP product line and so in general we think that content story that you've seen from TI for a couple of years now in the wireless space is going to continue moving forward and the emergence of 3 G is only going to help that.

Thank you.

Thank you, Michael.

Next caller, please.

Thank you.

Our next question is coming from John Lau from Banc of America Securities.

Great, thanks, Ron.

Moving to the -- back to the question of inventory, but now this time in the channel, what do you believe the inventory levels are in the channel and distributors, and do you feel comfortable that it is in line with demand and seasonality and then I guess the final one is what is the effect of the supply agreements that you have in place on your inventory and will that always keep it higher than the -- than the normal levels?

Thank you.

John, those are good questions there.

On the inventory, and the distribution channels, Ron talked about how the -- the new orders that we received in the second half of second quarter were a little bit lower on average than the orders we had in the first half, and those were, as you mentioned, largely attributable to our distributor customers.

As they indicated to us, their inventory levels were now getting to the kinds of levels and they were getting the kind of inventory turns that they preferred to have to meet their demand.

And so we think that those are -- have now moved back into a more appropriate balance versus where they'd been for the last three or four quarters.

Turning to the question of supply agreements, you're, I'm sure, aware that we do have, with some of our customers, consignment arrangements.

And as -- as those customers bring up their product lines, of course, we need to have consignment inventory in place and that does have a certain effect on our inventory because we carry that inventory that those customers would previously have carried on our books.

In addition to that other elements that can affect our inventory levels from a supply agreement standpoint is with some customers we have contractual required lead times and to the extent that those lead times would be inside our manufacturing cycle times naturally we'd have to carry either finished goods or work in process inventory staged such that we can honor those contractual required lead times.

So those kinds of two elements coming together do have a bearing on the inventory levels that we carry and they also give us a higher degree of comfort with the kind of inventory levels that we have decided to carry, too.

And to -- to finish off on that with regard to your comments on the distribution channel as they slowed down the orders as they came online, do you believe that the inventory levels at the disties are now in-line or are they too high?

From all indications that we have, we're continuing to receive orders, so that would suggest to us that they are comfortable with their general level and mix.

And we also understand that their resales quarter-over-quarter are increasing out of their warehouses so that would suggest to us again that they're generally comfortable with their inventory levels.

Great, thank you.

Thank you, John.

Next caller please.

Thank you.

Our next question is coming from John Barton of Wachovia Securities.

Yes, thank you.

Ron, I wonder if you can comment on price trends, both in two different categories.

I mean, you commented in the most recently closed quarter commodity prices were up.

Can we continue to see that with, you know, the bookings slowdown that we've seen.

And on top of that, obviously, it would appear as those some of your customers in the handset area are engaging in some rather aggressive pricing and have you gotten any push back on pricing as a result of that.

Okay.

Let's take those starting with commodity pricing and you're right what -- what we shipped in second quarter, shipped out at higher prices in general, on a blended basis, I would say, than -- than commodity prices in first quarter.

I would say more towards the latter part of the for -- the quarter, as we, -- first of all, as TI removes some of the bottlenecks that we had in our, call it capacities, specifically in the assembly test area, and also I would say as probably more notable, some of the distributors achieved desired inventory levels, what we've seen is more of a balancing between our supply that we have available and the end customer demand for commodity products.

So as that's happened, pricing has moderated.

So it's -- I don't really want to forecast, specifically, going into the third quarter, John, but I would say pricing and some of the price increases that we were experiencing in second quarter, I would describe as having moderated toward the end of the quarter.

Your second question on whether the handset customers and suppliers and what they're doing with -- with pricing is feeding back on TI, the answer is no.

With most of our handset customers, especially our large OEMs, we operate on longer term contracts with product pricing and so what they're doing in terms of the near-term environment for market share or for whatever reasons on pricing does not come back to TI in terms of lower pricing in the products that we would sell into them.

We stay in-line and consistent with the contracts we have in place with those customers.

Thank you, John.

Next caller, please.

Thank you.

Our next question is coming from Nimal Vallipuram of DRKW.

Yes, this is Nimal Vallipuram.

Say, about five years ago or so, the semiconductor industry, inventory was a bad word.

I mean, things have happened in the last two to three years which are pretty significant, however it looks like almost every semiconductor vendor is building inventory.

And in terms of Intel, they have decided that they have to pay the price for doing so.

Here, in your case, that your inventory turns are -- have come down pretty, you know, significantly.

Take a step back and can you let us know that, in terms of your wafer starts, wafer pricing from your foundry partners and also unit order demand, how comfortable are you that this is not the beginning of something more serious?

Nimal, that's quite a few things in there.

So let me see if I can try to address as many as I can on that.

I'll start out with your observation about inventory being a bad word.

I think one of the things that we've -- we've probably need to, all of us, keep in mind that, I think Ron made a good point of a few minutes ago, the structure of the source of revenue that TI is gaining today versus where we were, say, five years ago, is beginning to get much more from the high-performance analog side of things, and it is -- most of that sells off the shelf, it's in a catalog kind of fashion and so consequently its customary in that marketplace that you need to have a higher available of inventory on hand.

So that alone is going to shift any comparison for a model standpoint just for TI as an example.

Moving on to -- to wafer starts, you know, we moderate our wafer starts continually, just because of the mix of our products.

But clearly, as -- as we have now -- now feel that our inventories have gotten to a appropriate customer service level and we also feel that our distribution customers and some of our large OEMs are getting to more appropriate inventory levels, the kind of starts that we would have won't be at quite the velocity that we've had in the past.

And that will include our foundry starts.

So we'll see that moderate and our inventory changes in the future will begin to more directly reflect what we're actually shipping into and our customers, ultimately, shipping out in their end products.

As far as foundry pricing is concerned, we have advanced pricing agreements with our foundries and the foundries continue to honor those agreements.

We have no -- nothing to report on that front.

I think I hit all your questions.

Yeah.

Just a followup on the inven -- on the wafer starts, I'm not asking you to give us a forecast on your gross margin.

When you moderate the -- the lowest view of your wafer starts, what kind of sensitivity does it have in terms of your gross -- impacting your gross margin?

Also can you let us know when do you expect your inventory to peak?

Do you expect it to come down in the third quarter or do you expect it to come down in the 4th quarter?

Okay.

So let me try it on with the first one there.

To the extent that we do wafer starts in our analog factories, by large, recall that those are largely depreciated fixed assets so any starts there are principally variable costs.

To the extent that we have wafer starts in our digital factories, especially in our advanced lithography, well, recall that we've been using foundries now for quite a few quarters because we've essentially been at capacity in our advanced lithographies for quite a few quarters.

So to the extent that our inventory and demand requirements adjust in the advanced lithographies, we moderate those through the loadings that we put into the foundries.

So the result is that that there's no real -- that fixed -- that level of utilization, therefore fixed cost absorption, on the advanced lithographies has been at a near fully utilized level for a number of quarter in a row now.

And we continue to source wavers from the outsight to supplement that high level of utilization.

The second part of your question, Nimal, could you repeat that?

Yeah.

Like, when do you expect your inventory numbers to peak.

Sure.

Well, we're not forecasting inventory per se, but what we would anticipate is that our rate of change in inventory is now probably going to much more closely mirror the rate of change of our shipments into our customers.

Again, what was happening in recent quarters, as -- as I think that Ron indicated, we had kind of a double benefit or a double impact of both our shipments and inventory growth going to meet both our customer inventory levels as well as our own inventory for customer service purposes.

We expect going forward that our rate of change will be closer to the rate of change in our customers' end demand.

Now, that's not to say it's going to go up or down, it will fluctuate according to that change of rate of demand.

And that will be a function, again, of various seasonal factors and contractual requirements that we would have with them.

I would also remind you again that for -- at the TI level in the E&PS business, the graphing calculators, their peak selling quarters are second quarter and third quarter, after which their inventory levels will traditionally drop and that will have a bearing on IT's inventory levels also.

Nimal, let me take a stab also at just making an additional comment on that first question which is how much gross margin impact would a inventory adjustment have?

Keep in mind what Kevin said in his prepared remarks, which was that most of the inventory growth that happened in the second quarter actually was in the form of variable costs.

And so from that standpoint, it does not impact gross profit.

It would impact gross profit if that inventory were absorbing fixed costs that would then have to move to the P&L once we stopped the inventory growth, but that has not been the case in terms of what we've observed in our -- the composition of our inventory build in the second quarter.

So, with that I guess we'll move on.

Thank you, Nimal.

Thanks, Kevin, thanks, Ron.

Thank you.

Next caller please.

Thank you.

Our next question is coming from David Wu of Wedbush Morgan Securities.

Yes, hi, I have a question that's been asked already.

Can you help me -- two things, number one, on this -- how -- what's your capacity utilization of those two large eight inch fabs -- eight inch fabs that you have, and as those capacity increase won't the -- won't we have a richer gross margin in particularly with high-performance analog in Q3 and Q4 from a incremental margin standpoint?

And the last thing I have is from a lead time perspectives can you go through -- it sounded like the commodity products, the extended analog and the -- and the commodity logics are begin to come in.

Can you sort of go through your lead times on your various products, please?

David, I'll go ahead and try to address the utilization and the gross margin that you were discussing, and then Ron will take a shot at the lead time discussion there.

We -- we've stopped breaking out our utilization rates, I think almost a year ago now, so we're really not talking about that.

But generally speaking, by virtue of the fact that we're sourcing our advance lithography wafer, both internally and externally, you can conclude that we're pretty fully utilized on all of our advanced lithography nodes.

On the analog node, we still have open capacity there and I think that is the point you were making about profits going forward, would we see possible profit changes on that going forward?

What will drive that is as the high-performance analog becomes a larger share of the revenues, which I think is what you may have been leading to, David, it will favorably impact our profitability as we move forward and those are standard type products, again, to sell off the shelves so that is the sort of product that we've been building in the inventory to be ready to meet demand with.

Let me switch over to Ron for the lead times.

Sure.

On lead times, David, it's -- it's going to vary a lot depending upon process technology, package type, product type, et cetera.

But I can give you some general ranges.

Commodity products are generally probably in the 8 to 12 week lead time at this point.

Custom application specific products, things like wireless, broadband, et cetera would generally be in the 8 to 14 weeks.

In areas like some of the standard products, like high performance analog, catalog DSP, probably more in the 6 to 8 week range.

And, again, that partially reflects the inventory positioning that -- that we've been describing.

Ron, is there any possibility that the commodities business pricing will stop going up until you get into another batch were your lead times go out again?

Us trying to predict commodity pricing is a very difficult task, so I think -- I think you're right, it ties to supply and demand, things like lead time adjusts with supply and demand, as well as pricing does.

I don't know that I would say it's a -- it's contingent upon a change in lead time.

It's contingent upon having demand exceed TI's and the industry's in general capacity which it seems today to be reasonably well-balanced.

Thank you.

Thank you, David, next caller please.

Thank you.

Our next question is coming from Tom Thornhill of UBS.

Ron, if you could, on the -- or Kevin, walking through the profit-sharing issue, the net change that we should see going from this year to next year, if you can help us calibrate that.

If the 85 million that's going quarter-to-quarter right now, roughly what percentage of payroll is that number at this point?

Might help us with calibrating where this goes next year, as a percent.

Tom, we aren't really disclosing the percentage of payroll that that is right now.

I think that you can just see from the example, it's -- it's -- you know, the accrual itself is about three times what it would be if the new plan were actually already in place.

Trying to figure out how to give you a constructive answer without -- Ron, maybe you've got an idea.

Yeah, Tom, maybe one of the things I can do is just give you more details on the formula.

Kevin kind of gave you a couple the end points which was basically at 10% operating margin profit-sharing would be 2% of eligible payroll, at 35% it is 20% of eligible payroll.

It is not exactly linear basically, the slope.

Another data point you need would be at 24% operating margin profit sharing would be 9% of payroll.

And basically it is linear between 10 and 24, and then also between 24 and 9.

But -- but the slope moves up a little bit between the 24% operating margin and 35%.

What we've also told you, and this, I think, will help you close the gap on -- on what you are asking, is that based upon first-half performance of this year, that would have resulted in a 25 to 30% -- I'm sorry, 25 to $30 million profit sharing accrual and I think that comes out to be somewhere in the, based upon the formula I just gave you, something like a 6.5 to 7% profit sharing based upon -- based upon the operating margin you would have seen for first-half performance.

So if that confused you, we can take it off-line and I can try to -- try to explain in more detail.

But generally that's the formula, and how it would carry into next year.

Okay.

Two other real quick ones then.

On the royalty, this is now going to be semi annual on that -- on that -- so that we miss the 30 million here does that mean we get their normal run rate plus 30 in the next quarter?

We would anticipate, as we indicated there on the cash recognition basis, so we would anticipate that that would come due in third quarter, and that is in the estimate that we provided to you.

Okay.

And that is in the number.

And looking at -- looking out at your wireless customers, do -- there is a typical sort of third quarter to fourth quarter pattern -- pattern that we've seen in past years with some acceleration in fourth quarter.

You -- looking at the build rates that you would expect seasonally to happen here, do you see any reason why that doesn't occur this time around?

Well, I think -- of -- of course the holiday season will still be in fourth quarter, but probably what's been dif -- what is different this year is what I talked about earlier, which is we had a very robust first half so I think what we expect and what our customers and most analysts that cover that space expect is that second half will be strong, but you may not see the same kind of robust growth that we had from a year-on-year standpoint in first half.

Thank you.

Okay.

Thank you, Tom.

Next caller, please.

Thank you.

Your next question is coming from Chris Danely of JP Morgan.

Hi, guys.

Just -- just a couple quickies.

So -- so putting it all together, if inventories have kind of been normalized out there and the book-to-bill is less than one, and bookings trended off at the end of the quarter, why guide up?

For semis?

Well, Chris, on that front, we're seeing a similar phenomenon to what we did this time a year ago, and that is we had a point 99 book-to-bill this time a year ago also.

And we do tend to see a bit of a calm period, at least if last year is any indicator, before we begin to see a return to the types of demands that would give us that kind of guidance that we've offered to you, and our communication with our customers today suggest to us that that range that we've given to you is a appropriate range.

So you are just looking for, basically, a repeat of last year.

That is a good model for us to be stating from, yes.

But just because it happened last year is not the reason we expect it to happen this year.

We have a lot of communication with our customers and understanding what their plans are and the guidance that we're giving you is consistent with what our customers' plans are.

And, Chris, the other thing I would just ask you to keep in mind, is that not all of our customer plan shows up in the form of orders in the current quarter.

So, in other words, consignment inventory, the order does not come in, similarly the revenue does not get recognized until the customer literally pulls it out of the inventory rack at their -- at their factory.

Similarly, the revenue that we have on JIT or the shortened lead time revenue that Kevin talked about earlier, typically those orders don't come in until, you know, shortly before the revenue shifts as well.

So what we're saying is our visibility into our outlook goes beyond just the backlog and what we have in the order books as well.

Got it.

So as the lead times come in, you incorporate a little more turns business then?

I did not understand your question.

As -- as the lead -- you talked about lead times.

Correct.

So as the lead times come in, you incorporate a little more turns business.

Well, I don't -- first of all, I did talk about lead times, I do not believe I said they are coming in.

Generally our lead times through first half have been generally stable.

So we have not seen a big change or a big pull in on lead times in general.

Our expectation on turns in third quarter is pretty consistent and -- and in this case, when I'm talking about turns, I'm talking about literally something that's not in our customer' operational plans that they shared us, but literally the kind of turns business where you do not have any visibility into it prior to -- prior to the quarter at shipping.

Our expectations on turns in the third quarter is pretty consistent with what we observed in the second quarter.

So we're not building in, call a hope factor, in terms of the third quarter back forecast where we'd have a lot of expected higher turns level in third quarter compared to second.

Okay.

Thanks, guys.

Thank you, Chris.

Next caller please.

Thank you.

Your next question is coming from Adam Parker of Sanford Bernstein.

Yeah, hi.

I'm just trying to understand the profit-sharing here.

Is the total --how does it -- if I'm an employee, I mean, does this mean my total compensation is lower now if I work at Texas Instruments in terms of salary plus bonus plus sharing plus options, or what does it mean if I'm an employee.

You are exactly right.

It mean, as you described that, that the profit sharing -- the profit sharing formula has different thresholds and different requirements for total performance for the Company and to get the similar kind of profit sharing payments that employees will earn this year, we'll have to perform at a higher level next year, a much higher level next year in order to deliver that.

The other thing that, Kevin, I -- or, Adam, that I would add is if you look at the profit sharing formula that we -- that is driving the accrual this year, and compare it, for example, to what we're going to do next year, and, frankly, to what a lot of our competitors do, a lot of our competitors, as well as the new profit sharing formula, will tend to pay more what I will call smoother or dampened profit sharing payments.

Our existing formula that's driving the accruals this year, as Kevin noted, hasn't paid anything in the last three years, so this is the first year out of four that it will pay.

So it tends to pay when the company's performance is really good, as opposed to -- you know, and then pulls back in terms of that compensation expense when the market is weaker or when our financial performance is weaker.

So --

Maybe -- maybe you can help with why you guys did the change and is this -- is this your view that this is going to be kind of on a normalized basis kind of, you know, taking some money from the employee comp pool and give it -- and sort of letting the shareholders have it or --?

What stimulated the change?

The change is a function of our total compensation practices, Adam, and it was actually communicated to the employees late last year, that when we survey the competitive environment in which we operate in, the profit sharing plan that we had in place had moved a little bit out of the competitive norm.

As -- as Ron was just describing, it tended to pay pretty infrequently and when it did, it had kind of a -- a lumpy effect to it in how it paid.

Right.

And so the formula has been adjusted now starting in 2005 to be much more comparable to what we see in the competitive environment in which we operate.

So really the nemesis behind going and changing the plan had to do with aligning the total compensation strategy to be more consistent with the industry in which we compete because it had shifted and we need to shift our plans to match that.

Okay.

So in taking that one extra step, that means your -- your -- you were overpaying, historically.

No, that does not mean that.

It means that we had a different manner in which we paid it out.

Rather than paying some amount out every year, the same cumulative effect, it pays out more lumpy, or several years' worth pay out all at once, if you will, as we are seeing this year.

Okay, so it was just your view is that historically the average payout was the same at Texas versus other semi companies just with higher volatility and now you are just bringing it back in line with the same volatility level of the other companies.

I think that you've said that well, Adam.

Wow, that's a first.

All right, thanks, guys.

Thanks, Adam.

Next caller, please.

Thank you.

Our next question is coming from Mark Edelstone of Morgan Stanley.

Good afternoon, guys, first off, nice quarter in getting back to record levels.

First question, I guess, is really on the royalty recognition that you had here in the quarter.

When you look at the start of the quarter, did you expect that that one licensee was going to move to a semiannual payment schedule or was that something that developed during the quarter?

I think we understood that, Mark.

Okay.

And then I guess maybe you could just talk about the incremental gross margins then that you saw in the quarter and what drove those.

Clearly, they were adversely impacted by the decline quarter-to-quarter in the royalty revenues.

But at the start of the quarter, do you expect those to be somewhat better than they turned out to be?

There's probably a couple points to keep in mind as we look at that, Mark.

If you are looking at it on a sequential basis, which I'm presuming that's a point of view that are you looking at it from, the combination of the royalty and the -- the effect of the catchup on the profit sharing impacted about $40 million at a gross profit level.

In addition, on a sequential basis, depreciation is up about 15 million.

So combined those two together impact sequential fall through by about 12 points if you run the math.

And I think that may get more to the normalized level than perhaps you were thinking about when you asked that question.

Okay.

Fair enough.

There's just a follow-on then, with revenues now back at record levels and margins both at the gross and operating levels still well below the peak in 2000, can you give us a sense as to what type of revenue range, and I know it is a range, but what type of revenue range does it take in your opinion at this point to get back to those 2000 margin levels?

We don't have a good answer for you on that one, Mark.

We're focused much more on making sure that we're delivering the total earnings to the shareholders and therefore maximizing total operating margin as opposed to trying to get to a particular percent, and that's what we've been focusing on is when do we start getting ourselves to a point where we're delivering more earnings than we have in the past?

And the margins will be where the margins wind up at that point in time.

Fair enough.

But I think the -- the view internally there, Kevin, was that the gross margins ought to be able to get to record levels and certainly move into the 50% type of a range with operating margins exceeding the prior peak.

Has that changed?

Or is that still the operational assumption here internally?

No, I didn't say that that had changed at all, Mark.

That -- as I mentioned, that -- that will -- those margins will be what they are when we arrive at whatever that revenue level winds up being.

The point I'm trying to make is that we're focusing on making sure we're delivering maximum operating profit and therefore EPS, earnings per share, to the shareholders.

It doesn't mean that we believe that our ability to have higher total percentages has changed.

Just we haven't been focusing on -- on recalculating that model, which I think was perhaps offered to the investment community a number of years ago.

Okay.

Thanks a lot.

Thank you, Mark.

Next caller please.

Thank you.

Our next question is coming from Cody Acree of Legg Mason.

Hi, guys, can you give a little more definition on the WCDMA side, you said it was a big contributor to the -- .

But can you give maybe a little more gauge of how large WCDMA is as a contribution and what do you expect in the next few quarters?

I don't want to provide a specific number or percentage of wireless revenue.

The reason we gave the number that we gave, which is basically is contribution to growth, was that -- was so that you guys could start to understand that it is emerging as an important revenue growth driver and will be embedded in, you know, the wireless growth that -- that we talk about as we go forward.

And certainly, we'll talk about, you know, in any particular quarter what were the factors behind, you know, that -- that quarter's performance in wireless.

But we're not going to break out the wireless revenue beyond -- beyond the level that we have.

That being said, what I would say is that just in terms of adding color to the WCDMA, and let me be specific, this is -- when we talked about a quarter of the wireless sequential revenue growth coming from WCDMA modems, we really are talking about just the baseband function and the reality is, you know, above and beyond that we have the OMAP application processor.

But on that modem functionality, we have engagements with what I would characterize as industry leading customers in Europe, in Japan and in Korea on that WCDMA modem.

And then if you consider the position that we have in OMAP, which again, according to IDC and wireless overall, was something like 70% market share, and our viewpoint that the combination of those technologies, the modem and the application processor, are going to become increasingly important in the years ahead, you start to understand our enthusiasm for that whole technology space and what it has the potential to do in terms of growing TI or expanding TI's revenue as it becomes more and more important in terms of our -- our actual shipment levels.

So, again, a big piece, a big contributor already.

But we're not going to start breaking out the details of that revenue.

And maybe on with CDMA, can you just give us an update on where you stand with the -- the chipset, the partnership chipset and with regards to EBDV -- EDDV and EDDO with Sprint, Verizon both moving towards a little more endorsement of EBDO, does this play into a change in your thinking or timing of contribution of the standalone CDMA revenue.

Okay.

On -- on the chipsets, there are two CDMA chipsets that we are now sampling, the first is the 1XRTT which we started sampling in December of last year.

In that case, I would describe that -- really no update from what we've said before, but I'll just reiterate.

We have what I would describe as multiple OEM customer engagements on that chipset.

The timing as to when they're going to have phones in the market really is -- is their own internal timing at this point.

Generally it takes a customer about a year from sample to when they have handsets to void, but again that -- that has to do with our customers at this point, not TI.

The other chipset we have sampled is the EBDV sample and I think -- or chipset, and I forget, that was something about a couple of months ago, maybe it was April, when we started sampling that.

To the point of EVDO and some of the service operators that have announced deployments there, I guess what I would say is we haven't announced any specific plans for EVDO.

It is a market that you might say we're watching, and to the extent that we think it has a lot of potential and long term growth associated with it, you can expect that -- that we have the opportunity to react.

But at the same time, you know, right now, we're focused more on the 1XRTT and EVDB chipset that -- that we've already discussed.

So, you know, from there we'll just kind of wait and see as to -- as to how the market evolves over time between EVDO and EVDB.

Great, thanks, guys.

Thank you, Cody.

Next caller, please.

Thank you.

Our next question is coming from Manish Goel of Neuberger.

Yeah, hi.

Just a clarification on depreciation.

Do you expect the depreciation to increase in a step function, like 20-$25 million in third quarter and then again in fourth quarter to get to your guidance or do you expect bulk of the increase in the fourth quarter?

Manish, we're not specifically forecasting individual lines between the revenue and -- and PFO, but if you just look at traditionally what happens with our depreciation, we're on 150% declining balance, and you wind up with a step function down in the first quarter of the year and then it's slowly increases as new assets come online during the course of the year, and then it repeats itself, it step functions down again in the first quarter of the following year and so you'll have -- you generally have a fairly slow increase as you go through the course of the year.

Thank you.

Thank you Manish.

Next caller, please.

Thank you.

Our next question is coming from Ambrish Srivastava of Harris Nesbitt.

Hi, guys, thanks, all asked and answered.

I'm sorry, Ambrish, did you say you'd already been answer?

Yes, Sir.

Okay, thank you.

Next caller, please.

Thank you.

Our next question is coming from Tim Luke of Lehman Brothers.

Thank you.

Just wondering if you could give us any color on the -- on the mix in -- in terms of internal and external foundry usage or manufacturing and how that may have played into your gross margins.

Yes.

Tim, we, I think, tried to talk to that a little while ago so let me, maybe, help more clear fashion on how that worked.

If you take a look at our inventory change

Yeah..

from first quarter to second quarter, about a third of that growth was due to inventory that we sourced from third parties, and also none semiconductor inventories, such as our Educational and Productivity Solutions for the graph and calculations, for example.

Then there's about 9 million, if I recall, that was for fixed goods, so of course that's not -- excuse me, raw materials.

That's not absorbing any fixed costs.

Of the remaining inventory build, most of the products that were built were in fabs that are already highly depreciated.

So to a large extent there was very minimal fix costs that was allocated to inventory, that was mostly variable cost that came in.

Examples of those include our standard products that we talked about earlier.

And finally to the extent that we put into inventory any of our advanced lithography products, again, for quite a few quarters in a row now those factories have been operating at full utilization, that's why we've been sourcing from foundries and we modulate our foundry loading in order to keep those factories operating at or near full utilization and what's been occurring for quite a few quarters and we anticipate that continuing into next quarter.

And just, without getting specific, with respect to the mix, the customer mix in -- in the wireless arena, has -- has that sort of changed in the last quarter, and do you expect that mix to -- to adjust going forward in the second half, given some of the factors that Ron alluded to within the wireless arena.

Tim, are you referring to the mix in inventory?

No, more just in the general broader customer mix in wireless, if you have the color on how that's been changed.

Yes, Tim, I don't think we have any real color to add there.

In general, of course, with our -- the kind of growth you see out of TI, that's representing a wide range of customers and even as I said about -- in WCDMA, our exposure is across a pretty broad range of customers.

We're not being driven by, you know, one specific customer or a particular segment, even inside the wireless market.

Okay.

Thanks.

Thank you Tim.

Next caller please.

Thank you.

Our next question is coming from Ben Lynch of Deutsche Bank.

Yeah, hi, Kevin, hi, Ron, again, the hazards of being one of the last people on this call.

Can we just focus a little bit on wireless seasonality?

Historically cell phone seasonality in Q3 was around sort of up 10, 15%.

Last year it was up 20%.

We had sort of strong cyclical recovery I guess going on then as well.

This year it seems like most people are sort of pointing to flat.

Last year, when 3 Q cell phone growth was 20%, your wireless business grew sort of 22%.

Should we be thinking about the same sort of orders of magnitude of Q and Q change or, you know, is there something particular going on at the moment for your wireless business?

Well, the -- there is nothing specific going on to TI's wireless business.

If you look at the overall, other than, I think, you know, our content gains that we've talked about.

But if you look second half in general, you know, it -- it's -- what is different this year is the comparison to first half and the strength of first half.

So that's where, I think, most customers and analysts are not expecting that same pace of growth into the second half, yet at the same time the numbers should -- should continue to be very strong.

So, you know, beyond that I probably don't have a lot more color to add.

Okay.

Just sort of next question, was there much discrepancy between the disties semis book-to-bill in the quarter and the OEM book-to-bill?

Book-to-bill actually very little difference between disties and semiconductor overall.

They were -- they were both slightly below one.

Great.

Okay.

Thanks very much.

Okay.

And with that we're going to need to wrap up, given the time.

So before the -- we end the call, let me remind you that the replay is available on our website.

Thank you and good evening.

Thank you.

And thank you callers, this does conclude this evening's conference.

You may disconnect your lines at this time and have a wonderful evening.