Analog Devices, Inc.
Q2 2006 Earnings Call Transcript

Published: 12 May 2006

[Operator:]

Good afternoon. My name is James and I will be your conference facilitator. At this time, I would like to welcome everyone to the Analog Devices Second Quarter 2006 Earnings Conference Call. All lines have been placed on mute to prevent any background noise. After the opening remarks, there will be a question and answer period with our analyst participants. If you would like to ask a question at that time simply press “*” then the “1” on your telephone keypad. If you would like to withdraw your question press “*” then the “2” on your telephone keypad. Thank you. Ms. Tagliaferro, you may begin your conference.

[Maria Tagliaferro:]

Thank you. Hello, this is Maria Tagliaferro, Director of Corporate Communications for Analog Devices. If you don’t yet have our second quarter 2006 release you can access it by visiting our website at analog.com and clicking on the headline displayed on the homepage. The conference call is also being broadcast live on the internet and a recording of the call will be available within about two hours of its conclusion, and we’ll leave that available via telephone and on the internet for playback for about one week. Participating in today’s call are Jerry Fishman, our President and CEO, and Joe McDonough, Vice President for Finance and CFO. We have schedule this call for about 60 minutes and we’ll begin in a moment with Mr. Fishman’s opening remarks, and then the remainder of the call will be devoted to answering questions from our analyst participants. In fact analysts participants in today’s call can press “*” and “1” beginning right now to queue up for questions. There is an important announcement I’d like to make today and point to those of you listening and those of you who have accessed our financials on the web today, that the results of the second quarter for fiscal 2006 reported today are in accordance with GAAP and include a gain of $13 million related to the sale of our DSP-based DSL ASIC and network processor product line, $17 million stock option expense, and expenses of $6 million associated with the previously announced restructuring action related the closure of our California wafer Fab. In order to help investors compared current results to our history and thereby better understand the underlying trends in our business, our comments during today’s call will at times make reference to results which exclude these items. We have included in our press release details of these stock option expenses and restructuring related items for all quarters from fourth quarter of fiscal 2005 through the second quarter of fiscal 2006. We’ve also provided estimates to these items and other items for the remaining two quarters of fiscal 2006. Investors may also download this information in spreadsheet format from the investor relations page of our website. In addition, please also note that the information we are about to discuss include forward-looking statements for purposes of the Safe Harbor provision under the Private Securities Litigation Reform Act of 1995. Such statements involve risks and uncertainties. The Company’s actual results could differ materially from those discussed herein. Factors that could contribute to such differences include but are not limited to those items noted and included in the Company’s SEC filings, including our most recent quarterly report on Form 10-Q. The forward-looking information that is provided by the Company in this call represents the Company’s outlook as of today and we do not undertake any obligation to update the forward-looking statements made by us. Subsequent events and developments may cause the Company’s outlook to change. Therefore, this conference call will include some time-sensitive information which may only be accurate as of the date of this broadcast, which is May 11, 2006. With that let’s begin with opening remarks from Mr. Fishman.

[Jerald Fishman:]

Well good afternoon. As you can tell from our press release, the second fiscal was a very strong quarter for ADI. Our revenues totaled approximately $644 million, which was up 4% sequentially and 5% sequentially for the continuing businesses that we have. Our strongest growth came from industrial and also from consumer customers. Notably, in the second quarter, our sales to our broad base of industrial customers increased 7% sequentially and were up approximately 13% year over year. The strongest performance came from our diverse space of industrial instrumentation measurement and medical customers who together accounted for 26% of our total sales. Other major portions of our industrial customer base included automatic test equipment which was approximately 3% of sales in the second quarter, automotive which was 8% of sales, and defense electronics which was approximately 5% of sales in the second quarter. Overall our sales to industrial customers represented 42% of our total sales. We believe that this growth is the result of continuing strength of our core analog and DSP technology and continuing strength in the worldwide economy, which is simulating higher capital spending, industrial capital spending worldwide. Our sales to consumer customers grew 14% sequentially and were up 13% year over year fueled by digital cameras and a broad array of audio and video product sales to leading consumer customers. In aggregate consumer products represented approximately 17% of our sales in the second quarter. We remain very well positioned in digital cameras, flat screens TVs, and high-end audio products. All applications were a signal processing technology which enhances the consumer’s experiences. For example, many of the recent introduced high-definition DVD recorders and players rely on chips from ADI’s audio and video portfolio. Our high-performance analog and DSP products are found in upwards of 20 sockets in new high-def DVD systems. Another example of how ADI’s signal processing technology is transforming the consumer experience is the recently introduced Nintendo Wii game console that was just announced this week in the press. The controller replaces traditional push-button commands with realtime live action motion sensing using our newest iMEMS devices with integrated analog circuitry included on those. We expect that customers will continue to integrate the link between consumers and electronics and that ADI signal processing technology will continue to be a key enabler of their ideas. In the communication end market, strength continues from our wireless infrastructure products, which delivered the strongest sequential growth amongst the communication end markets. Wireless handsets also grew during the quarter. As expected, networking revenues declined in the quarter as we completed the sale of our DSP-based DSL ASIC and network processor product line as we reported last quarter. Revenues from these products totaled approximately $3 million in our second quarter compared to approximately $11 million last quarter and $14 million in the year ago quarter. As a result, revenues from communication customers were essentially flat in the second quarter on a sequential basis and represented 29% of our total sales. Computer revenues declined sequentially in the second quarter inline with industry trends and represented approximately 12% of our sales. During the second quarter, Analog product sales, which represented 84% of our total sales, increased 5% sequentially. Converter products increased 8% sequentially, amplifier products increased 9% sequentially, and other analog product categories declined sequentially by 3%. The combination of converters and amplifiers represented 63% of our total second quarter revenues. Recently market research firms have begun publishing 2005 market share statistics for amplifiers and converters. In converters, ADI continues to lead the industry by a wide margin. According to DataQuest, ADI’s 2005 market share for converters was approximately 43%, approximately flat to last year and up 10 full points over the last five years. ADI share remains over 15% of our nearest competitor, whose shares incidentally declined last year, according to this report. Our amplifier share also remains high, driven by our investments in the high-performance sector of the amplifier market. Revenues from DSP products represented 16% of our sales in the second quarter. Among our DSP products a 6% sequential increase in general purpose DSP revenues combined with increased handset DSP revenues somewhat offset the $8 million sequential decline that resulted from the sale of our DSP-based DSL ASIC and network processor product line. As a result, overall our DSP revenues declined 4% sequentially in second quarter. During second quarter we experienced significant increases in orders from both OEM customers and distribution customers for both our analog and our DSP products. As a result, our backlog for shipment in the next 13 weeks grew significantly, improving our visibility into the third quarter. This sets the stage for what we believe will be a strong third quarter for ADI. As Maria described at the beginning of the call, during the second quarter we incurred expenses related to previously announced restructuring and a one-time gain on the sale of the product line I mentioned earlier. We also have charges related to the expensing of stock options. In my remarks this afternoon I’ll refer to results which exclude these items, because we believe that it will help investors compare our current results to our history and thereby better understand the underlying trends in our business. Gross margins were 59.1%. Stock option restructuring expenses impacted the second quarter gross margins by 1.1%. Excluding these items, gross margins reached 60.2% of sales in the second quarter, up from 59.2% of sales in the first quarter on the same basis. Gross margin expansion was driven by improved factory utilization given the increased demand for our analog products that we build in our internal Fabs. We also maintained strong DSP margins aided by a now improving DSP product mix. Inventory grew to approximately 125 days from 118 days last quarter, which was in line with our plan for the second quarter. We built positional inventory in anticipation of the planned shutdown of our California wafer Fab and in preparation for planned sales growth in third quarter. We’re planning for inventory days to decline over the next few quarters. We believe the total inventory of ADI products throughout our supply chain is reasonable. However, stock shortages are already reported by external foundries and backend subcontractors have impacted the leap times for certain ADI products. Nevertheless, of the 17,000 products that ADI offers for sale, 83% of those products are available with less than eight-week leap times, which are leap times coincidental with what our customers need. Of our top 500 products, 72% are available with less than eight-week leap times, also which is clearly within the expectations of our customers. As a result of higher gross margins and continued expense control, operating margins increased to 23.5% of sales, which includes stock option and restructuring expenses of approximately $23 million. Excluding these items, operating profits for the second quarter were 27.1% of sales, up from 25.7% of sales on the same basis in the first quarter. Our diluted earnings per share was $0.39 and the same fixed stock option and restructuring expenses long with one-time gains on the same of our DSL products resulted in a $0.02 reduction in earnings per share. Excluding these items, earnings per share were $0.41 for the second quarter, up from $0.37 on the same basis in the first quarter. Our balance sheet remains very strong. The second quarter cash flow from operations totaled $205 million or 32% of revenue. Capital spending totaled $29 million producing free cash flow for the quarter of $176 million or 27% of sales. Account receivable was up to 51 days from 47 days last quarter, primarily as a result of the disproportionate amount of shipments in the last month of the quarter as many supply issues we had earlier in the quarter got resolved. We’re planning for account receivable to decline to approximately 48 days this quarter. Our cash balance at the end of the second quarter totaled approximately $2.7 billion after we repurchased 6.2 million shares of our stock for $238 million and we paid $44 million in dividends. As we announced in March at our annual meeting, in June we will pay a dividend of $0.16 a share, up from the $0.12 we declared in the first quarter. Based on the order patterns and all the demand signals we’re getting from our OEM customers and our distributors, we’re planning for a strong third quarter for both our analog and our DSP products. In aggregate, we’re planning for revenues to be in the range of $675 million to $685 million for the third quarter. We’re planning for gross margins to be approximately the same as the second quarter and we’re planning to limit expense growth to 2% sequentially, primarily to support higher employee profit sharing and commissions as our sales and our operating margins continue to grow. These results are planned to produce EPS in the range of $0.38 to $0.39 for the quarter, and we’re planning to stock option previously announced restructuring and acquisition expenses to reduce diluted earnings per share by approximately $0.06 for the third quarter. So, excluding these items, our plan is for diluted earnings per share in the range of $0.44 to $0.45 cents. Our revenue growth plan for the third quarter represents a 16% to 18% year-over-year increase. This is in the ballpark of what we believe to be the long-term growth opportunity for ADI giving us virtually all types of electronic equipment found in homes, in cars, in offices, in factories, in telecommunication infrastructure, and in medical applications is now and will continue to be enabled by our signal processing technology.

[Maria Tagliaferro:]

Thank you, Jerry. During today’s Q&A period, please limit yourself to one primary question and no more than one follow on. Operator, we are ready to begin.

[Operator:]

Thank you. I would like to remind everyone that in order to ask a question please press “*” followed by the number “1” on your telephone keypad. Your first question comes from the line of Bill Lewis with JP Morgan.

[William Lewis:]

Great, thank you…I guess my question is related to the outlook you provided. Could you talk about what your bookings growth was this quarter, if you can quantify how much that grew? And specifically, relative to the comments you made last quarter, at the time you saw bookings growth that was a little bit ahead of consumption, could you talk about maybe how that played out and how that actually translated into maybe better bookings growth even though I though that might have impacted your bookings growth this quarter?

[Joseph McDonough:]

This Joe McDonough. The bookings growth., the book-to-bill ratio was about 1.1, so we had about 10% growth in bookings. We had backlog that began the quarter at $400 million and ended the quarter at $471 million. That’s the 13-week backlog in those bookings, the bookings that we’ve taken from both our OEM customers and from our distributors. As we’ve said in the past, that represents the end-customer bookings or backlog on our distributors. It’s indicative of the demand patterns that we expect to see, and at this point in the cycle as we’ve seen in other times when the business is building and the demand is growing, we do see backlog in bookings starting to grow ahead of what we expect to be able to shift or realize in revenue. We recognize revenues only when the distributors ship the product to their end-customers. We also have another demand signal that comes from our OEM customers and that’s their forecast. Some of our customers give us forecasts rather than bookings and those forecast turn into orders and shipments during the quarter. That demand pattern is also increasing this quarter from last quarter. So, we have signals that would suggest that they’re ahead of what we’re looking at in terms of the revenue guidance for next quarter, but we think the guidance that we’re giving is consistent with the plan that we have for the quarter regarding the product that we plan to build and be able to ship.

[William Lewis:]

Okay, that’s helpful. As a followup to that, just in terms of the revenue outlook, can you maybe talk about the composition of the revenue and where you see the growth coming from, maybe versus Analog versus DSP level and any other market-related commentary?

[Jerald Fishman:]

Well, I think to our first approximation, the revenue growth that we’re anticipating in both our analog and DSP businesses is about the same. I meant that could vary given that we don’t have order and that we’re not going to ship yet, but based on what we’ve seen the trends in the market where Analog and DSP products go, to a first approximation in the second week of the quarter looking forward we see about equal growth rates. We expect the industrial business to stay strong, the consumer business was good. We expect sequential growth in handset business again. We expect the infrastructure business to be good. Probably we’ll pick up a little in the computer business as a result of some new products and also better product cycle coming up for us as Vista Operating Systems start to get deployed. So, I think our best guess while looking at the backlog and what the customers are seeing is that we should see reasonable performance pretty well across the product lines.

[William Lewis:]

Thank you very much.

[Operator:]

Your next question is from the line of Michael Masdea with Credit Suisse. Mr. Masdea your line is open.

[Maria Tagliaferro:]

I guess you can come back to him, take the next caller.

[Operator:]

Your next question is from the line of Steve Smigi with Raymond James.

[Steven Smigi:]

Thank you. I was wondering if you could comment a little bit on your power business. It sounds like it was little bit weaker this quarter. I was wondering if you could talk about when that might recover and specific areas looking for portable stuff other than notebooks that you might go into going forward.

[Jerald Fishman:]

Well, yeah, I think that’s true. We have been talking about that part of the business has bee declining; that’s mostly intentional, and the portable stuff is growing, and I think next quarter we are counting on that business being up sequentially and certainly in the quarters following, but we think we are getting towards the point where the new stuff is growing faster than the old stuffs declining, and I think in the third quarter that will begin to show up.

[Steven Smigi:]

And could you comment a little bit on some areas outside of the notebooks where you’re hoping to gain some traction?

[Jerald Fishman:]

Well, in power management, there have been areas that go along with our products. In any vertical where we’re in, cameras or any other consumer product, they also carry power management and that’s one of the reasons we are very interested in that business because we command a lot of the bill of materials already and our customers really want us to be there. So, I think over time that business will be sort of in the applications or vertical businesses, but also a lot of those same architectures will be very relevant in some of the horizontal markets as well, but I think initially most of it will be in verticals because that’s were the revenues are right now and that’s where most of the growth is possible in the short term. But over time, there’s no reason we can’t build that out and that would be very similar to the other product areas where we are very strong, like amplifiers and converters. It’s been a long haul for us as the desktop stuff has been declining out for the better part of the year and a half and the other stuff has been increasing but not the way the other stuff has been declining. But, as I said, I think we’re pretty well past that now, or at least that’s our plan and our hope.

[Steven Smigi:]

Yeah, and that was a very nice quarter. Just quickly, Jeff, could you comment about linearity throughout the quarter? Thank you.

[Jerald Fishman:]

Well, the linearity, it was a difficult quarter except for the fact that early in the quarter we had some supply constraints from the foundries and there was a whole bunch of issues with the subcontractors over there in terms of leap times, spread outs. So, we had a good July but we had a good May and June also.

[Steven Smigi:]

Thank you…

[Operator:]

Your next question is from the line of Adam Parker with Sanford Bernstein.

[Adam Parker:]

I shouldn’t ask you what day is today, Jerry?

[Jerald Fishman:]

Monday.

[Adam Parker:]

All right. I’m a little surprised by your guidance for the flat gross margins sequentially, even with the really good revenue growth. So, maybe just a little bit where the pushes and pulls on the margins, it would seem that higher utilization would help. So, can you help me a little with that, and do you expect may be margin expansion beyond October quarter, beyond whatever issues around your July flush out?

[Joseph McDonough:]

This is Joe McDonough. The gross margins as we have been saying for the better part of the year that our plan was to get that up to 60%. There have been a number actions that have been underway there and there were a couple elements to that, some of them are just some cost reduction, better utilization issues, and our gross margin is mostly influenced by mix in any particular quarter and that’s always much more difficult to predict in the cost side of the equation. So, what we have seen in this past quarter and it was what we had planned was for the utilizations in the factories to go up. They are now running above 70%, somewhere between 70-75%. We saw benefits of some of the cost reductions, we saw some shifts and mixes of the products, and so overall we ended up where we had planned, which was in the 60% range, actually a little bit ahead of that at 60.2%. Now, looking forward, we still do have the actions underway to move the production from our California Fab to our other Fabs and that Fab will shut down at the end of the fourth quarter, the production will transfer. We’ve been building some inventory in anticipation of that transfer. We obviously have to sell that inventory, build at lower prices in the new Fabs, and that will occur during the early part of the next fiscal year. During that whole period of time, we would expect to see continued shifts in the mix of the business and some products will sell with very high margins and some with slightly lower margins. Very few products sell below 50% margin. So, the gross margins the way we have been modeling our business is to run a business that can run 60% gross margins. We think that’s a good business and that’s the target that we’ve had, and we believe that’s realistic. In any quarter, we certainly can be a point ahead of that, we can be a point below it, we can be even two points ahead of it, but we’re not prepared at this point to reset the model. We do have to, as time goes on, recognize that there’s stock option expenses that’s being absorbed in the cost of sales as well. Our employees that are in the manufacturing organizations have received options and we do want to run this company with an operating margin that absorbs the stock option expenses and have a 60% gross margin and a 30% operating profit.

[Adam Parker:]

All right, so, I guess from boiling that down, first of all the 60% margin target is a pro-forma 1 and not a GAAP 1, and second of all, the guidance…Jerry said that you seem to have equal DSP and analog mix. So, given that notion, there’s some negative mix effect going on in the July quarter…

[Joseph McDonough:]

No, in the July quarter, there’s actually larger growth of DSP product than analog product in that plan for next quarter. But even within the analog products, we build some of those products in our own Fabs, build some of the products in foundries, the consumer products tend to have slightly lower gross margins than the products that we build in our own Fabs when you look at variable ones.

[Adam Parker:]

Okay, I’ll leave that one. The second question I had was on the operating expense growth and the few percent, I guess dollar terms, sequential increase you expect, can you talk about whether changes made to your profit sharing or commission structures…I wasn’t expecting a big GAAP up like that until you more attained the operating margin goals of 30% as opposed to on the way. So, I’m just trying to model the OpEx going forward after that few percent increase in July. So, if you could help there, that would be great.

[Joseph McDonough:]

Well, we pay a normal bonus to our employees when earn 25% operating profit. So, we have been over the past few quarters moving quite nicely through that and as we move up towards the 30% range, I think that’s a 1.5 bonus. So, we certainly have to pay those bonuses, we pay commission to the sales people, and that’s been part of our expectation as we have gone along.

[Adam Parker:]

So, those are based on pro-forma numbers?

[Joseph McDonough:]

Right. Now, back to the question that you asked me about the GAAP pro-forma on gross margins and operating margins, so that I don’t leave any confusion. As we’re talking about the 60.2% of this quarter and similar gross margins next quarter, those are pro-forma. But as we look forward into 2007-2008, the expectation is that the world will evolve, we have to evolve, we certain are changing our own competition programs to recognize that we are going to have to be able to make those kinds things to work, the equity relating expenses, so that will be a transition if it would happen…

[Adam Parker:]

So, ultimately if you do reset it, it would be to GAAP targets at the same level as the pro-forma also?

[Joseph McDonough:]

Yeah, obviously we have two or three points there that we have to absorb.

[Adam Parker:]

Right. One last thing, in the earnings guidance, what are you assuming for the share count? Do we assume the same repurchase rate that you just did or how should we figure in your share count or your share repurchase in that quarter?

[Joseph McDonough:]

For the first quarter we had 377 million shares within the calculation. Our plan would be for 374 million next quarter. The way that works is on an average number of shares outstanding during the quarter, but we’re buying shares throughout the quarter and this tends to lag a bit.

[Adam Parker:]

Great, thanks for your time guys.

[Operator:]

Your next question is from the line of Douglas Freedman with Am Tech Research.

[Douglas Freedman:]

Hi guys, thanks for taking my questions. If you could briefly discuss the acquisition of the TTPCom assets and what your long-term goal and strategy there is going to be?

[Jerald Fishman:]

Well, I mean it’s not a big deal. It’s a situation where TTP provided most of the software that went alongside our chipsets and handsets, and I think increasingly our customers had the interest to have one vendor do the whole thing; I mean customers don’t want to fuss with in the middle of what they are doing and what we were doing. So, we had an opportunity to acquire those assets that are on quite reasonable terms, and we thought it would be very a strong help to us with our customer base, particularly in Asia. I think at the end of the day, we cross that and what we get out of it is about neutral to the P&L. So, it’s just really a question of getting control over the software, which enables us to interface and interact at a different level with our customers.

[Douglas Freedman:]

All right, and has there been any change to the expected cost savings from the Fab closure in California?

[Joseph McDonough:]

No, that’s on schedule and the cost savings are the same.

[Douglas Freedman:]

Terrific, thanks so much.

[Operator:]

Your next question is from the line of Rohit Pandey from HSBC Securities.

[Rohit Pandey:]

Thank you, two quick ones. How much of the utilization improvement by the inventory buffer build up in inventory buffer to prepare for the Fab closure versus demand, is there a way to quantify it?

[Joseph McDonough:]

Well, the Fab closure buffer stock was about $6 million of the inventory growth.

[Rohit Pandey:]

Okay, and when I look at your OpEx on per-employee basis, it’s about $90,000 compared with let’s say about $70,000 for similar companies like. I know these numbers can be different given different cost structure, but do you think there are parts in your cost structure if you can further optimize like outsourcing more or testing or other line items or other things that you could elaborate on?

[Jerald Fishman:]

Well, I understand your question is why can’t we get our cost covered, that’s the question?

[Rohit Pandey:]

Yes.

[Jerald Fishman:]

I think, last year we constantly looked for opportunities to do that and we tried to balance them with trying to grow the company at a pretty good rate here. We believe that if you have a business that’s running 60% plus gross margin and 30% plus operating margin and growing at a pretty good clip, producing 28-30% over your sales and free cash, buying stock back, paying dividends, pretty good rates, having high yields on the dividend, one of the highest in the industry, it’s a pretty good business. I think that the goings of trade off there between growth and profits for long term and we are always looking to fine tune our balance.

[Rohit Pandey:]

Okay, thank you.

[Operator:]

Your next question is from the line of Tom Thornhill with UBS.

[Tom Thornhill:]

Joe and Jerry, if you could looking at the orders and growth trends, looking beyond the book to bill this quarter and ending backlog for the current quarter, on a qualitative basis can you talk a little bit about your customers’ forecasts, your conviction level in this longer term growth rate in this 15%, 16%, 18% range?

[Jerald Fishman:]

I think you really have to keep it down. A lot of what we’re seeing has been stimulated by industrial capital spending. I think there’s a widely held view that most factories around the world are going to start running out of capacity, so people are trying head capacity. I believe that’s sort of a long-term trend, that’s healthiness, and in particular in the industrial business where the processing content keeps going up and up and up. So, I think that’s okay. If we want the customer to tell us, he’s really got to discount that a little bit, which I think you can translate from Joe’s comments, that you never quite believe all the backlog and all the order rates, and I think people are trying to get ahead of themselves a little bit. But, the kind of the growth that we are talking about this year, the kind year-over-year growth rates that we’re looking forward to over the next couple of quarters seem indicative of what we believe long-term growth rates should be able to provide. So, I think it’s very different when you look back at some of the bubble periods where other companies were reporting the 40% year-over-year numbers and that thing got really over the top, and you know it. I think these kind of year-over-year numbers are here given the expectations in the markets, and therefore I think a little bit more believable than other periods where things were so far over the top that either the world had changed fundamentally, which turns out it never does, or they were overheated, which turns out it was. So, I think when you’re seeing the kind of sequential numbers that increase these rates or these are what we are going to ship in these rates and you look at the year-over-year growth rates and they are in that range, I mean all that sounds to us like that’s sort about where it should be. A year ago it will be higher, or a year further it could be lower, and the fundamental consumption rate modulates with order patterns. But, we’ve said 15, 16 those kind of numbers, 18 maybe sometimes in some quarters, I mean that is what this business should be able to grow in the long term. So, we don’t think in that sense we all need to break that up.

[Tom Thornhill:]

Looking at the order book in the backlog going into the third quarter, your reference business should run about what it was in the quarter you just finished or…

[Jerald Fishman:]

We only have to be a little bit careful about that because the more of backlogs we have the less reference business we have. So, that’s what happens in this part of the cycle. A while ago, it was also reference business, now people place some backlog on you so reference business…trigger exactly, but that’s what happens with this part of the cycle.

[Tom Thornhill:]

What percentage of your reference business last quarter where you able to ship?

[Joseph McDonough:]

Well, the reference business was somewhere about half of our business, but at this point we really don’t even look at that internally from week to week. We put the information together to respond to this call, but it isn’t really the way that we manage the business because once your start to get the kind of backlog and forecast that we have, and a lot of it comes from the distributors and the distributors have some different numbers from there end customers, you start to approach some demand signals that look almost like the entire next quarter, and what really happens is there’s a lot of shifting that starts to go on as customers recognize what they need immediately and what they want to push out a little bit. So, the backlog and the terms, orders, and everything are not terrible great signals for the future. So, we go and we have business unit meetings a couple of times during the quarter, we have inputs that come from the sales organization and their contacts with the customers. We put together business unit plans from the bottom up at the product level, look at it from end market situation, and we put together a business plan. So, we don’t start with the backlog or the forecast from the customers in the aggregate, we start with a lot of detail.

[Jerald Fishman:]

So, I think higher backlogs makes you feel better. I’m not sure it changes the dynamic a lot other than a little better sense of what to do that you would have if you had a lot of reference business.

[Tom Thornhill:]

Thanks Jerry.

[Operator:]

Your next question is from the line of Romit Shah with Lehman Brothers.

[Romit Shah:]

Thanks in terms of the long-term gross margin target, I think you mentioned last quarter that you’d be disappointed if ADI’s margins had peaked out at 60%, now it sounds like you’re backing off that. Is the company taking a view…that you’re looking at the competitive landscape where it seems that there appears to be increasing pressure from both the high end and the low end if they want to grow, if ADI wants to grow at the top line at an above average rate, then 60% plus net gross margins is not realistic target?

[Jerald Fishman:]

Well, first of all, what Joe was saying earlier is that the target of 60% ultimately is going to include the GAAP target, and that’s a couple of points higher than the pro-forma target. Number two is, having said that, I think if you come back to this that if you have a business that’s around 60 points, particularly if it includes all this other stuff in it, that’s a pretty damn good business. It generates the kind of returns ADI does. So, I think it is somewhat of a tradeoff there. I think trying to force the gross margins up at the expense of growth with the kind of returns we are getting probably isn’t all that smart to us. You make a list of all the companies doing 60% reliably or little bit higher if you include the pro-forma numbers, it’s a pretty short list of companies that do that growth.

[Romit Shah:]

My followup, I may have missed this, but it sounds like there are some changes in terms of personnel in your product management division, can you just discus what catalyzed those changes and I guess looking out over the next 12-18 months, which applications you see as the high runners in that business?

[Jerald Fishman:]

Well, I think what really precipitated that is we’ve been working on this business a while. We have some very talented engineers in that business that are working on some great products, and we came across an opportunity to re-hire a guy that used to work for us that we know is a tremendously talented guy, and we took that opportunity. I think the combination of his experience and understanding of that business with some tremendous engineering talents we have to put in that business over the last year or two, I think we’ll fundamentally improve our performance in that business. It is sort of an interesting thing as I mentioned earlier that it’s crazy because the customers have been after us to produce these products, they really want to buy them from us. As I said earlier, particularly the customers where we’re showing a reasonable part of the bill of materials. So, I think we’ll start off as we have been focussing on some of the places where we already sell our products and ultimately our goal is to broaden out that franchise to a much larger customer base.

[Romit Shah:]

In which applications again do you see as the…

[Jerald Fishman:]

There are a lot of products that go into the consumer space, a lot of products that going into the communication space, anything that’s portable obviously is where the opportunities we’re applying for management and portable power stuff is all over the place. I think it will be in virtually all the verticals that we serve, particularly those where we already apply a lot of other analog and DSP stuff.

[Romit Shah:]

Thank you.

[Operator:]

Your next question is from the line of William Conroy with Sanders Morris.

[William Conroy:]

Hi and thanks for taking my call. Jerry, could you just talk a little bit about the sustainability of the improvement from the industrial side that you are seeing. My sense is this would be relatively sort of a long and slow but steady…and I’m not asking to prognosticate about whether we get a worldwide recession or not, but your sense of this type of business that could lend itself the big pops or more of this kind of blow up into the right?

[Jerald Fishman:]

My take is the latter. The reason for that is that it’s spread out among tens of thousands of customers. So, I think it’s more the kind of thing that if industrial capital spending keeps moving up to the right, which it seems like it has and will continue to, that business should continue to be good. I don’t expect it will be a business that all of a sudden you’ll see a blow out quarter run. And if we did I’d start to worry about it frankly.

[William Conroy:]

And just quick followup, Joe, one for you. With the different sort of moving parts that you’ve described, these are the inventory and your expectations going forward, can you give us any sense of what you’d anticipate factory utilization to be in the current quarter, should it be about flat?

[Joseph McDonough:]

The factory utilization in the current quarter will be slightly up. Now, we’re in the 70% to 75% range, so it will start to move up a little bit. But in our business we never get to 100% and when we get up to the 90% that’s quite a bit. We have a lot of head room though in terms of modest capital expenditures, we can increase the production within those factories, ship the product around in terms of what kind of products you produced and what dollars they sell for. So, there’s quite a bit of flexibility we have there as well.

[William Conroy:]

All right, thank you very much.

[Operator:]

Your next question is from the line of Michael Masdea with Credit Suisse.

[Michael Masdea:]

I guess, Jerry, when you’re referring to this part of the cycle and typically when you hear about backlog growing almost 20% and…not fully believing what’s going on in the channel somewhat, it’s always a little bit scary, so tell us why it’s not a problem and why you think it’s sustainable?

[Jerald Fishman:]

Well, I think the primary reason is that the sequential rates that we’re putting out on the sales front…I mean orders go up and down and they are always magnified on the up side and they are magnified on the down side, but I think the kind of year-over-year numbers that we’re talking about and we’re putting up are indicative of a fairly typical year. I think we are both old enough to remember the last cycle where we and other people were putting about 30-40% year-over-year increases. I don’t think we’re seeing that right now and I think that gives us confidence that what we’re seeing is mostly about assumptions. The order rates are sort of irrelevant, because that’s just a question of what kind of inventory levels and what kind of safety stocks they run around. So, we don’t pay much attention to that; I think, as we’ve been saying, we don’t ship, we don’t pay much…I mean it’s just part of the noise out there in the channel. So, our goal is to try to keep the leap times low, we’re trying to have customers that order what they really need and have that sort of field right now, like it’s sort of normal. As I said, the order rates go up and down. I don’t think any of us pay much attention to that; that has been around for a while. We’re just not seeing any really segment of our business on the verticals to the industrial companies frankly going on. We’re just seeing them trying to order what they need and what they really want, and I think with the margin they are trying to get ahead of a little bit, they’re afraid of shortages, but not in a big way. I mean that’s why even Joe keeps harping on this part about what the backlog increases and when you read some of the headlines out there, orders and all that stuff, not very relevant.

[Maria Tagliaferro:]

Michael are you there?

[Michael Masdea:]

Can you hear me?

[Maria Tagliaferro:]

Yeah.

[Michael Masdea:]

Okay. The consumer piece was pretty strong in the first quarter, is that something very specific to ADI in terms of penetration or is there something going on here to grow that kind of strength at the end of the year?

[Jerald Fishman:]

The consumer part in the second quarter for us?

[Michael Masdea:]

Yeah.

[Jerald Fishman:]

No, I think it was nothing extraordinary. I think it’s mostly related to the kind of stuff we are doing, to sell well. It’s not so much a question of the seasonality for us in that business. So, we’re in a whole bunch of new products. We mentioned one of them where there was a high-def DVD players which was…so, it’s much more the proliferation of the kind of stuff we’re doing at the end market than it is the seasonal part of that business.

[Michael Masdea:]

Great, thanks a lot.

[Operator:]

Your next question is from the line of Sumit Dhanda with Banc of America Securities.

[Sumit Dhanda:]

Joe, I wanted to go back to your outlook on gross margins going forward. You said that the 60% long-term gross margin target incorporates about two to three points of impact with stock options. But this quarter I think it’s only about 70 basis points, so do you expect that DSO impact to increase on a dollar basis significantly from here…

[Joseph McDonough:]

Let me clarify that. The goal that we have in running the company is to run a company that has a 30% operating margin including the impact of option or equity compensation going forward. We’re running a company today that is 27% on a pro-forma basis and we are about three points lower than that on a debt basis with the equity accounting. So, we have a fair amount of leverage that we’ve got to get out of the business in order to get to the 30% operating margin. We have a lot of work underway in other parts of the operating expenses to try to get that leverage. And on the gross margin, most of the leverage that we have been looking for has already been achieved. That’s not to say that there isn’t some leverage left in the gross margin, but from quarter-to-quarter the mix of the business we do in a particular quarter, we’ll be probably more determined to put the gross of the margin than getting the utilization of the factory up to 50% to somewhere in the 70s. So, the place that we are working the hardest is in operating expenses to get the leverage, in order to get the operating margin of the company to first 30% operating margin without the equity cost of compensation and then to 30% including those.

[Sumit Dhanda:]

I guess I had a couple of followups as it relates to that. First, my understanding was that you were planning to keep operating expenses relatively flat on a dollar basis for at least the first three quarters of the year, but it does not seem like that’s necessarily the case, so I’m curious as to how you’re going to get the operating leverage that you’re talking about.

[Joseph McDonough:]

Some how there seems to be two misunderstandings, one we expect we would just be disappointed if the gross margins didn’t go above 60% and second that the operating expenses would be held flat. We have always indicated that our compensation programs have elements in it that are related the success of the company that we have to pay out more bonuses, we obviously have to pay out more commissions, and everything in the world doesn’t stand still in terms of product development and a lot of other things. So, we have to make a lot of decisions internally within the company in order to constrain the operating expenses even as we’ve been doing now, and that’s what we’re trying to do.

[Sumit Dhanda:]

…give you another 600 basis points on operating margins unless it is purely leveraged from much higher topline.

[Joseph McDonough:]

We certainly expect to have leverage from higher topline growth and we do not expect for the operating expenses to grow at the rate of the topline. Holding them dead flat has been never anything that we have intended to communicate as our objective.

[Sumit Dhanda:]

As I’m trying to tell you this over and over again, as I try to boil it down, is it that you’re just expecting much faster topline growth as the primary driver of operating leverage, or is there something specific you can really point to where you think there’s operating cost benefits you just haven’t seen in your Company yet?

[Joseph McDonough:]

Our operating expenses for quite a long period of time have been growing at a lot slower rate than the growth of the sales, and that’s the result of the things that we’ve taken internally. It’s a cumulative effect of a lot of small things and we intend to keep working on that, but we don’t expect to be on the telephone discussing every single item that we do in a company the size of Analog Devices.

[Sumit Dhanda:]

The other question if have, Joe, relates to the consolidation efforts that you’re undertaking here. If my memory serves me right, you talked about $45 million in savings associated with that, and my understanding was that a lot of that would impact cost. First of all, is that correct or incorrect, does that still hold?

[Joseph McDonough:]

Yes that’s correct.

[Sumit Dhanda:]

Then I guess my question is why don’t gross margins benefit more from that consolidation activity?

[Joseph McDonough:]

They will benefit from it and at the same time there will be business that will be produced externally from external foundries that will have gross margins that are below 60%. Our belief is that a 60% gross margin in semiconductor business is a great business.

[Sumit Dhanda:]

One final housekeeping question, the tax rate that we just modeled at, what do we model it at going forward?

[Joseph McDonough:]

It was 23% this quarter, our expectation is that it will be between 22% and 23% next quarter.

[Sumit Dhanda:]

Thank you.

[Operator:]

Your next question is from the line of Tore Svanberg with Piper Jaffray.

[Jeremy Kwan:]

Good afternoon, this is Jeremy calling for Tore. Joe, I believe last quarter you mentioned the internal utilization was about 57%, can you give us an idea if that changed very much this quarter?

[Joseph McDonough:]

Yeah, the utilization this quarter was between 70% and 75%, and last quarter it was in the 60s.

[Jeremy Kwan:]

The internal versus external?

[Joseph McDonough:]

Oh, the split. In the first quarter, internal was about 57% this quarter and 55% last quarter.

[Jeremy Kwan:]

And do you have an idea of what that was on the backend?

[Joseph McDonough:]

No, we don’t break that out. We do a lot of the assemblies with subcontractors and a fair amount attached from our own factories.

[Jeremy Kwan:]

Okay. I guess with the overall market kind of picking up, are you seeing any indication from your project supplier or project partners that things are turning up a little bit for them, is that a concern for you?

[Jerald Fishman:]

Well, I think the times we are in is pretty overheated right now, demand has picked up and I think we’re seeing the results of that. We have a spectacular relationship with our foundry partners and they generally provide what we need to us as per our expectations. I think so far that’s mostly been okay. They got a little bit behind earlier on the quarter, but I think as we go forward my expectation is that they’ll provide what we need.

[Jeremy Kwan:]

It’s more of the leap times versus pricing, is that a fair way to put it?

[Jerald Fishman:]

Pardon.

[Jeremy Kwan:]

Is it a fair way to put that capacity has shown up to you in the form of extended leap times versus pricing?

[Jerald Fishman:]

It really isn’t pricing. The margin pricing is a different a little bit. We resolve all differences at this point in the cycle, but that’s not a significant factor.

[Jeremy Kwan:]

And finally, Jerry, just looking at your analog business, has anything there changed in terms of the product lifecycles, has it been consistently high or has something changed in terms of whether it’s end market mix that could change the product lifecycles?

[Jerald Fishman:]

I think in the horizontal business, which is the analog business where one product might sell to 1000 or 2000 customers, those lifecycles are the same as they’ve always been. In some of the much higher volume verticals, analog businesses, lifecycles are a little bit shorter, but the architectural lifecycles are still very long. Even though we might go from one extension of product to another, generally the architecture or the base of the product stays about the same, some of the features or forms of the product tend to change a little bit faster, but by and large the lion share of our analog business is still typically extremely long lifecycles.

[Jeremy Kwan:]

Great, thank you very much.

[Operator:]

You next question comes from the line of Louis Gerhardy with Morgan Stanley.

[Louis Gerhardy:]

Good afternoon. Your incremental operating margins were 64% on a pro-forma basis, so nice draw there. But, if we think about this is in the context of your October press release where you mentioned the number of refocussing initiatives, how should we think about the benefit from the operating margin perspective over the next couple of quarters? I’m trying to get at where the benefits of those initiatives which you’re executing upon now, are they front-end loaded, are they going to be spread out over the next two quarters? And then also maybe related to that, I know it’s probably tough given that there’s a number of initiatives underway, but can you give us a percent complete on the initiatives that you announced in October?

[Joseph McDonough:]

Well, that’s a little hard because there are number of different items that for the most part have been completed except for the Fab shutdown that I think I’ve discussed before. I guess the easiest way if you’re just trying to get to what might we get out of incremental revenue dropping towards operating margins, I tend to think in terms of we got 50% down at the operating margin line, that would be pretty good and that’s what we’re trying to do, and we’ll probably be a little bit above that some quarters, a little bit below it in other quarters, primarily as a result of the mix of the business that we have in any particular quarter. But, we’re running a business now that is generating a pretty good running rate of earnings per share. We’re running around $7 share of cash. We’re trying to deal with that. I think the actions that we’ve taken are indicative of the sensitivity we have to the shareholders, and so ex-cash are starting to trade at $28, and we think we’re earning pretty good earnings per share, and we’re moving forward in the direction that we’ve been saying that we’re moving. So, beyond that, I don’t think we want to get into all the details of all the actions that are underway within the company other than to the extent that I’ve discussed it before.

[Louis Gerhardy:]

Okay, great, thanks for that. Just a product related question; of the three next-generation gaming platforms that are out there now, can you talk about the range of dollar content that you would have in all three of those collectively and would you expect to sell the iMEMS devices into more than just one?

[Jerald Fishman:]

I don’t even know that number, but clearly that technology is very relevant in games and the only thing that we can sort of talk about is what’s been publicly announced. This is a unique feature that is very important to those game manufacturers, but I think there are lots of other opportunities in those games beyond that. So, all the present games are just single processors, so it’s not a huge part of our consumer business, but hopefully that’s going to be a larger part in the future.

[Louis Gerhardy:]

Okay, nice quarter, thank you.

[Operator:]

Your next question is from the line of Seogju Lee with Goldman Sachs.

[Seogju Lee:]

Hi, thanks. Jerry, we just got back from Dallas at the Texas Instruments panel meeting and they talked of their DSP products. So, I’m wondering if you could talk about your products in terms of competitive positioning, in particular related to consumer and communication infrastructure market. Thank you.

[Jerald Fishman:]

Well, I think our DSP product portfolio now that we have up there selling is highly competitive by every measure of the technology of those products. They take a long time to get out there and get sold, but I think the progress that we’re making that I just reviewed is pretty good. I have no idea what our competitors say about that, but I think outside the handset business our DSPs have done extremely well, and I think we’ll continue to get even better in the future. I thin the roadmap is good, the products are good, the real challenge is to really just get ourselves up in those to cover the expenses in that business, and we’re working hard to do that. Other than that, I don’t know what TI says and I couldn’t comment on that.

[Seogju Lee:]

Okay, thanks.

[Operator:]

Your next question is from the line of Ross Seymore with Deutsche Bank.

[Ross Seymore:]

Hi guys, actually similar sort of question. Down at TI where most of us were the last couple of days, they put up a lot of slides about their HPA business, taking a bunch of share. I’m not sure you would exactly agree with that given your comments on the converter and amplifier market, but, if you were to look back and say where you might have lost some HPA share over the last year, can you give us some color on that? And then what your belief is on how ADI will hold or grow or lose share over the next year? Any sort of color there would be very helpful.

[Joseph McDonough:]

Well, I guess the data we have at this point that we’ve been analyzing is the DataQuest market share report that Jerry alluded to; it came out just recently in April, and that indicates that we had 43% market share in 2005, 43% market share in 2004, and that TI was second with 15% market share in 2004 and 14% market share in 2005, and Maxim was third with 10% market share in both years. So between the three of us we have roughly two-thirds of the converter market. As you know, that’s our largest product category of 43%. And if you go back to 1999, our share gains have been about 10 percentage points. I think our compounded growth rate and that according to the DataQuest study was about 17% for converter growth since then. So, we have a hard time understanding how we’re not doing pretty good against our competitors in converters, amplifiers. It looks like it is similar, although we don’t have the data broken out because our amplifier sales tend to be concentrated in the higher performance portion of that market, and the market is just not broken out that way.

[Ross Seymore:]

So, I guess one explanation could be that the power management subsegment of the analog grew market faster than converters or amplifiers?

[Jerald Fishman:]

Yeah, I think that’s what happened last year and that’s why we’ve been investing heavily in that business and we’ve made the changes to get the growth rate of that business up. But, any of the statistics out here about the converter products, Joe was quoting directly, you have to go to the statistics, and I think that statistics indicate that our share in converters is very strong, its’ been strong, it’s a lot stronger than it was five years ago, and everyone of our competitors — there is no one of them, that’s a major competitor — who has gained any position against our converter by any published data. So, beyond that I don’t have the answer to that question.

[Ross Seymore:]

I think you just did. One followup on that, in the power management area, you’ve made some new hires in that area, you’re definitely investing organically. One of the new guys entered the market, got in through some relatively sizable acquisitions and it’s taken about five years to do it, given that you have the $7 per share in cash on the balance sheet, is there any sort of thought about expediting your time to market by doing some acquisitions or is that something that you would rather just build organically.

[Jerald Fishman:]

Well, we look at a lot of companies and we’re always looking for the indication of who’s really good and how much are they worth in terms of accelerating the path on that, but certainly we would consider that to accelerate growth as the right opportunity came along.

[Ross Seymore:]

I guess I have one quick followup in the wireless infrastructure market that you pointed to as being strong, could you give us any color on where you actually saw the demand, was it 3G, 2.G, 2.5G, anything like that would be helpful?

[Jerald Fishman:]

It’s really a combination. The EDGE stuff and the GSM stuff, there’s just a lot more volume that they’re trying to pump through there so that they find more base stations, and I think a lot of the carriers now are starting to build out 3G infrastructure. That’s certainly true in many locations including China. So, it’s really a combination of more capacity on the existing base stations and new capacity for new types of service going on, 3G and CDMA.

[Ross Seymore:]

Great, thank you.

[Maria Tagliaferro:]

We have a lot of people remaining in the question queue, we’re already past our time. So, we’re going to take one last question. I just ask anyone who we haven’t got to, to just call back here to the office at 781-461-3282 and we’ll take your question. Also, for your calendars, just to remind you that our first quarter earnings call is presently scheduled for August 10, 2006, after the market closes. So, operator, can we get our last question please?

[Operator:]

Yes mam, your final question comes from the line of Craig Ellis with Citigroup.

[Craig Ellis:]

Thanks for that. The question is, Jerry, with the foundry capacity tightening that you mentioned earlier, are you seeing any impact on the gross margin line as you look out and give guidance for the coming quarter. Secondly, you had the product refresh on the low end in the digital base spend late last year, is some of the momentum you’re seeing on the handset DSP side related to that product, and how should we think about how that could play over the course of this year?

[Jerald Fishman:]

Well, on the first question, I think I tried to answer that a little earlier by saying that the margin in the price is apparently stiffened a little bit there, a little harder on not dropping the prices that we’d like to do always, but I think it’s really minimal right now relative to the gross margins that we’re reporting. On the average chipset, the take up for that has been good. It turns out we make good gross margins on that, even though it’s at the low end of the market. There are many other products of typically of some of our larger customers that are more high-end products, so it’s really a combination of things. But, certainly the take upon that is it is good so far.

[Maria Tagliaferro:]

Well, I think that concludes our call for this afternoon. We thank you all for participating and we look forward to reporting our third quarter earnings on August 10, 2006. Thank you.

[Operator:]

This concludes today’s Analog Device Conference Call. You may now