Third Quarter Conference Call Wednesday, October 24, 2007
Carlo Bozotti President and Chief Executive Officer
Hello and thank you for joining us on this call today to discuss our financial performance, business highlights and outlook. I appreciate your interest in ST.
To summarize, let me share some key highlights of the quarter:
First, we came in at the high end of our revenue range due to better than anticipated wireless volumes and strength in computer peripherals.
Second, gross margin, excluding the one time charge, came in at the middle of our range. We could have done better in capturing the higher revenue performance if not limited by weak the industry conditions in flash memories.
Third, ASG posted very strong sequential growth in revenues and improvement in operating margin, lifting it over 10%.
Fourth, we are strengthening our position in wireless, and believe we are very well positioned in this market in comparison to other competitors.
Fifth, cash flow from operations continues to grow, and is up significantly from the year-ago three and nine-month periods.
And finally, RONA, in total, was 10.4% and excluding Flash, RONA was approximately 14% in the third quarter.
Now, I would like to begin with a discussion of the results for the Flash Memory Group and an update on key steps to completing the divestiture of our FMG group.
FMG sales increased 6% sequentially, a good performance.
The operating margin loss increased to 9.9% from 7.6% in the second quarter reflecting some underutilization of capacity. Also, the third quarter FMG financial results do not reflect a significant impact of suspended depreciation, as most of it is currently in inventory within the Assets Held for Sale category. Obviously, this suspended depreciation policy only impacts FMG.
Turning to the divestiture of FMG, we have cleared some of the most important gating factors. Last week, regulatory clearance was received in the US adding to the European Union regulatory approval which was received earlier. We are working now with our partners to stand up Numonyx and bring the transaction to completion. As Intel indicated last week at the time of their earnings call, we expect to conclude by year-end.
Now let's shift our focus to what ST will look like after January first and how our ongoing businesses are doing.
Turning first to our Application Specific Groups, this segment will account for about 63% of our total sales compared to 54% today.
Looking at the performance in the third quarter, ASG‘s revenues increased 7% on a sequential basis, on double-digit wireless and computer peripherals growth.
More specifically, we have a very strong dynamic in our wireless segment:
Wireless sales increased double-digits sequentially on strength in several areas including: RF, power management and connectivity.
In addition, we have started to ramp our 3G digital baseband business at Ericsson Mobile Platform licensees. This product ramp is basically progressing in line with the plan we articulated at our analyst day in May. In fact, current volume estimates for 2008 are looking more robust that what we saw back then.
For the medium and long term, we entered into a strategic 3G digital baseband sourcing agreement with Nokia on August 8th. In connection with this transaction a talented team of design engineers, about 200, in total, will join ST from Nokia.
Turning to computer peripherals, sales were up double-digits sequentially on strong unit growth led by data storage with sequential growth of our hard disk drive business as the key factor. Sequential strength also benefited from the second quarter comparison, where, if you recall, we were impacted by quarter-end shipment shifts. But comparables aside, it was a very solid quarter for computer peripherals, and as we look to the fourth quarter, we will begin volume shipments of our proprietary system on a chip for the data storage market—a significant accomplishment for us, and a revenue driver in this segment for 2008. And on top of that, we were recently awarded a design win for our next generation 65 nanometer SoC, again, based exclusively on our own intellectual property.
Consumer revenue was up mid-single digits sequentially on continued strength of our set-top box offerings and deployment of our high-definition enabling solutions. Historically, the third quarter was the highest quarter for our consumer segment sales, but just as we experienced last year, we anticipate growth to continue in the fourth quarter of 2007. Our recent announcement with Korea Telecom for high definition IP set top box products is an example of our continued success in this competitive global market.
In automotive we saw the normal seasonal weakness on a sequential basis, but year over year automotive revenues were up 2.7%, and we expect the growth to restart in the fourth quarter. Two recent design wins, a next generation worldwide airbag platform and our penetration of the portable navigation device at Garmin, point out ST's significant capability to not only serve existing global customers, but expand into new markets as well.
From an operating margin perspective, the sequential swing was quite dramatic, with operating profit growing about $90 million. We benefited from a more favorable product mix and manufacturing cost improvements.
Manufacturing delivered a significant improvement in the second quarter, the quarter when the products sold in Q3 have been primarily fabricated, with improved loading, technology enhancement and improved efficiency.
Product mix in the third quarter was favorably impacted by our MMC group which grew faster than our other groups in ASG. And within this group, application-specific products increased much faster than camera modules. In the fourth quarter, we anticipate higher unit sales of camera modules, which would have a moderating influence on ASG's product mix.
So overall, looking to the fourth quarter, we expect to see good sequential top-line growth in our ASG segment-.
Turning now to our IMS segment, sales increased both sequentially and year over year, with MEMS products in wireless and gaming applications posting the largest growth. Our product design wins in MEMS are continuing with these applications, as ST accelerometer products offer customers enhanced functionality and flexibility. We also benefited from good growth in industrial, power conversion and advanced analog products, where we continue to add design resources for these important product categories. IMS accounted for 31% of net revenues in the quarter and will represent about 37% of the company post the completion of the FMG transaction. Finally, in the third quarter of this year IMS was able to demonstrate good leverage translating the sales performance into operating profit.
In the press release we discussed that, following a comprehensive review of employee benefit programs within ST, we have revised the accounting for a seniority recognition program at one of our large affiliates, which had been in place since 1986. Historically, we have expensed the costs when incurred and they are now accrued over the service period of the employee. In connection with this revision we incurred a one-time, non-cash charge for the past periods of about $21 million pre-tax. More than $7 million were charged to Cost of Goods, more than $8 million to R&D and nearly $5 million in SG&A expenses.
Our gross margin for the quarter came in at 35.5% without the impact of the one-time charge. Excluding FMG, our gross margin was 39.1% posting a very significant progression from the prior quarters. However, entering Q4 this performance will be challenged by the negative effect of currency.
Operating expense control allowed us to reach our target of expenses being less than 28% of net revenues. In Q3, SG&A and R&D combined represented 27.8% of sales, and 27.3% excluding the one-time charge.
Inventory, excluding FMG, increased by $33 million in total and included a currency translation adjustment of $29 million. Indeed levels remained substantially flat with a 6.1% sales expansion, which accelerated inventory turns to 4.0 times excluding Flash. I cannot say I am happy about that performance, but want to note the move in the right direction.
Now, let's move to a discussion of our outlook. At the end of the second quarter we indicated that we expected to see sequential growth in both the third and fourth quarters. We also indicated that we expected to see over 20% growth in ASG net revenues from Q1 to Q4 of this year. In the third quarter, we came in at the high end of our 2% to 7% range. For the fourth quarter based upon our backlog and order visibility, we are anticipating a higher sequential growth opportunity, in the range between 4 to 9%. And we are also confirming the ASG growth objective.
For the gross margin we are targeting 36.5%. The factors influencing this outlook are mix and currency. The significant negative move in the dollar since the end of the second quarter will be fully visible in Q4. Currency is the largest single reason for the limited leverage. While manufacturing improvements have been realized, they will not completely offset currency impacts.
To address this most recent move in the dollar, we are now focusing additional efforts on aggressive product portfolio management within our divisions; identifying for action those product families that are underperforming and are more vulnerable in this currency scenario. We will continue to implement these and other actions, to offset currency effects.
Looking ahead to 2008, industry analysts are forecasting semiconductor industry growth in the mid to high single digits. While it is too early for us to comment precisely on this, as we are completing our budgeting for 2008, we are ready to share our capital expenditure plans. We believe that following the separation of FMG, we can grow faster than the industry while targeting to keep our capex to sales ratio below 10% for next year.
At the outset of 2007, we set a capex budget of about $1.2 billion and anticipate coming in at or below that figure. Our guidance for 2007 and 2008 capex also assumes that we will purchase tools from Crolles 2 as they are needed for expansion of our own capacity for 300 mm logic.
Net operating cash flow reached $255 million in the third quarter and $652 for the first nine months of 2007. For the 2007 year to date net operating cash flow was 9% of sales and clearly showed the implementation of our lighter asset policy and the figures demonstrate that we are well in line with our goals. And with our planned further reduction in capital spending we will further boost cash flow in 2008.
Overall, this was a very solid quarter for ST. We have made significant progress since the start of the year in strengthening and improving the performance of our largest business segment, ASG. In particular, our core wireless business remains strong, and recent developments will further improve our positioning. Recall that ST is home to Europe's largest and, we believe, best positioned wireless semiconductor supplier—and as we look to 2008 we see continuing wireless sales growth.
As we approach the last quarter of the year, ST is much stronger than at this same time in 2006. While on the surface net sales and earnings look similar, we have engineered a significant rebound since the start of this year. After a difficult first half, we are positioned to end the year growing in 2007 in line with the industry estimates, and to see further market share progress in 2008.
Now let me stop to take your questions.
President and Chief Executive Officer