Ladies and gentlemen, good morning or good afternoon. Welcome to the second quarter 2018 earnings release conference call and live webcast. I'm Ira, the conference call operator. I would like to remind you that all participants will be in listen-only mode, and the conference is being recorded. After the presentation, there will be a Q&A session. You can register for questions at any time by pressing star and one on your telephone. Should you need assistance, please press star and zero to call an operator. The conference must not be recorded for publication or broadcast. At this time, it's my pleasure to hand over to Mr. Tait Sorensen, Group Vice President, Investor Relations. Please go ahead, sir.
Good morning, everyone. Thank you for joining our second quarter 2018 financial results conference call. Hosting the call today is Jean-Marc Chery, ST's President and Chief Executive Officer. Joining Jean-Marc on the call today are Lorenzo Grandi, President of Finance, Infrastructure, and Services, and our Chief Financial Officer, Marco Cassis, President of Sales, Marketing, Communications, and Strategy Development. This live webcast and presentation materials can be accessed on ST's investor relations website. A replay will be available shortly after the conclusion of this call. This call will include forward-looking statements that involve risk factors that could cause ST's results to differ materially from management's expectations and plans. We encourage you to review the safe harbor statement contained in the press release that was issued with the results this morning, and also in ST's most recent regulatory filings for a full description of these risk factors.
Also, to ensure all participants have an opportunity to ask questions during the Q&A session, please limit yourself to one question and a brief follow-up. I'd like to now turn the call over to Jean-Marc Chery, ST's President and CEO.
Thank you, Tait. Good morning, everyone. Thank you for joining us on our call today. I am very pleased to be here to talk with you together with my colleagues in my first earnings results call leading ST. Let's begin with an overview of our Q2 performance. Our second quarter results were solid and in line with our expectations. We had another quarter of double-digit year-over-year revenue growth, balanced across all product groups, regions, and end markets. We drove another quarter of improved performance across key financial metrics. Looking at our Q2 business results, both revenues and gross margin were above the midpoint of the company outlook. We grew revenues 18%, our seventh consecutive quarter of year-over-year double-digit sales growth. The revenue growth was broad and balanced. This is important to achieving sustainable revenue growth. From an end market viewpoint, industrial was particularly strong during the quarter.
Our gross profit increased substantially, $911 million, up 24% over the year. Our gross margin was 40.2%, increasing 190 basis points year-over-year, largely driven by improved manufacturing efficiency and by a favorable mix shift toward higher-value products. Operating expenses were $622 million, above our expectations, mainly due to one-time non-recurrent items that were not embedded in our Q2 expected range. Importantly, our sales growth translated into operating leverage, driving expansion of our operating income, margin, and net income. ST's operating income increased 60% to $289 million. Our operating margin improved 330 basis points to 12.7%, and our net income increased 73% to $261 million. Turning to our cash and investments, our profitable growth is driving improvements in our net cash from operating activities with an increase of over 36% on a trailing 12-months basis. For the quarter, net cash from operating activities was $360 million.
Free cash flow was negative $40 million in Q2, mainly Q2 elements. A high level of CapEx in the quarter above the annual run rate of our expected 2018 CapEx range between $1.2 billion-$1.3 billion. A change in working capital mainly due to inventory increase to support demand in Q3. We expect to return to a positive free cash flow for the third and fourth quarters and for 2018 to generate free cash flow well above the dividend paid during the year. Our goal is to exit 2018 with a higher net cash position compared to 2017. Let's move to our product groups performance, starting with Automotive and Discrete. During the second quarter, ADG revenues increased 15.2% year-over-year on a double-digit growth for both automotive and power discrete. Operating profit increased by 20.8% to $84 million, and operating margin increased to 9.7% from 8.7%.
On a sequential basis, ADG revenue increased 6.5%. Revenue growth did not immediately translate into an improvement in operating profit and margin during the second quarter. This is mainly due to some temporary manufacturing efficiencies and extra cost in the supply chain. In terms of ADG's operating margin looking forward, we confirm that this will be in the low teens for the second half of 2018. Turning to the Microcontrollers and Digital IC groups, MDG posted a strong year-over-year increase, with revenue up almost 28%. This double-digit sales growth came from both microcontrollers and digital ICs. In terms of profitability, MDG's operating margin increased sharply year-over-year to 20.3% from 11.7%. On a sequential basis, MDG's revenue increased 4.3% and its operating margin also expanded. Our microcontroller business remains the main driver of operating profitability. The digital business contributed to the operating margin improvements on the sequential and year-over-year basis.
We confirm that MDG's operating margin will be above 20% for the second half of 2018. Finally, Analog, MEMS and Sensors. AMS revenues increased 10.7% year-over-year on the double-digit growth for both imaging and analog. In terms of profitability, AMS operating margin increased to 10.5% from 9.4%. On a sequential basis, AMS revenues decreased 6.4%, as anticipated, on lower smartphone activity. Analog and MEMS revenues posted sequential increases. The improved product mix led to a sequential operating margin progression. For AMS, we anticipate second half operating margins to move into the mid-teens as we benefit from revenue leverage, specifically from smartphone applications. Let's now discuss how this performance translated in new business and product leadership across the end market we sell. In automotive, we sell most of the electronic applications in the car, with a particular focus on car electrification and autonomous driving.
In car electrification, during Q2, we continued to expand the design win pipeline for our silicon carbide products, and we achieved an important galvanic isolation technology design win for an electrical vehicle. Galvanic isolation is one of the focus areas for us in expanding our portfolio of differentiated high-value products for industrial and for automotive. We also continued to win business in more traditional automotive application areas like braking, engine management, and body control. Industrial is a very broad area for us with many customers and many different applications. Here, we focus on smart industry, where we build on our leading position in general purpose 32-bit microcontrollers and on our strong portfolio of power, analog, sensor, and connectivity products. We also deploy our system solution expertise to deliver multiple products and complete solutions. Some examples this quarter include awards for a satellite tolling module and a custom powerline modem.
Moving to personal electronics. Our main focus here is on smartphones. In Q2, we expanded our reach with customers, in particular in Asia. We have design wins for time-of-flight sensors, touch screens controllers, motion sensors, and protection devices. We also won a design win with our STM32 microcontrollers at a key Japanese OEM for high definition televisions. This is an expansion for us into a new market that was traditionally difficult to penetrate. In communications equipment, computers, and peripherals, we are leveraging our in-house processes in a number of focused application areas. Examples this quarter are designed for fiber optics infrastructure with our BiCMOS process that is optimized for high-frequency communications applications, and an ASIC design for 5G infrastructure with a silicon-on-insulator process that meets the latest cellular RF requirements. Let's conclude with our Q3 guidance. We expect revenues to increase about 10% at the midpoint on a sequential basis.
This would represent year-over-year growth of about 16.8%. By end market, in Q3, we expect sequential strong growth in personal electronics. We also anticipate solid growth in automotive, despite the fact that we will normally see some seasonality here, and we are expecting normal seasonality for industrial. By products, we expect sequential revenue growth to be driven by imaging, automotive, and power discretes. We anticipate normal seasonality in analog and microcontrollers. We anticipate a third-quarter gross margin at about 40%. This is in line with our communication at our Capital Markets Day, that in the second half of 2018, we see revenue growth as the main positive driver for the gross margin, substantially offset by the product mix evolution. As a result, we expect to maintain our current level of gross margin, which will drive gross profit increases in line with revenue growth.
Adding together the different ingredients, including OPEX discipline, we expect to continue to make steady year-over-year progress at the gross profit, operating profit, and net income levels. I would like to reconfirm our top priority: deliver our 2018 objective of making another step forward in term of year-over-year revenue growth and profitability. Overall, we are on track with the goals set at our Capital Markets Day in May. Grow 2018 revenues between about 14%-17% versus 2017, and in the second half of 2018, ADG operating margin to be in the low teens, AMS operating margin to be in the mid-teens, MDG operating margin to be about 20%. We are also on track with our longer-term goal of sustainable profitable growth to continue to create shareholder value and to make ST an even stronger player in the semiconductor industry. We are happy to answer to your questions.
Thank you.
We will now begin the question and answer session. Anyone who wishes to ask a question may press Star and One on their touchtone telephone. You will hear a tone to confirm that you've entered the queue. If you wish to remove yourself from the question queue, you may press Star and Two. Participants are requested to use only handsets when asking a question. Anyone who has a question may press Star and One at this time. The first question is from Achal Sultania from Credit Suisse. Please go ahead.
Hi. Good morning. Two questions. First, on gross margins. Jean-Marc, you mentioned that there is some headwind from product mix as we go into Q3. Can you give us some color as to, is it one particular product in a high-end smartphone application, or is it multiple products which is impacting gross margin headwind? Secondly, on the inventory, we've seen inventory rise for a couple of quarters now by about more than $100 million. I just wanted to understand, is it driven by just one or two specific projects, or is it broad-based inventory increase across different products? Thank you.
Thank you for the question. I address it to Lorenzo, and I will make a compliment, okay, if needed.
Good morning to everybody, Lorenzo Grandi speaking. About Q3 gross margin, as we said at our Capital Markets Day, we have on the gross margin for Q3, definitely in part related to the product mix. In particular, you know we are growing significantly in Q3 and also in Q4 in personal electronic, in particular in smartphone. This growth, of course, from a point of view of gross margin is not accretive. Gross margins will be impacted by this ingredient of product mix. On the other side, we will have a positive effect related to improve manufacturing efficiency that will substantially offset this negative impact. That's why we are guiding in the range of 40%, as was already anticipated on our Capital Markets Day. In respect to the inventory, we grew our inventory. You know we were smoothing somehow our production over Q2 to fulfill the demand in Q3.
We have a strong demand definitely in personal electronic, in the smartphone, but as well as also in automotive. We do expect to see a normalization of inventory and in Q3 and in Q4.
That answer your question, Achal Sultania?
Yeah. Thank you. Thanks a lot, Lorenzo. Thanks.
Okay. Thank you. Next question, please.
The next question is from Alexandre Faure from Societe Generale. Please go ahead.
Yes, good morning, thank you for taking my question. I would just have two. The first one would be, if you can come back a little bit on ADG margins that went down, despite the sequential revenue growth. You mentioned some input costs. Anything else going on in terms of mix and why exactly that is reversing in the second half? Then secondly, more general question on how the current trade war rhetoric coming out of the U.S. could influence your perception of risk for the semi industry as a whole, for yourselves, and for some of your key end markets, particularly in automotive. Thanks.
Thank you for the question. The first one will be answered by Lorenzo, I will take the second one.
About the deterioration in ADG, let's say not the improvement in ADG. You're right. You know that in ADG, both in automotive and power discrete, we are encountering a very strong demand. To follow up this demand, we are investing significantly, and we encounter during the quarter some temporary manufacturing inefficiency due to this increase of investment that we have done in order to follow the demand. Investment that are not yet at a full speed. On top of that, we encounter also some increased cost in the supply chain. This temporary inefficiency will be fully reabsorbed in the course of Q3 and definitely also in the course of Q4.
We do expect actually to recover in term of profitability for ADG, and we confirm what we have said at the Capital Markets Day , that we do expect ADG to be in the low teens in the second half of the year in term of operating margin.
About the second question. I have to say that at this moment, okay, the direct impact on our company is really negligible. However, like global companies, we are monitoring the situation. First, we are very attentive about any potential impact on our own customers, which is, let's say, a normal attention. If the trade war escalates, we are more concerned, I have to say, about the consequences that this can have on the global microenvironment. I guess, okay, this is a common concern widespread across our piece. At this moment, okay, I have no more to add on top of that. Thank you, Alexandre. Next question, Ira.
The next question is from Sandip Deshpande from JPMorgan. Please go ahead.
Yes, thank you for letting me on. My first question is regarding the automotive market and either your ramp-up of silicon carbide. Jean-Marc, can you comment on the ramp-up of silicon carbide revenue in the first half of the year, and how you see that progressing in the second half? Secondly, with regard to the margin, can I ask a question on the currency that whether the currency shift that has taken place year-on-year is impacting your OpEx, which is reducing to some extent your leverage associated with the operating margin? Thank you.
Thank you, Sandip. I answer the first question, and Lorenzo will answer the second question. I really confirm that we expect our revenue from silicon carbide to be about, okay, $100 million in 2018. I have simply to say, we are on track. Second point. We are engaged, okay, with the key players in car electrification, supporting car makers with power modules on a worldwide basis. Today, we have more than 25 projects in discussion, I have to say that 85% are about silicon carbide. As the industry, okay, has been adding capacity, we are securing what is needed to serve our customers in term of substrate for the short term. We have several silicon carbide substrates, and we are preparing our capital expenditure, okay, for the next quarters and months to support, okay, all the demand we have.
In a nutshell, okay, Sandip, we are really on track on silicon carbide, I confirm, I am fully convinced it will be important game changer for the industry.
Thank you
I think the second question was about expenses, the impact of the exchange rate in our expenses. If I look at the expenses, yes, indeed, let's say if I look on a year-over-year basis, last year, our effective exchange rate in Q2 was 109. This year in Q2 has been 119. On the expenses, of course, we had an impact, and this impact is in the range of $35 million or something like that. If I look forward, our effective exchange rate moving from Q2 to Q3 is substantially flat because we stay at 119 with the current spot rate in the range of 117. If I look at Q4, we do expect with the hedging contract that we have in place to be in the range of 118.
I would say that moving forward, there will not be a significant impact on expenses related to the exchange rate if we stay at this level of exchange rate.
At an absolute amount, will the OPEX remain at these levels? How do you look at that?
Well, in terms of expenses, in Q2, our expenses came at $622 million, net expenses. This was a little bit higher than what we were anticipating. Our range, if you remember, we were more in the range of $610 million and $615 million. Q2 expenses were, I would say, impacted by a couple of one-time events. Actually, we have a loss of credit in one of our jurisdiction, plus some termination benefit costs related to a certain number of our former executives. These two impacts were not in our, let's say, guidance at the time. If I exclude these two impacts, I would say that we were in the range that we were communicating. What it will be, the evolution of our expenses entering in the Q3 and in Q4. Moving in Q3, the expenses will be impacted by two negative effects, let's say, and one positive.
On the negative side, there will be the impact of annual salary increase. This was of course a factor in [inaudible] . Also by a one-time expense related to the social charges on vested share that are distributed to our employees that are accounted for the full year in Q3. On the other side, on Q3, we will have the positive impact of the seasonality. You know that in Europe, there are a lot of number of days of vacation. We do expect in the range for the next quarter between $ 615 million and $620 million. When we move forward in Q4, we expect a similar amount with, on one side, let's say, unfavorable calendar in respect to Q3, that is offsetting by the benefit not to have any longer the social charges.
At the end, we do expect substantially to be in that range Q3 and Q4.
Thank you.
Thank you, Sandip. Next question, please.
The next question is from Anthony Stoss from Craig-Hallum. Please go ahead.
Good afternoon, gentlemen. If you wouldn't mind commenting about your biggest customer on the smartphone side, on a year-over-year basis to your total content. I think in the last quarterly conference call, you talked about expectations of having more content than a year ago. I just want to confirm that that's still the case. Secondly, for Q4, can you confirm that you expect all three of your business segments to grow sequentially in the December quarter? Thank you.
Tony, just as a clarification, I think on our previous calls with our largest customer at the time, we talked about having increased revenues, not necessarily content. Just a clarification there, and then let's answer that, and then we'll come back to your second question, Tony, just as a clarification.
Thank you.
Jean-Marc?
Can you clarify this first question exactly?
Tony was asking in terms of our largest customer and how that is evolving on a year-over-year basis.
On a year-over-year basis? No, we do not comment at this level of detail with our major customer. First, we do not comment. However, you know that they will introduce three phones. This is well-known everywhere. They will announce it basically in September, and we will see. Our guidance in Q3 is encompassing this acknowledgment. For the full year, I confirm what I have said during my address. We see a year-over-year growth for ST from 14%-17%, end of 2018 versus 2017, well across end market we address and product group. We are convinced personal electronics end markets and our sensor will perfectly be in line with this target.
Tony, on your second question, you were asking for Q4, if all the product groups were gonna grow sequentially. Was that your question?
That's correct.
Okay. That's a Q3 Crolles.
You have to wait for Q4.
Just checking to see if you expect a normal seasonality.
Would say that, Lorenzo speaking, that our expectation is to have growth. At the end, what we do expect for the year was mentioned by Jean-Marc just a minute ago, was to be balanced across the various groups. We expect, let's say, to grow in the range of 14%-17%, with a growth that is quite balanced across our groups. For sure, let's say now guiding Q4 is a little bit too early.
Yeah, I think, Tony, as Jean-Marc already got the question on the trade war and things of that nature, there's some uncertainty out there, we'll just talk about Q3 on this Crolles.
No, we-
Understood. Thank you.
We simply want to be consistent and we are on track again with what we say at our Capital Markets Day in May. We will grow this year, okay, between 14%-17% year-over-year.
Thank you.
Thank you, Tony. Next question, please.
The next question is from Janardan Menon from Liberum. Please go ahead.
Hi. Good morning. Thanks for taking my question. Just back on the gross margin side. If I remember at your Capital Markets Day, you had pulled out both smartphones as well as discretes as having a mixed impact on your gross margin into the second half, and you were talking mainly about smartphones just now. I was just wondering, is discrete also still having a negative impact from a mixed point of view in the second half? On those product segments, I was just wondering what the outlook is for gross margins going, let's say, over the next 12 to 18 months or so. Is it likely that gradually you will be able to achieve some cost reduction in those product areas, which is having the lower gross margin and therefore you could bring those gross margins up?
Is it that you would be facing, let's say, price pressure there, and the gross margins in those kind of segments are going to be structurally lower than some of your other businesses, even on the longer term? As a follow-up, you said you pulled out industrial as being specifically strong in Q2. I was just wondering what part of the industrial market would that refers to? Is it broad or was it predominantly IoT products from the distribution channel, or was it something from the larger industrial companies, et cetera?
Thank you for the question. Lorenzo will answer the first one, I will take the second one.
About gross margin, you are right. When we were at Capital Markets Day, actually, we underlined the fact that the gross margin for our personal electronic, specialized image sensor, and also power discrete are below the average of the company. The Q3 revenues, that means there is a strong contribution coming from these two product family. As I said, in terms of gross margin, these are not accretive. On the other side, there are the other products that are improving their product mix inside the various family, contributing, let's say, to mitigate the gross margin impact. On top, we have also improvement in terms of manufacturing. The gross margin of the company was enjoying, if you look at quite a significant growth moving from last year to this year, mainly driven by manufacturing that now is running at full speed, fully saturated.
Moving forward, of course, we will work in order to have some improvement. That will for sure not a big step, but it will be a continuous improvement, as well as we will work on the product mix. Today, the market conditions are such that we may, let's say, really work on the product mix. We may work in order to optimize. We think that we can, somehow, have a mitigation related to maybe the growth of some product family that are not the average gross margin of the company. Anyway, as we said, the progression in terms of operating margin will come, in short and medium term, more from the leverage on the revenues than improvement in the gross margin.
Just to paraphrase what you said, if I look forward, can we assume, let's say in the 2019, that you would expect or try to achieve a situation where your higher gross margin products are growing faster than your lower gross margin products?
No, as I said, let's say what we see in the short and medium term is to stay in the range of the forty-ish, let's say, in terms of gross margin.
Got it.
About your second question, I would like to say that from a sales channel side, it is really a broad range. Okay. Whatever I put, distribution channel or key OEM. We don't see a specific point to mention. As far as product group are concerned, this is the same because, of course, I get you take note our MDG growth year-over-year. Our STM32 contribute a lot to this industrial end market growth. I have to say analog as well. It's exactly happening what we expect, okay. Leveraging our STM32, but our strong portfolio in analog, strong portfolio in power discrete, and sensors as well. Simply to say that it is really broad range from both sides, channel distribution and key OEM, and product as well.
Understood. Thank you very much.
Thank you, Janardan. Next question.
The next question is from Jerome Ramel, from Exane BNP. Please go ahead.
Yeah. Good morning. Two questions. The first one is, Lorenzo, how should we model the depreciation and amortization, going forward? I saw the increase in Q2. With your strong CapEx, you already spent Q1 and Q2. How should we model for the rest of this year, and maybe for the full year? Maybe one question for Jean-Marc. Could you update us on your manufacturing capabilities with the new fabs you have qualified with your foundry and the ramp-up in Singapore? Thank you.
I take the question about the depreciation amortization, Jerome. Yes, there will be an increase. This year, we model in the range, for the full year, we see this amortization and depreciation in the range of $780 million, $785 million. That is definitely an increase in respect to last year. For the second half, it should be in the range around $200, $210 per quarter. It answer your question?
Yeah. Thank you.
About your second question. First about Amkor technology transfer.
Singapore.
Singapore. Sorry, Singapore. Amkor is the name of where the fab is located. Clearly, they are on track. They are really doing a fantastic job. Of course, we know very well this fab, there is absolutely no learning curve from ST to take back this fab in our industrial footprint. They will be perfectly on track to continue to support us on our growth, both for STM32 low power microcontroller and STM8 microcontroller. This is really a good news. They are supporting us as well on some power discrete and Vertical Intelligent Power. This fab will be really instrumental, starting to support the overall revenue growth of ST starting Q4. About our strategy to increase our, let's say, outsourcing for wafer fab, which currently are at 20%. As you know, we have decided to outsource now technologies for embedded flash.
80 nanometer is already done and engaged. We have decided 40 nanometer as well. Let's say all the program are agreed, the transfer have started, and they will support ST medium-term growth, in order to mitigate our capital expenditure. As I told you during my various address, again, to support our next three-year growth, ST is not intend to add any additional infrastructures on top of pilot line in Agrate. Of course, I will also mention that we can add an additional capacity in Crolles, but within the current infrastructure. Really, I am pleased to say that we are totally on track with our strategy to say, ST internal manufacturing focus on proprietary processes. Standard processes or advanced CMOS processes are totally outsourced.
Mixed processes, derivative processes from CMOS or power, will be outsourced 50/50, with the flexibility to go up to 80 or to go down 30, according the market situation. We are totally on track with this strategy.
Thank you.
Thank you, Jérôme. Next question, please.
The next question is from Andrew Gardiner from Barclays. Please go ahead.
Good morning, gentlemen. Just two quick ones. Firstly, just to try and address some of the cycle concerns a bit more. I was wondering if you could make a comment on inventory levels you see through the channel, particularly at distribution, whether there's any change there. Also on the silicon carbide wins you mentioned in Asia and Europe, can you explain where in the car these wins are? Is it just charging? Is it inverter? Is it both? Just a bit of detail around that would be helpful, if you can. Thank you.
Thank you for your question. I am pleased to address the question to Marco Cassis.
Good morning. On the first question about the level of inventory in the channel, I have to say that first of all, in Q2, we had high record level of sales
Through the distribution channel. This means that our level of inventory now is very healthy. It's less than three months, we do not see any increase or dangerous increase of inventory at distribution level. For the silicon carbide, we cannot go too much in detail, but it is usual subsystem. Okay. You know that silicon carbide power modules are instrumental between inverters and onboard charger. Okay. At ST, we address all the subsystem of the electrical car.
Okay. Understood. Thank you, guys.
Thank you, Andrew. Next question, please.
The next question is from David Mulholland from UBS. Please go ahead.
Hi, thanks. Just two quick questions. Firstly, as you look into Q3, you made the comment that you expect sequential growth in automotive. I guess typically it can sometimes be a slightly softer quarter. In the last couple of months, given what's happening with the new testing cycles and the tariffs potentially, there have been some concerns what would happen from production. Can you maybe just drill in a little bit to what's giving you the comfort that sequentially the automotive business can grow? Secondly, can you possibly comment on your bookings performance in Q2? What was the book-to-bill in the quarter and how that broke down by product area, if possible?
I take the first one about automotive confidence level. You take the second one?
Yeah. Okay.
About the first one, we are really confident. The demand is really strong on automotive and again, whatever is a legacy part of the automotive application. Body, engine controls, braking, lighting, this kind of stuff. Electrification of the car, as you know, is really booming and pushing, and connected car and ADAS as well. As Lorenzo said a few minutes ago, we have prepared ourself, okay, second half last year and first half this year to support, okay, this growth with our capital expenditure. That's the reason why our capital expenditure, I confirm, will be in the range of $1.2 billion-$1.3 billion, but is a bit front-loaded in order to prepare this growth of H2 on automotive.
Our confidence level is very high, okay, to see this end market and our ADG group, to achieve a growth consistently, okay, with the overall objective of the company.
Coming to your question about book-to-bill, this confidence is confirmed also from the order entry that we see during the quarter and we continue to see. Our book-to-bill is above parity. It's quite above parity. It's one to one. It is quite strong, I would say, definitely in the area of ADG, in the area of power and discrete. We see actually, a quite strong and healthy demand that, as underlined, make us confident that in the third quarter, against the normal seasonality, we should see automotive really grow.
Can I maybe just follow up, just specifically on the seasonality into Q3, because guiding for growth sequentially in a quarter when normally a lot of your European customers, facilities take a bit of a break. I know last year you saw the ADG Group up sequentially, but the two years prior, it's normally down. Just specifically on Q3, what's different this year and what's driving that? Is it just the structural growth drivers coming through, or what's driving the adverse seasonality as such in Q3?
It is clear that for the fast-growing and innovative application, the seasonality effect do not play, okay, because you are growing so fast that absolutely, okay, the car maker and the tier 1, they do not slow down their demand. Again, on the legacy, okay, we are really seeing a strong growth in the legacy because also simply, the pervasion of the semiconductor and electronic system. The content of semiconductor, especially, okay, with a smart switch, okay, enabled by our Vertical Intelligent Power technology, are really booming. This year, we see a clear effect that first, the silicon content increasing in the legacy, offset a lot the seasonality effect. The fast-growing application definitively are totally offsetting the seasonality effect.
That's the reason why we are in this position to confirm that, okay, on Q3 and H2 overall, we will see sequential growth on automotive and a year-over-year growth for the automotive completely aligned with the overall objective of the company.
That's great. Thanks very much.
Thank you, David. Next question, please.
The next question is from Stéphane Houri from Oddo BHF. Please go ahead.
Yes, good morning. This is Stéphane Houri from Oddo BHF. I have two questions, if I may. The first one is about the full-year guidance that you have reiterated from 14%-17%. I know it's a call for Q3, but when you look at what it can make for Q4 It gives you anywhere between 1%-11% of sequential growth in Q4. If you could give us some more clarity on what you're seeing at the moment for Q4 would be very helpful. Also, I have a question about the tax rate, which is particularly low at this moment. Is there any explanation, and what should we be looking at going forward? Thank you very much.
Lorenzo, you can
Yes. Maybe I take the one of the tax rate. You know that, you are right, our tax rate is quite low, but you have to consider that we have the use of NOL that is substantially reducing significantly our tax rate. If you consider, let's say our level of tax rate, ETR, once this NOL will be, let's say exhausted, completely used, and this will be looking forward probably in the next year. It will be more in the range of 15%-17% our tax rate. This year.
For next year?
Next year, yes. Probably, yes, sometime next year when we will learn.
Okay. Yeah. Thank you.
About year-over-year growth guidance. We confirm this guidance up to about 14% to 17%. Clearly, it is a result of the variable we control and variable we do not control. I have a question a few minutes ago about the overall trade war and so on. Today we simply confirm that we don't see weak signal for the market. We are very confident to grow on automotive. As anticipated, our personal electronic will grow in the second half. We already show a strong growth on industrial. We will have simply a seasonal effect on Q3. At this moment, there is no reason to narrow this guidance. We confirm, we strongly confirm the guidance to grow the company year-over-year about 14% to 17%.
About the operating margin guidance improvement of 300 basis points, you talked about steady improvement, are you confirming the number, the 300 basis points?
What we said at the Capital Markets Day is that moving from H1 to H2, we envisage something in the range of 360 basis points improvement in the operating margin. Still, we are on track. We work in order to get there, I think that at this stage we still have this in our view. At the end, we confirm what we said a couple of months ago.
Thank you very much.
Thank you, Stéphane. Next question, please.
The next question is from Amit Harchandani from Citigroup. Please go ahead.
Good morning, everyone. Amit Harchandani from Citi. Thanks for taking my question. Two, if I may. My first question, again, comes back to the topic of near-term demand trends. Could you maybe help us understand how the lead times have shaped up across different segments over the quarter? Have they stabilized? Are they coming down or are they continue to stretch? In that context, I would appreciate your thoughts on how are you thinking about where we are in the semiconductor cycle? What are the key variables you are looking at to gauge the sustainability of the demand, for example, say on the industrial side or any of the end markets? That would be my first question, and I have a follow-up.
Okay. Thank you for your question. I am pleased to address to Marco Cassis.
On the question about lead times, what we see is that lead times are now stable and our effort is in giving a good service to our end customers. For the second part of the question, can you repeat?
It was on the variables of the cycle. Is that correct, Amit? Or no.
Just in terms of how do you internally look at where we are in the cycle, the key variables you look at, and how does that give you confidence on sustainability of demand?
Today, the visibility that we have on our market in terms of growth of the market is in the range of 7%. About 7% of the growth of our market in year 2019. Next year, let's say the last forecast in terms of growth of the market is 5%. Where we stand in the cycle? We think that so far what we see is that we have a good and healthy demand. Difficult to say. The projections are what I said, and we don't see signs for the time being of a real slowdown of the market.
No, there is absolutely no weak signal about semiconductor market, at least on the end market we address. Automotive, industrial, personal electronics, okay, you know this is a specific case with smartphone. Showing us that something has happened. Today we are really fully concentrated, okay, to serve our customer at the best of their demand, for automotive, where the demand is very, very strong, and for industrial, where the demand is strong as well, driven by secular demand, with the initiative, okay, for better process control, better maintenance control, better facilities control. We confirm that automotive and industrial are showing secular demand in electronics. At this moment, we don't see any weak signals.
Thank you for the color, gentlemen. Just very quickly, unrelated follow-up, could you share your latest thoughts on M&A, please? During, I think earlier this month, you made a move for Draupner Graphics. Just understanding how you're thinking about M&A at this stage. Thank you.
About M&A. Clearly, okay, [inaudible] , today, ST plan of record to drive the company in a sustainable, profitable growth, okay, our strategy is organic growth. We already said that we will make acquisition, a small acquisition, in order to complete our strengths, in STM32, in analog, mainly. Here, the recent acquisition is exactly, okay, fitting with this strategy. About other M&A, as I told you, okay, during the Capital Markets Day, the team of ST, myself, we are engaged in, let's say, strategic plan elaboration, okay? As I told you during the Capital Markets Day, we will come back early next year. Of course, M&A, okay, will be a subject we will cover.
Today, I would simply like to confirm, we are totally focused on H2 execution, organic growth, and definitively, we have acquired, and we could acquire specific small IPs or companies in order to make ST stronger.
Thank you, Jean-Marc.
Thank you, Amit. Next question, please.
The next question is from Francesco Provitera, from Macquarie. Please go ahead.
Good morning, everybody. A question more general on duties and possible tariff that can be imposed and distort the trade. Can you have a general comment on this issue, in respect with the position of STM? Thank you.
The tariff.
In respect to this, I think Jean-Marc already touched this point in one of the answers before. As we said, there are two folds. On one side, the direct impact for our company about the tariffs. This is, of course, something this is not nice to have, because there is some impact, even if the materiality of this impact is quite low, because it's not really something that is significantly impacting us directly. Of course, there is some concern, as I think everybody has, in a situation in which, let's say, there is this uncertainty. So far, as we said, notwithstanding this uncertainty related to this, let's say commercial wars, these kinds of things, we don't see in our reference market. Definitely, it's something that is not welcome in the sense that at the end, it may create a turbulence in the business.
So far, I confirm what has been said since now. For the moment, we don't see really any significant impact. Demand in automotive is still strong. For what concerns our company, yes, there is some impact, but really, the materiality of this impact is very, very low. Thank you.
Thank you, Francesco. Next question, please.
The next question is from Günter Hollfelder from Baader Bank. Please go ahead.
Yeah, many thanks. Just one follow-up question on the automotive market and the above normal seasonality you're seeing in the quarter. Here in Germany, there are some issues in car production with Volkswagen, Audi, also Mercedes-Benz, due to this WLTP, new test process. I understand that you're not seeing any signs here for production cuts or postponements, or are you saying the net impact is positive as you have other growth, which is offsetting this weakness? Aren't you seeing any weakness at all?
Marco will take this. Again, we confirm that we do not see any slowdown or sign of weakness in automotive. Actually, it's exactly the opposite. The demand is extremely strong, and we are doing our best in order to cope with the requirement from the market. We confirm again that absolutely there is no sign of slowdown during Q3 in automotive.
Okay. Maybe one follow-up question on silicon carbide. You mentioned earlier or confirmed $100 million sales level for 2018. Can you help us to understand the breakdown of this business? Can you say what's approximately automotive, what is renewables, what is industrial, including EV infrastructure, to get an idea?
For this year, it's fully automotive.
Fully automotive. Yeah. Okay. Many thanks.
Thank you, Günter. Next question, please.
The next question is from Robert Sanders from Deutsche Bank. Please go ahead.
Good morning. Sorry to come back to the 2018 full-year guide again, if you hit the midpoint of that guide, your year-on-year growth rate would come down to 7% in Q4. Is there something about last year's Q4 that was unusually strong, for example, in automotive or industrial, that makes that quarter a tough comp? I have a follow-up. Thanks.
Okay. Yes. As we said, our guidance for the year is between 14% and 17%. If we will have this, let's say, enough is nine quarters substantially, so at the end of the month. You have to remember that in Q4 last year was quite a strong quarter. At the end, I think that we will have in next quarter, still a significant growth. You remember also that we said that we are struggling, let's say, with the level of CapEx between 1.2, 1.3 to target somehow the high end of our range. Fine, yes, at the end, in Q4, we will see growth, we will see sequential growth, quite significant sequential growth. At the end of the year, we reconfirm, we will be between 14% and 17%, and with the ambition to be maybe a little bit higher than the midpoint.
Great. Just on microcontrollers, it looks like you're doing about mid-20s EBIT margins, in that group, which is a great performance, substantially up year-on-year. This group now represents 40% of profits. How do you see the opportunity to grow your profitability further in microcontrollers, maybe as the 32-bit mix rises or through production changes or die shrink? Thanks.
No, I don't want to comment too much, okay, further, 2018, okay. What I can say, clearly, our microcontroller business is addressing a mix of industrial applications, which are, let's say, for sure based on our STM32. We address as well, some personal electronics application. Overall, clearly, the gross margin is a result of the manufacturing efficiency and this end market and product mix. You know that microcontroller supply chain is based on the well-balanced internal and external manufacturing, okay. Today, we are clearly close to 50-50, 50% internal, 50% external. 50% internal, as Lorenzo said, we have already done great achievement. We have still opportunity of continuous improvement, but certainly not at the same pace, that in the past few quarters, because now our manufacturing is fully loaded.
Okay, for the external manufacturing, definitively it is a link, okay, to the wafer price, cost decrease, okay, we will have. Overall, this is the key ingredient, mix between industrial, which are very strong, where we want to focus, both okay addressing OEM and through strong distribution channel. Personal electronics as well, but being very selective. Manufacturing will continuously improve both internal and external. Certainly internal, not achieving breakthrough as we have done during the past few quarters. This is the element, okay, we are considering to foresee our gross margin improvement on microcontroller.
Great. Thank you.
Also, definitively, you know that we are today completing our portfolio of STM32 with industrial microprocessor. Clearly, okay, for the future, it will also be a booster consideration, okay, for our gross margin.
Great. Thanks a bunch, Jean-Marc.
Thank you, Rob. Next question, please.
The next question is from Lee Simpson from Stifel. Please go ahead.
Hi, good morning, guys. Thanks for squeezing me on at the end there. Three quick ones if I could. I'm just trying to get a handle on the importance of packaging or packaging advantages you may have in silicon carbide, particularly for autos, as rivals seem to be dismissing the need for any new packaging technologies.
Second question, I just wanted to clarify, did you say that the inventory is reduced in absolute terms in Q3 and Q4, or we just see the DIOs come in a little? The third question, it looks, when you certainly scan the 3D face space and smartphones, that the market is now pivoting much more to stereo vision. We just wondered if that's a trend that you could play into or if that was running counter to your normal time-of-flight focus. Thanks.
Thank you for your three questions. Lorenzo will answer on the inventory one, I will answer silicon carbide and the 3D depth sensing.
I go straight on the inventory. I assume that you are referring to our inventory, right? Not in the channel. The ST inventory.
That's correct.
Correct? Yeah. What we see is that, as we said, we prepare the growth for the second half. In Q1 and in particular in Q3, there was a quite significant increase in inventory. What we do expect is that we will increase in Q3, definitely the turns, so reduce significantly the number of days of inventory. We do not foresee significant reduction, let's say, in the absolute value of the inventory in Q3, while in Q4, we do expect to have some reduction.
Coming back to silicon carbide. It is clear that for the application we address, inverters and on-board charger, the module, the package is a critical enabler. Simply ST, we apply our strategy. We have the capability to design by ourself custom design power modules and to enable, competitive silicon carbide power MOSFET. This is what we have done, and we are going now with the success, I shared with you a few minutes ago. If we address other application, and I repeat today, we have 25 project and 85% are on silicon carbide. And here you have various situation. It's either custom design module or standard package, standard module. If it is standard package and module, we use OSAT. Generally speaking, we outsource. If it is custom design power module, we are doing by ourself.
You have all kind of configuration, and this is simply our strategy. About 3D sensing. About 3D sensing, clearly, we follow what we consider our roadmap. You know that ST, we address proximity ranging sensor. Clearly, time of flight technology, which is based on the, what we call SPAD, single-photon avalanche diode, clearly is the area of focus of ourselves. And here we have accumulated millions and millions of pieces, and we will continue to address successfully this market. On depth 3D sensing. You know, and it is not a secret, that ST has been a key supplier pathfinder on the structured light. We have a roadmap. We have all the technology blocks. We have all the capability to continue to sustain successfully customer who would like to continue on structured light or to adopt structured light.
Here again, in structured light, a part of the structured light is a component using time of flight. There is a total synergy between the structured light and the time of flight of proximity ranging sensor. Now, still on front facing, we know that in the near future, some solution could encompass a time of flight, a part of the sub-system, taking place of some component of the structured light. ST is ready. We will address this market as well, whatever is Android-based smartphone or other operating system. For world-facing, we know that the critical enabler is time of flight. Again, here we have the adequate roadmap to support. We are convinced about that, and we are following our conviction, and we will be, and we are already successful on this roadmap.
Thanks so much. Thank you.
Thank you, Lee. Next question.
The next question is from Adithya Metuku from Bank of America. Please go ahead.
Yeah. Good morning, guys. I have three questions. Firstly, just on the automotive group revenues across the board. Can you confirm what was the growth rate in the quarter? Not just in ADG but across the group as a whole. Secondly, on silicon carbide, there have been some news flow that Tesla is asking for price cuts with their suppliers. How do you see this impacting you going forward? More generally, when you look at the silicon carbide market, can you give us some color on any pricing changes that you're seeing in this market? Finally, just as a follow-up to a question on modules earlier, you said that you're working with partners on standard modules and you're designing your own custom modules. How is this different to what happened with IGBT modules?
I remember four or five years ago, you were trying to get into this space. You didn't really have a lot of traction there, so why do you think this time it will be different? Thank you.
Well, I take some question. Lorenzo will take the question about the growth.
Growth.
Yeah. Well, on module for your last question, okay. Clearly here, we have a key differentiating factor. It is the silicon carbide. I repeat today, ST is a unique supplier able to produce mass production on silicon carbide. We consume about 60% of the worldwide supply chain of raw material silicon carbide. Clearly, the key enabler in our success with a power module using silicon carbide is the silicon carbide technology. As we have the capability to make modules, custom design, both of them make our success. In the future, we aim to continue with the same determination. I am very sorry, I absolutely cannot and does not want to comment any commercial discussion or transaction about price with our customers, okay? It's totally out of our, let's say, habit to do it. On the silicon carbide price.
More than, let's say, a general statement, okay. You know this technology is innovative one. You know this technology is growing very fast. All the actors worldwide have to invest important amount of CapEx to support this growth. Clearly, all the actors worldwide who will participate to this huge market, again, I am convinced it will be a game changer. We have our mind that, okay, the price will be going on according the usual roadmap to support automotive and industrial market. There is nothing new here. It is clearly in our, let's say, medium long-term roadmap, for silicon carbide. About the short term, okay, I do not want to comment.
In respect to the last question, if I well understood that the question was about our trend of sales in automotive overall. As you know, we have revenues in automotive, not only in ADG group, but is across others groups inside the company, both in AMS, in MDG. What we see, let's say, today in the first half of the year, our growth was in the range of 17% year-over-year, H1 2018 compared to H1 2017. What we expect is to be substantially the same level for H2, even slightly improving. Means that for the full year, we see a growth that will be higher than the average of the growth of the company. Definitely will be on the high side of our range. 17% is slightly above. Automotive is strong.
17% in automotive. Did I hear you correctly?
Yes. Overall, let's say, including all the sales in automotive, in all the groups.
Understood. Just a quick follow-up to Jean-Marc. On SiC MOSFETs, you said that is the main advantage for you at this point. Can you give us some ideas to where your advantages are coming in the MOSFET space? Just any color there would be helpful. Thank you.
For silicon carbide?
Yes.
For silicon carbide, you know today in production, let's say we start with diode, then we have MOSFET. This is the second generation. We have adopted a technology architecture which, let's say, help us to go very fast on the market, and we have cooperated with important partners in order to introduce the technology very fast. Clearly now we are accumulating a know-how and a learning curve, which definitively is providing a competitive advantage of ST, first, to develop the third generation, okay, with Trench, and to be able to introduce soon this third generation in production. I say our, let's say, main competitive advantage is based on the fact that we have developed and worked on innovation since a long time on silicon carbide. We have taken the risk to introduce very early in the market, thanks to our cooperation with an important partner.
Now we are ramping up successfully because ST is an IDM. We have manufacturing capability well recognized. We have the capability to fix very fast all the extrinsic or intrinsic issues we can face. Now, okay, our control of the technology is really a state of the art. We are pushing. This, let's say early adopter and pathfinder attitude, make ST now in a stronger position compared to the competition.
Thank you, Adi. We're going to move to our last question, please.
Today's last question is from Gianmarco Bonacina from Equita. Please go ahead.
Yes, good morning. Just a quick follow-up question. In terms of the OpEx, just to confirm if I understood correctly. You had about $10 million of one-off cost in Q2, and you will also have about $10 million one-off OpEx cost in Q3. For the year, when we model for 2019, we should consider that in 2018, you had about $20 million of costs, which are kind of non-recurring in nature. Is that right? Thank you.
Just to clarify, when I was commenting Q2 next expenses, yes, we had something in the range of $10 million that is not recurring. When I was commenting Q3, I said that in Q3 we have, let's say, salary increase, that, of course, every year it happens. We have, let's say, one time, expense related to the social charges on vested share. It means that these are the yearly expenses that it happened in Q3. It's something that is recurring every year, but in Q3, let's say, and this is significant. What I said, I said that we expect to have expenses in Q3 in the range of $615, $620 million, as similar expenses in Q4.
Okay, this should be considered a kind of run rate?
Yeah. We are in that.
Okay. Thank you.
Thank you, Gianmarco. At this point, we'll go ahead and conclude our Q2 2018 earnings. Thank you.
Thank you.
Thank you.
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