I would now like to turn the conference over to your host for today, Mr. Ali Husain, Director of Investor Relations. Please proceed.
Great. Thanks, Jennifer. Good afternoon, everyone, thank you for joining Analog Devices' second quarter fiscal 2015 earnings conference call. We've posted a press release with relating financial schedules at investor.analog.com, and I'd encourage you to follow along as we go through our results today. Our agenda for today's call is as follows. First, I will provide a brief overview of our second quarter results. Then Dave Zinsner, ADI CFO, will review our financial performance in the second quarter. Finally, Vincent Roche, ADI's President and CEO, will provide our business outlook for the third quarter, along with closing remarks. After our prepared remarks, we will have a question and answer session. The information we're about to discuss, including our objectives and outlook, includes forward-looking statements.
Actual results may differ materially from these forward-looking statements as a result of various factors, including those discussed in our earnings release and our most recent 10-Q. These forward-looking statements reflect our opinion as of the date of this call, and we undertake no obligation to update these forward-looking statements in light of new information or future events. Our comments today will also include non-GAAP financial measures, which we've reconciled to their most directly comparable GAAP financial measures in today's earnings release, which is posted on our investor relations website at investor.analog.com. With that, let's get started. As you've likely seen from the press release, after a very good first quarter of fiscal 2015, ADI produced another strong performance in our second quarter.
The strength of our innovation, the diversity of our business, and our strong execution drove revenue to a record $821 million, which is an increase of 6% from the previous quarter and an increase of 18% from the same period a year ago. By end market, industrial, automotive, and consumer exceeded our revenue expectations for the quarter and offset what was a weak wireless infrastructure CapEx environment. The industrial end markets, which are typically seasonally strong for ADI in the second quarter, grew 11% sequentially and represented 48% of our total sales. All of the major application areas within industrial grew sequentially with the strongest growth coming from the aerospace and defense, instrumentation, and industrial automation sectors. By region, sequential industrial revenue growth was strongest in North America and Europe.
The industrial market is truly the lifeblood of ADI, where we develop and deploy our high-performance signal processing technology and system domain knowledge across our tens of thousands of industrial customers and their myriad applications to help create more intelligent, robust, connected, and energy-efficient products. Revenue from automotive customers, at 17% of sales, increased 13% sequentially and 3% year-over-year in a seasonally strong period for ADI's automotive business. Sales increased sequentially across all our automotive focus applications in powertrain, infotainment, and safety, with particular strength in both advanced driver assistance systems and in powertrain applications as car manufacturers respond to consumer demand and pending government mandates that help make vehicles safer and more fuel efficient. The consumer end market, at 13% of sales, grew 15% sequentially and 40% year-over-year, marking the second straight quarter of year-over-year revenue increases in consumer for ADI.
Prosumer audio video was stable both sequentially and year-over-year, with portable applications driving our consumer growth this quarter. Our consumer strategy remains the same. We play in applications where our high-performance technology allows us to solve our customers' toughest challenges and where we can make a meaningful difference to the user experience. Revenue from communications infrastructure customers at 22% of sales declined 10% sequentially, following a 4% decline in the prior quarter. A weaker-than-planned wireless infrastructure market, particularly in North America and China, drove the sequential revenue decrease. We believe that these declines are temporary and that ADI will continue to benefit as 4G penetration rates increase from their current low levels. Revenue from wireline customers represented about a third of our communications infrastructure revenues and was stable to the prior quarter.
Now I'd like to turn the call over to Dave for details of our financial performance in the quarter. With the exception of revenue and other expense, Dave's comments on our second quarter 2015 P&L line items will exclude special items, which in the aggregate total $26 million. When comparing our second quarter performance to our historical performance, special items are also excluded from prior quarter results, and reconciliations of these non-GAAP measures to their comparable GAAP measures are included on Schedule E in today's earnings release. With that, Dave, it's all yours.
Thanks, Ali, and good afternoon, everyone. The second quarter of fiscal 2015 was another very good year for ADI, revenue totaled a record $821 million. Gross margin in the second quarter of 66.5% was well within our model range of 65%-68% and was up 90 basis points from the prior quarter as factory utilization rates increased to the mid-70s from the prior quarter's mid-60s level. Inventory on a days basis in the second quarter increased by one day to 127 days on a dollars basis increased by $27 million, with approximately half the increase relating to the positioning of inventory for higher-than-expected sales or higher expected sales in the third quarter, and the balance of the increase relating to the timing of customer demand. Deferred revenue on shipments to distributors increased by 5%.
Most of the increase related to the Hittite product catalog, which was added to our distribution channel in the quarter. On a weeks basis, inventory and distribution was lean at approximately seven weeks, down from the prior quarter's approximately eight weeks. Operating expenses in the second quarter increased 2% sequentially, lagging well behind the 6% increase in revenue as we continue to gain more operating leverage in our model. As a percent of sales, operating expense in the second quarter declined 140 basis points compared to the prior quarter. Operating profit before tax as a percent of sales increased 230 basis points from the prior quarter and increased 200 basis points from the same period a year ago, and at 33.7% of sales was well within our operating model range of 32%-36%.
Other expense in the second quarter was approximately $4 million and was lower than planned on a small gain on investments. We expect our net interest expense to be approximately $5 million per quarter for the remainder of 2015. Our second quarter tax rate was approximately 15%, which we expect will be our non-GAAP rate for the remaining two quarters of the year. Excluding special items, diluted earnings per share of $0.73 increased 16% over the prior quarter and 24% year-over-year and was near the high end of our guidance range. At the end of the second quarter, our cash and short-term investment balance was $3.1 billion, with $760 million available domestically. We had approximately $870 million in debt outstanding, which resulted in a net cash position of $2.2 billion. During the second quarter, capital additions were $49 million.
Our capital expenditure plan in 2015 is to be between $160 million and $165 million. We have a strong financial model that generates solid cash flows, and we are committed to returning cash to our shareholders. For the trailing 12 months, we generated free cash flow of $830 million or 27% of sales and returned $800 million or 96% of that free cash flow to shareholders in the form of a dividend or share buybacks. In addition, our capital allocation strategy supports our regular dividend increase of 5%-10%, and last quarter we raised the dividend 8% from $0.37 to $0.40. Today, our board of directors declared a cash dividend of $0.40 per outstanding share of common stock, and that will be paid on June 9th, 2015, to all shareholders of record at the close of business on May 29th.
In summary, this was a very successful quarter for ADI. The strength and diversity of our business, combined with our strong operating model, generated strong cash flows and converted a 6% sequential revenue increase into a 16% earnings growth. Now I'll turn the call over to Vince for our outlook for the third quarter, which, with the exception of revenue expectations, are on a non-GAAP basis and exclude special items that are outlined in today's call and release. Vince?
Thanks, Dave, and good afternoon, everybody. As we've talked about in today's remarks, the second quarter was, as you've seen, a strong quarter for ADI on several fronts. I'm very proud of our execution. As we start our third quarter, order rates continue to be stable across the industrial, automotive, and communications infrastructure markets, which leads us to plan for demand in these markets to be similar to the second quarter levels. In the consumer end market, we have had good order growth, and are planning for another quarter of sequential growth in that sector. In total, we expect revenue to be in the range of $825 million-$865 million. The midpoint of this range represents a 3% sequential increase and a 17% increase on a year-over-year basis.
Given the expected mix in our business, we're planning for utilization rates in our fabs to be slightly lower in the third quarter. As a result, we expect gross margins in the third quarter to be approximately 66%. We anticipate operating expenses to increase approximately 2%-3%, a modest increase from the prior quarter, primarily the result of a full quarter of annual salary increases that went into effect in April. Based on these estimates and excluding special items, diluted earnings per share is anticipated to be in the range of $0.71-$0.77 in the third quarter. Beyond these near-term events, our basic philosophy and the cornerstone of our strategy remains the same. Superior innovation drives superior business results.
We possess the broadest product portfolio, system, and manufacturing capabilities and high-performance signal processing to solve our customers' toughest challenges at the intersection of the physical and the digital worlds. Our product development strategy is to identify the fundamental challenges that our customers are facing in our target application areas and leverage our solutions across as diverse a set of opportunities as possible. This strategy is evident in the breadth of our product portfolio and the diversity of our markets, applications, and customers, where we harness the strength of our portfolio and where barriers to entry are high and where our innovation can be sustained. Today, customers are choosing their long-term partners very carefully. Our engagements with them are occurring earlier and earlier in their innovation cycles. Our collaborations are becoming longer-term in nature.
There is no limit to the level of innovation that they are demanding from ADI. We are responding by continuing to push the boundaries on technologies, products, and systems engineering. An example of this approach in action is our acquisition of Hittite, where we are building an RF and microwave signal processing portfolio that makes ADI even more relevant to our customers and helps them solve their ever-increasing design challenges. Our brand remains stronger than ever. Our employees are engaged and passionate about our customers' success, all of which provides us a terrific platform upon which to continue building our strong franchise. Our drive for innovation and engineering excellence and our deep systems and application domain know-how enable ADI to stay ahead of what's possible.
We are focusing on the right markets and products that will drive sustainable and profitable growth and superior shareholder returns well into the future. I firmly believe that our best is yet to come.
Great. Thank you, Vince. Everyone, during today's Q&A session, please limit yourself to one question. We're going to run today's call until 6:00, after you ask your primary question, please re-queue if you'd like to ask a second question. The reason we do this, we run our call in this format, is that everybody gets a chance to ask at least one question. With that, operator, let's start our Q&A session.
For those participating by telephone dial-in, if you have a question, please press star and the number one on your phone. If your question has been answered and you wish to be removed from the queue, please press the pound key. If you are listening on a speakerphone, please pick up the handset when asking your question. We'll pause for just a moment to compile the Q&A roster. Our first question comes from David Wong with Wells Fargo.
Thanks very much. You were talking about how your gross margin will drop a bit because of loading. Although, of course, it's difficult to forecast what our revenues are going to do going forward, do you expect to be able to raise your fab loadings going forward after this current quarter? Do you expect your inventory to be where you want it to be at the end of this quarter?
I wouldn't say that I anticipate inventory to be where we want it to be, but a lot of why our inventory is where it is not related to running the fabs hotter than expected. In fact, most of it is actually wafers we outsource externally. I think, a large part of our kind of utilization is driven off of the industrial business, and depending on how that business goes, that would somewhat determine how our loadings go. We're obviously expecting that business to do well over time, and we anticipate that our fabs will continue to increase over time, the utilization levels. I think that would be, over time, a positive impact to the gross margin.
Yeah, David, I'd like to ask David Zinsner here, I would just ask, look, the third quarter for us, we tend to do some retooling anyways in our fabs, it tends to be a slower quarter on the utilization side as a result of that. I think it's kind of a seasonal thing. The other thing I'd add is on the gross margin line, we're running our business to run at operating or at gross margin model ranges of 65%-68%, that's still the case, and that'll still continue to be the case going forward. Thanks for your question, David, and we'll get to our next question, operator.
This question comes from Christopher Danely with Citigroup.
Hey, thanks, guys. I guess just as a related question, can you give us your expectations for the relative growth rates of the end markets, I guess, for the rest of the calendar year? If you would, maybe talk about your expectations for relative growth rates longer term, say, for the next one to three years from the end markets.
I think it's safe to say, given that the third and fourth quarter are usually good quarters for consumer, that as we sit today with the limited visibility that we always have in the semiconductor space, that we would expect the consumer business to do quite well for the latter half of this year. I think industrial generally sees, on a half-year to half-year basis, generally starts to flatten out for the second half of the year. That's generally true of the automotive space as well. The communications business, I would say, is a wild card. We do expect this to be a temporary perturbation that we're experiencing right now in the communications market, and that the long-term trends to build out infrastructure around the world still exists, and the need for more data or higher data rates still exists.
I think it's a matter of when on the communications business, but that should come back at some point and may indeed come back in the fourth quarter. Longer term, we hope all the businesses grow quite well over the next three years. I think as we look at the pipelines in each one of our businesses, Vince and I just reviewed it a few weeks ago with the team, we're excited about every one of our end markets and the things that are getting done, the incredible innovation that's going on together with our customers. We expect all of them to do quite well.
I think as well, Chris, we've put a number out there. We've said that our expectation is that we should be able to grow this business and aggregate it two to three times global GDP. We stick by that. My sense is, if the markets behave, we'll be on the higher end of that.
Great. Thanks, guys.
Thanks, Chris. We'll get to our next question, operator.
This question comes from John Pitzer with Credit Suisse.
Question. Dave, you've always said that mix of business doesn't have a significant impact on the gross margin line. If you look at the strength in the consumer going into the July quarter and the incremental gross margin in that quarter being relatively weak, I think I understand the issue with utilization. Can you remind us again how consumer influences gross margin longer term? I guess given where it is today as a % of revenue, how big would you want consumer to be before it got sort of too big?
Well, on the gross margins front, I think, what we're talking about with our guidance is we'd be 50 basis points off the second quarter gross margin level and roughly probably half of that's impacting us from utilization and probably half that is mix. It's, again, relatively modest impact that we get off the consumer business, in terms of mix. We actually will take all comers in terms of good, profitable, innovative type revenue streams. We're not going to arrest any market that's going to do well for us and drive revenue growth and more importantly, earnings growth. I think that though, just based on the way we're investing our R&D, which has been very balanced across all those end markets, I think you'd expect that we'll have a very balanced growth trajectory for all of the businesses.
Thus, you probably won't see significant differences in % by end market over time.
To add a little more color to what Dave has just said, we're leveraging a platform of technology for the portable space in particular, that is based upon our many years of developing precision signal processing technologies for many different types of applications within portable devices. As always, we're solving the toughest problems that our customers can throw at us. We're looking for sustainable innovation. We're looking for sockets where we can sustain a position for generations to come. That approach will give us the kinds of ASPs and the kinds of margins that we find attractive to our business overall.
Thanks, guys. Helpful.
Thanks.
This question comes from Craig Ellis with B. Riley.
Thanks for taking the question, guys. Wanted to focus a little bit on a follow-up to the points that were just being made. In the consumer business, there have been some teardown evidence of a marquee design win for your product. Can you talk about your ability to drive your technology across a broader base of both customers and applications?
Yeah. As I've just said, we're leveraging technology that is primarily precision centric, we generate very often breakthrough process technologies, breakthrough circuits, breakthrough products, from which we build platforms. Ultimately, those platforms are purposed into industrial automation, into battery management in cars, into portable devices in consumer. It's very much a platform play and where we can leverage the quality and the strength of our technology to solve really difficult problems in those areas, we build products very often that sometimes go into a catalog and sometimes are purposed for those individual applications. That's the philosophy. Our technologies, as you know, we've got more than 20,000 product SKUs in the catalog of ADI. We've got about 100,000 customers across many different applications.
That's been the approach in the past. It served us very well, and I believe that approach will serve us very well in the future.
Thanks, Craig. Let's get to our next question, operator.
Your next question is from Blayne Curtis with Barclays.
Thanks. I just actually wanted to follow up on that. As you look at a consumer space, you've been able to put a good barrier from competition in industrial type markets. When you look at consumer, when you're leveraging that precision signal expertise, do you think you can enjoy a similar barrier to entry? If you just kind of highlight the competitive landscape in portable applications.
Well, the portable landscape itself, has a lot of different modalities within. There's many different sensor types, many different types of media. As I said, we have very much picked out areas of the portable space where the problems that are really important to our customers to solve, to develop a really high-quality user experience. Those problems are very tough. We are pushing our technology right to the edge. We're living at the edge of the technology. We're enabling certain features to be provided in these systems. That's where we like to play as a company, whether it's industrial, automotive, consumer, communications infrastructure. We apply that wherever we go. That's the philosophy of the company. We like solving tough problems at the intersection of the physical world and the world of digital or virtual.
Thanks.
Thanks, Blayne. Get to our next question, operator.
This question comes from Ross Seymore with Deutsche Bank.
Hi, guys. Just a question on the cash return. You guys have done a great job over time doing that. I think you've laid out clear targets. When we boil it down between the buyback and the dividend, I think you've said in the past you have roughly a third of your free cash flow generation is onshore. By that math, it looks like your dividend is actually more than your onshore. I know you have a ton offshore. Just talk about how you balance that with the statement you made earlier in the call about increasing your dividend each year.
Yeah. We obviously have a U.S. entity that generates cash flow. Some of the dividend is supported by how much of the U.S. cash flow is generated. Beyond that, as you probably noticed, we have added leverage at times. I think we have a couple of bonds now outstanding to bulk up the cash reserves of the U.S. entity. We utilize that cash as well, to fund the dividend and buyback. Of course, offsetting that, the international entity accumulates cash. Net-net, we have a pretty good balance sheet, pretty conservative balance sheet. We do use leverage on the U.S. balance sheet, in order for us to fund the buybacks and dividends, to create the cash return that the shareholders want.
Okay, great. Thank you.
This question comes from Tore Svanberg with Stifel.
Yes, thank you. Just had a question on your guidance, I do recognize that most of your end markets are sort of moving into flattish seasonality. Just based on conversations you're having with customers, especially those in the industrial space, does it feel like they are upbeat or are they being guarded, cautious? Just trying to understand directionally what your customers are feeling after what was a fairly turbulent March quarter.
Yeah. I think there's kind of two sides of the conversation with industrial customers. One is the long term and how we're working together to generate great innovation in industrial automation, instrumentation, and so on and so forth. We've had a very good industrial quarter in the quarter just gone. Sequentially it was strong. It was up considerably year-over-year. I think it's really going to be a question of how well the macro environment behaves. My sense is it's stable. We see it in the order rates. We hear it in conversations with our industrial customers as well.
Thank you.
This question comes from William Stein with SunTrust.
Great. Thank you for taking my question. I'd like to ask a bit about the automotive end market. You mentioned that there were some pending government mandates in autos. Is that Euro 6 or is it something in the U.S.? Any color would be helpful. Thank you.
Hey, Will, it's Ali here. I think specifically what I was mentioning in the prepared remarks is certainly around Euro 6. It's also around the CAFE standards in the U.S. that are coming online. I did mention government mandates, I think it's above and beyond that, right? There's NCAP standards, there's five-star ratings, I think a lot of the car manufacturers are really angling to hit those ratings, get those various certifications, because I think it really helps them differentiate their products with the end consumer. I think those are the kinds of things that are coming online. Interestingly, customers are also adding the various options, right? Something may be part of a particular government mandate, be part of a particular NCAP program. Customers are actually now, particularly in the premium vehicles, are opting for the various functionalities.
I think that's also been really good and it's been driving our business.
To add a little more color there to what Ali has just said. Obviously car companies, it's important for them to comply with government regulations. Car companies are in a massive transformation mode. They're all trying to become IT centric because that's how they're really building value into the products that they're developing and delivering. I think there's many years yet of headroom to innovate in cars as the OEMs themselves are trying to automate and electrify everything they can inside the car. I think that's more the driver of innovation than regulation.
Okay. Thank you.
This question comes from Craig Hettenbach with Morgan Stanley.
Hi, this is Vinayak calling for Craig. I have a follow-up on automotive, like, solid sequential growth this quarter. When you look at the portfolio, you're playing in the right applications. When I look at growth on a year-over-year basis, the growth has kind of slowed down to the low single-digit range from high single-digit, double digits in the prior quarter. How should we think about growth, like, in the intermediate to longer term in automotive?
Look, we've had a very strong growth pattern in automotive over several years. We've been growing at a compounded growth rate of around 20% over the last five years. When I talked earlier on about the aggregate expectation for growth for ADI, I talked about two to three times global GDP as being kind of a good benchmark. My expectation in the years ahead is that, given where we are now, that the higher end of that growth expectation is what automotive will deliver for ADI. I think that's how to think about it.
Thank you.
This question comes from C.J. Muse with Evercore ISI.
Good afternoon. Thank you for taking my question. I guess my question's on the consumer side. Great job in terms of that business finally topping, and some interesting wins that you've alluded to in the past. Curious, what kind of growth we could see for that business here in calendar 2015. Based on that kind of growth, what kind of impact would that be, all things equal, in terms of impact to gross margins? Thank you.
Well, as I mentioned on the gross margin front, most of these businesses are pretty close to the corporate average, so within 20, 30 basis points, it's not much different. I think we'll have to defer until next quarter to really give you, I think, a good sense of the full-year growth rate of consumer. We're just not ready to provide complete guidance out through the year on any of our businesses, because we just don't have that visibility. I think it's safe to say, though, that as we sit today, normally consumer has a seasonally strong fourth quarter, and that's kind of how we're building the internal plans at this point. We'll wait until the third quarter is behind us. We'll give you some better clarity around the fourth quarter, and that'll give you a sense for the full-year growth rates.
Thank you.
This question comes from Stacy Rasgon with Bernstein Research.
Hi, guys. Thanks for taking my question. Had a question on, I guess, the shorter-term outlook here. Obviously very strong consumer, was up 15% this quarter. You seem to be guiding it up more than 20% next quarter. Flat in the rest of the other businesses. You're talking about kind of core industrial and auto. Auto, again, usually seasonally weaker in the second half. Com's a wild card. You're taking their internal utilizations down, which to me suggests maybe a little bit more caution potentially in kind of those core businesses. I guess, do you think it's possible, can we actually see growth in the second half outside of consumer for the rest of your businesses? And I guess, would you say your outlook for the second half in industrial and auto today is maybe better or worse or the same versus where it was three months ago?
Well, even if industrial stayed relatively flat through the rest of the year, they'd be up because the first quarter was a pretty down quarter for industrial, as it usually is. I guess the answer to your first question is, yeah, I think there's certainly an expectation that, or could be an expectation that we could see growth second half over first half of the core businesses. What was the second part of the question, Stacy?
I'm sorry, just would you classify your sort of industrial and auto kind of core outlook into the second half today better, worse, or the same as where it was three months ago?
Yeah, I think we generally are in the same range that we expected coming into the year. Obviously, there's all these crazy macro indicators, some of which contradict other macro indicators. The best we can do is look at our order flow, and I think recently the order flow has been pretty stable. We did have maybe a weaker February, partly due to the Lunar New Year, I suspect. Outside of that, those businesses have been pretty stable all the way up until today. Of course, we don't know with 100% confidence how things will look like going forward. Just based on the customer input, what we've heard from our distributor partners and what we're seeing in terms of the order levels, I think it's a pretty stable environment.
Thank you.
Sure.
this question comes from Romit Shah with Nomura Securities.
Yes, thank you. Vince, given the LTE deployments that we've seen already, some of your competitors are a little bit more guarded about their communications businesses recovering over the next year, and I'd be curious why you're more optimistic. Thank you.
Well, look, we're at very early stages of 4G build-out across the globe. The penetration rates are still very modest. There's a long way to go. We've obviously had this short-term wobble, but that is short-term. It's centered around the behavior of a couple of carriers that had a strong ripple effect throughout the entire market. I think the long-term prognosis in terms of the build-out of hardware infrastructure to be able to deal with the bandwidth, with the data capacity requirements, there's no question about that. I think also, we talked on the last call about the emergence of small cells, and we are very well-positioned in the small cell sector that will complement the strength that we have in the macro area. We've a stronger product portfolio than ever. We are very well-positioned with all the OEMs across the globe.
I believe the short term has really been, as I said, a behavior issue with a couple of carriers. I think in the medium and long terms, this is a great space to be. I think we're going to see a recovery here sooner than later.
Thank you.
This question comes from Vivek Arya with Bank of America.
Hi. Thanks for taking the question. This is Shankar on behalf of Vivek. I have a question regarding Hittite and its contribution for this quarter related to the prior quarter. Can you talk about how the split has changed between the communication and the industrial? My understanding is 40% is in industrial and 60% is in communication.
Let me take the first one. The revenue growth sequentially of the Hittite business was basically the same as the total company. It performed exactly as expected, and we're very pleased on how they did on a top-line basis. Also, we were expecting for 2015, I think when we originally talked about the Hittite acquisition, that it would be kind of in the high single digits in terms of accretion. I probably updated this last quarter, but I would just tell you that it looks more like it's in the 10% zip code this year. We feel really good about Hittite's accretion for next year, which is likely to be in kind of the mid-teens. From that perspective, it's going quite well. The business had, I think that's probably fair to say, had a bit more industrial as a percent of revenue versus communications.
Obviously, communications wobbled for us. It wobbled a bit for the Hittite portion of the business as well, not surprisingly. One of the areas of the industrial space that did particularly well for us this quarter was the defense business, and that is where Hittite had very good exposure. They definitely knocked the cover off the ball on that category within the industrial space, did quite well.
Thank you.
This question comes from Steve Smigie with Bank of America. I'm sorry, with Raymond James.
Great. Thanks. Thanks, guys. I just wanted to follow up a little bit on the Hittite accretion question. Dave, I was hoping you could talk a little bit about what we should think about OpEx over the next 6 quarters. If your OpEx grows something maybe half the growth of revenue, does that suggest we should model something even less growth on OpEx? Is that the right way to think about it?
I think for the most part, most of the OpEx benefits of the Hittite acquisition are kind of in. What synergies we got from an operating expense standpoint, I think pretty much were captured by the time the first quarter ended. There might be a little bit, but it's not enough to move the needle for the total company in terms of OpEx. Really, where you'll see the next wave of benefit is on the gross margin line and not the operating expense line. Personally, I think your rule of thumb, roughly OpEx growing at roughly half the rate of revenue over time probably makes a lot of sense.
Certainly, there'll be quarters where that doesn't necessarily happen, and there'll be quarters where we do a little bit better than that, as we did this quarter. Over the course of several years, I think that that's a pretty good rule of thumb.
Okay, great. Thanks. Then just a quick follow-up. As I think about industrial, it seems like medical could potentially become a bigger area. You guys talked about some very interesting medical solutions at Analyst Day.
Does medical become 5% of revenue sometime in the next year or two, or is it more it'll still take 10 years to get that to be a big percentage of revenue?
Well, I'd say we wouldn't break it out for 5% revenue. It's a healthy business today. Where we might break it out as a separate category is when it got closer to the kind of 10% category. That would be kind of the reason to bring it out. It's actually a pretty meaningful part of the revenue of Industrial.
Okay, great. Thanks.
I think, just to add a little more color, it's a space with tremendous potential. It's the one area of our business where technology, in many ways, IT, is going to be the solution to many of the problems to be able to produce the kind of diagnostics that are important for healthcare, for wellness and healthcare management. To solve the cost problems that are just really crucifying that industry. It's very important to the overall delivery of healthcare from a performance and cost standpoint. It's a modest investment for ADI, but we're very excited about many of the things we're doing in delivering photonics to bit solutions, for example, in the area of CT and MRI scanners. Big iron is an important part of what we're doing. We've built some really enabling technologies in digital X-ray that are starting to ramp up into decent-sized revenues.
Of course, there's the vital signs monitoring, for consumer plus applications and moving into clinical grade healthcare over the coming years. There are several areas with a very modest R&D spend that is allowing us to create tremendous leverage, again, off the technology platforms that we've developed. Has all the attributes that we look for in terms of hard-to-solve problems, multiple generations of sustainability, good ASPs and margins. I think it's a terrific space, and it's one of these spaces where you really have to take a long-term view to playing in, because things don't happen overnight. I think we're very well positioned and excited about the future there.
Great. Thank you.
This question comes from Gabriel Ho with BMO.
Hi, this is Gabriel calling in for Ambrish. Thanks for taking our question. I have a follow-up on the communications end market. I think you mentioned it in the Q&A session that you're well-positioned in the small cells, and I think also you mentioned before that you see 4G has a higher 20%-30% higher opportunity than 3G. How should we think about your opportunity in small cells as it ramp as opposed to 4G and 3G?
Yeah, it's very hard to say. There's definitely the introduction of these small cells. By the way, when we talk about small cells, I should make it clear, we are not talking about femto cells. We are talking about high-performance, infrastructure-related small cells. I want to make that clear. The introduction of those small cells, we've said for several quarters now, we believe that the second half of this year will see the introduction in a meaningful way of these products, and that indeed now is beginning to happen. I think second half of 2015 is when we'll see a meaningful introduction of those products. There's no precedent in terms of ASP increase for those products over the prior, because there really wasn't a prior. It's all been macro cell to date.
What we have seen, of course, in macro is an increase of 20% to 30% in bill of materials value to ADI based on the extension of our portfolio and the integration of functions into our solutions there.
Gabriel, this is Ali. I would just point out, I think the long-term trends of this market are terrific. You look at 7.1 billion subscribers out there, 4.5 billion are still on 2G. North America, barring the short-term perturbations this quarter, mobile data in North America is growing 50% year-over-year. Penetration rates here are set to move higher over the next few years, China is on this multi-year 4G FDD, TD build. I think we're in the infancy here, and I think the points that Vince made are absolutely correct because you have the macro coming in, you have the small cells layering in on top of that. I think it's going to be a great market for ADI for many, many years to come.
Thanks, Gabriel. We'll move on to our next question.
This question comes from Ian Ing with MKM Partners.
Yes, thanks. Could you talk about your ability to handle volume ramps in portables? This is something you've done in the past, but not more recently. Would you say you've been audited pretty well on manufacturing capability, ability to fulfill requested lead times? Thanks.
Yeah, we have one of the best manufacturing organizations in the world of semiconductors. We have a manufacturing organization that's been consistently, irrespective of volume or market, we've been able to deliver greater than 95% of our products within six-week lead times, no matter what the perturbations in markets, with sub one part per million quality levels. We're very agile in terms of our manufacturing capability. In the case of the consumer area, we're leveraging external foundries and external backend manufacturing and test capabilities. As I said, our supply chain is second to none in the industry, very agile, and we have a lot of experience, by the way, of playing in these consumer markets over many, many years. We're very much up to the challenge and pleased with where we are.
Great. Thanks, Vince.
This question comes from Jim Covello with Goldman Sachs.
Hey, guys. Thanks so much for taking the question. I appreciate it. I was wondering if you could give us a little bit of insight in terms of how you're going to think about the trade-off between revenue growth and gross margins as you ramp some of your big consumer opportunities. Do you think you'll prioritize the revenue growth, or would you prioritize holding the line at a certain level on gross margins as you face the inevitable cost pressures in the second and third generation of these devices that the big customer drives?
I think we feel pretty confident that we can stay within the range of our gross margin target, which is 65%-68%. Ultimately, we're about growing earnings at 8%-15%, we certainly want to be on the higher end of that range if we can. That's number 1 priority. What Vince, I think, said in the prepared remarks, I think he said sprinkled through his answers on questions today, has been that we're very focused on innovation. When you're focused on innovation, you don't necessarily see the competitive pressures that people see in every market that we participate in. Because if you come out with commodity parts in any of these markets we're in, you're going to find a lot of price pressure. What we try to do is stay on the innovation curve, ahead of the innovation curve.
We get paid for that. We have what we believe is superior R&D thrown at these problems. I feel pretty confident that you're not going to see us wobble away from on the gross margins.
Very helpful. Thank you. Good luck.
Sure.
This question comes from Joe Werner with Peter Canell and Company.
Thank you very much for taking my question. I guess I'm turning to the balance sheet, and we all know we have interest rates at the lowest level in our lifetime, yet I see that we have an exorbitant amount of cash at this time. At a time when many companies are borrowing money, we have cash that is earning very little return for our shareholders. I wonder, is there any thought being given to the idea of maybe borrowing $2 billion instead of having $2 billion on the balance sheet? I remember when it wasn't long ago when the company had about 400 million shares outstanding.
Today, it's close to the Well, it got down to about 300 million shares, now it's been creeping upward to, well, I see 312 million on a basic number, but 317 million on a fully diluted number.
By my calculation, it could be down to about 250 million if we took on about $2 billion of debt and/or swung the balance sheet in about $4 billion. We could reduce our share count by about 20%, increase our earnings by about 20%. What type of response would the board have to that type of thinking?
Well, I appreciate the question, Joe. We're constantly looking at trying to optimize the balance sheet. Part of the challenge is the fact that a majority of that cash is offshore and isn't easily accessible, although it can be accessed. We have to balance, I guess, three priorities. One is, I guess, a two-part priority, which is to return cash to shareholders, focused first and foremost on the dividend, but also on opportunistic buybacks. If you look at our cash balance probably back, I don't know exactly when that was, 2005 or something, I think we have come down quite a bit in terms of cash balances. The other priority is, obviously, to augment what we do organically in terms of development with some inorganic, call it development, Hittite being a perfect example.
At one point, I don't know, a year and a half ago, we were probably at $5 billion of cash. We brought that down to $3 billion. Didn't necessarily reduce the share count, but I think dramatically improved the earnings leverage within the company by adding incredible technology, very synergistic with what we're doing, also accretive right out of the gate. That's the kind of balancing act that we have as we manage the capital structure. I think, if we look over the long term, our goal is not to be accumulating tons of cash. It is to be very judicious, but very shareholder-friendly in terms of returning cash, also to augment that with M&A to continually drive the earnings growth.
I don't think that we're just sitting here trying to collect the relatively small amount of interest income we can get on this cash balance. That's certainly not our goal. We hear what you're saying. It's definitely something that we're paying a lot of attention to internally. It's definitely something that the board pays a lot of attention to when we meet with them. I think over time, you'll be quite happy with the end result of where we're headed.
Thank you very much.
Sure.
Thank you.
This question comes from John Pitzer with Credit Suisse.
Yeah, guys. Thanks for letting me ask a follow-up. Dave, just relative to that consumer mix, I think there's been a lot of questions about the gross margin impact. I'd be kind of curious relative to the op margin impact, how do we think about kind of the OpEx around those consumer opportunities that tend to be fairly significant unit volume opportunities where you're kind of leveraging core IP that you've developed in other areas?
Yeah. We'll see in the future as to how the consumer business grows and how fast that can grow. I think it's safe to assume that if consumer is growing at a reasonable clip, that we'll get very good leverage on that and very good fall through to the bottom line, and that will be accretive to our operating margins number. There's no question that that's the model.
Dave, if I could take a quick one in. On the step-up of $5 million on deferred because of Hittite, is that now the full impact of Hittite, or should we expect to see more in the July quarter going forward?
No, I think that we got all the inventory generally in the places we want with our distributor partners with regards to the Hittite products. So I think we're going to see the deferred margin number kind of ebb and flow with how the distributors themselves are managing their inventory and how their point of sales are going.
Perfect. Thanks again, guys.
Thanks.
This question comes from Tore Svanberg with Stifel.
Yeah, I just had a follow-up on your consumer and then slash medical business. I mean, right now, your medical revenues and better on industrial. If you look at some of the consumer opportunities, there seem to be a convergence between medical and consumer. I'm just wondering, as we go down the road next couple of years, how are you going to be reporting this to the street, given the convergence that's currently happening?
Yeah, just to be clear, we internally look at the healthcare business in total, and that's how it's managed internally, which is the way Vince was describing it. When a product is targeted to a consumer customer, we already classify it as a consumer product. It is in the consumer category today.
Okay. Even though eventually it's healthcare related, if it's sold to a hospital, it's medical, if it's sold to a consumer, it's consumer.
Better described it is, if it's sold to a hospital, it's counted in our industrial business. Well, it wouldn't be to a hospital, but to a customer that supplies to the hospital.
Yeah.
It's in our industrial business, if it's supplied to a consumer products company, it's a piece of consumer rev.
Thanks for that clarification.
Thank you.
This question comes from Stephen Chin with UBS.
Thanks for taking my question. Earlier, you provided some good color on the distribution channel and inventories and also orders. I was wondering about the other half of sales to your direct customers. In particular, can you remind us what products or end markets are mainly represented in your direct sales, and also any color on order trends, as well as inventory levels at the direct customers? That'd be great.
Well, we have OEM customers in all of our end markets. I would say that a disproportionate amount of our distributor revenue is sold into the industrial market, and a disproportionate of our OEM revenue is sold into the consumer communications and auto markets. What was the follow-on question? I missed that part.
Yeah, just the order trends, coming into the current quarter versus last quarter. Are they stable, similar to the business?
Yeah, sure. I think, we probably saw the weakest month in February, but as I said, I think that was pretty much as expected given the Lunar New Year. It kind of popped back up in March. It was a little bit better in April, and it's been pretty stable through at least May 19th. I would characterize the environment right now as pretty stable.
Great. Thanks.
Thanks.
This question comes from Deepon Nag with Macquarie.
Hi, guys. Talking about distribution inventory, they came down pretty hard. First of all, was that primarily due to European customers just not wanting to hold inventory? Have you seen them more willing to take on inventory now that currency has hopefully stabilized a bit? On incremental gross margins, should we still think of 80% as the correct drop-through? Can you talk about the puts and takes, especially as Hittite starts moving their products internally? Thanks a lot.
I wouldn't read too much into the fact that inventory came down this quarter, because I think that generally happens this quarter. It's usually a very strong POS quarter or ship-out quarter for distributors. We generally do see inventory roll off a little bit. I don't think it had anything to do really with currency, and it wasn't specific to any one geography. They all kind of came down pretty much at the same rate. On the gross margin front, the fall through, it generally is 80%. Obviously, if you do the math, for the third quarter, that wouldn't be the case, mainly because we're bringing utilization down a little bit, and the mix impacts.
I think generally, rule of thumb, that's probably in the range of what we would expect gross margin to fall through, as long as the growth rate is pretty balanced across all the end markets. The products manufactured internally get as much of a lift as the ones that are manufactured externally.
Great. Thanks a lot.
Thanks.
This question comes from Harlan Sur with J.P. Morgan.
Yeah. Hi, good afternoon. This is Bill Peterson calling in for Harlan. Thanks for letting me sneak one in.
Sure.
I guess, thinking about the auto segment, and since the pipeline trends, you have some visibility, I think, for next year's models, things like that. Where would you see the relative growth? I believe you said safety would be relatively outperforming, but how would you rank safety, infotainment, and powertrain, for the coming years in terms of growth potential?
Yeah. Probably, with three primary applications. We have infotainment, safety, and powertrain. I would say in terms of relative growth, probably safety and powertrain will lead. We'll have good growth in infotainment, but I think a lot of the growth should be driven by safety and powertrain.
Okay. That's helpful. Thank you.
Thank you.
Thank you very much. Looks like that was our last question. Thanks for joining us tonight. We look forward to talking to you on our next quarter's earnings call, which is scheduled for August 18th, 2015. With all that, good night, everyone.
This concludes today's Analog Devices conference call. You may now disconnect.