Good afternoon. My name is Huey and I'll be your conference operator for today. At this time, I'd like to welcome everyone to AMD's third quarter 2013 earnings conference call. All lines have been placed on a listen-only mode at this time. After the speaker's remarks, you'll be invited to participate in a question-and-answer session. As a reminder, this conference is being recorded today. I would now like to turn the conference over to Ms. Ruth Cotter, Vice President of Investor Relations for AMD. Please go ahead.
Thank you. Welcome to AMD's third quarter earnings conference call. By now, you should have had the opportunity to review a copy of our earnings release and the CFO commentary and slides. If you have not reviewed these documents, they can be found on AMD's website at quarterlyearnings.amd.com. Participants on today's conference call are Rory Read, our President and Chief Executive Officer, Devinder Kumar, our Senior Vice President and Chief Financial Officer, and Lisa Su, our Senior Vice President and General Manager, Global Business Unit will be present for the QA portion of the call. This is a live call and will be replayed via webcast on amd.com. I would like to highlight a few dates for you. Devinder Kumar will attend the Credit Suisse Technology Conference on December 3rd in Arizona.
John Byrne, our Senior Vice President and Chief Sales Officer, will attend the Raymond James IT Supply Chain Conference on December 10th, and the BMO 2013 Tech & Media Conference on December 11th. Our fourth quarter quiet time will begin at the close of business on Friday, December 13th. Lastly, we intend to announce our fourth quarter and year-end earnings on January 21st, 2014. Dial-in information for the call will be provided in mid-December. Please note that non-GAAP financial measures referenced during this call are reconciled to their most directly comparable GAAP financial measure in the press release and CFO commentary posted on our website at quarterlyearnings.amd.com. Before we begin today, let me remind everyone that the discussion contains forward-looking statements based on the environment as we currently see it.
Those statements are based on current beliefs, assumptions, and expectations, speak only as of the current date, and as such involve risks and uncertainties that could actually cause results to differ materially from our current expectations. Please refer to the cautionary statement in our press release for more information. You may also find detailed discussions about our risk factor in our filings with the SEC, and in particular, AMD's quarterly report on Form 10-Q for the quarter ended June 29th, 2013. With that, I'd like to hand the call over to Rory. Rory?
Thank you, Ruth. Third quarter revenue of $1.46 billion increased 26% sequentially and 15% year-over-year as we return to profitability and delivered positive free cash flow. Revenue was higher than guided based on incremental demand for our new semi-custom SOCs. The three-step turnaround plan we outlined a year ago to restructure, accelerate, and ultimately transform AMD is clearly paying off. We completed the restructuring phase of our plan, maintaining cash at optimal levels and beating our $450 million quarterly operating expense goal in the third quarter. We are now in the second phase of our strategy, accelerating our performance by consistently executing our product roadmaps while growing our new businesses to drive a return to profitability and positive free cash flow. We are also laying the foundation for the third phase of our strategy as we transform AMD to compete across a set of high-growth markets.
Our progress on this front was evident in the third quarter as we generated more than 30% of our revenue from our semi-custom and embedded businesses. Over the next two years, we will continue to transform AMD to expand beyond a slowing, transitioning PC industry as we create a more diverse company and look to generate approximately 50% of our revenue from these new high-growth markets. We have strategically targeted the semi-custom, ultra-low-power client, embedded, dense server, and the professional graphics markets where we can offer differentiated products that leverage our APU and graphics IP. Our strategy allows us to continue to invest in the products that will drive growth while effectively managing operating expenses. This is best exemplified by the 10% sequential reduction in our expense-to-revenue ratio as we drive to best-in-class performance on this key metric.
Several of our growth businesses passed key milestones in the third quarter. Most significantly, our semi-custom business ramped in the quarter. We successfully shipped millions of units to support Sony and Microsoft as they prepare to launch their next-generation game consoles. Our game console wins are generating a lot of customer interest as we demonstrate our ability to design and reliably ramp production on two of the most complex SOCs ever built for high-volume consumer devices. We have several strong semi-custom design opportunities moving through the pipeline as customers look to tap into AMD's IP design and integration expertise to create differentiated winning solutions. We made good progress in our embedded business in the third quarter. We expanded our current embedded SoC offerings and detailed our plans to be the only company to offer both 64-bit X86 and Arm solutions beginning in 2014.
We have developed a strong embedded design pipeline, which we expect will drive further growth for this business across 2014. We also continue to make steady progress in another of our growth businesses in the third quarter as we delivered our fifth consecutive quarter of revenue and share growth in the professional graphics area. We believe we can continue to gain share in this lucrative part of the GPU market based on our product portfolio, design wins in flight, and enhanced channel programs. In the server market, the industry is at the initial stages of a multi-year transition that will fundamentally change the competitive dynamic. Cloud providers are placing a growing importance on how they get better performance from their data centers while also reducing the physical footprint and power consumption of their server solutions.
This will become the defining metric of this industry and will be a key growth driver for the market and the new AMD. AMD is leading this emerging trend in the server market, and we are committed to defining a leadership position. Earlier this quarter, we had a significant public endorsement of our dense server strategy as Verizon announced a high-performance public cloud that uses our SeaMicro technology and Opteron processors. We remain on track to introduce new low-power X86 and 64-bit Arm processors next year, and we believe we will offer the industry-leading Arm-based servers. Now looking at our traditional businesses. In the third quarter, our graphics business was in transition as our AIB partners prepared to launch new products based on our new Radeon R7 and Radeon R9 graphics chips.
The transition is now complete, and we are seeing strong demand for our new products, which we believe will drive consistent growth in the coming quarters. A key innovation in these new chips is Mantle. Mantle was developed in conjunction with game developers to allow them to take better advantage of the capability of AMD's latest graphics cores, resulting in dramatically better performance and power efficiency. Mantle also means the investments developers make to create great content for the Sony and Microsoft consoles translates into optimized experience for all AMD APUs and GPUs moving forward. Turning to the PC business. The 300-million-plus unit market remains an important part of our business. The market is clearly in transition, as evidenced in the third quarter by consumer notebook softness, which we expect to continue for the next several quarters as tablet adoption increases and our customers' inventory levels remain lean.
We expect PC industry unit shipments will decline approximately 10% this year and by a similar amount in 2014. We have the right product and IP and will continue to compete effectively in this market. We are well-positioned to expand our channel business and strategic OEM partnerships around consumer notebooks and commercial products. Kabini continues to ramp in support of a number of high-volume OEM platforms, and Temash adoption is growing. Toshiba and HP announced the first Temash-powered convertibles, and we expect more designs from other OEMs to launch this quarter. Our work to strengthen our desktop business is gaining momentum. We delivered a second straight quarter of channel revenue growth based on strong demand for our high-end A8 and A10 APUs and FX CPUs. We expect this trend to continue.
We remain on track to begin shipping our next generation Kaveri APU for the channel this quarter, and key motherboard partners are already offering new products in anticipation of this launch. In summary, we are successfully hitting key milestones of our three-step strategy to diversify and transform our business. We have completed the first step, restructuring AMD and stabilizing our business. We effectively managed cash at the optimal levels and beat our $450 million quarterly operating expense goal in the third quarter. We are now in the second phase, accelerating our performance by consistently executing our product roadmap and growing our new businesses. Our success here drove 26% sequential revenue growth and returned AMD to profitability and generated free cash flow in the third quarter.
Our progress sets us up to ultimately transform AMD in the third and final step as we leverage our IP and design expertise from our traditional businesses to generate approximately 50% of our future revenues from high growth markets over the next two years. We are in the middle of a multi-year journey we outlined over a year ago to redefine AMD as a leader across a more diverse set of growth markets. I'd like to take this opportunity to thank AMDers across the world who have pulled together to deliver on our commitments and successfully execute our plans. The job is not done, but we are making good and real progress. I look forward to the next steps of our strategic transformation. I'd like to hand the call over to Devinder. Devinder?
Thank you, Rory. Our third quarter results met or exceeded our guidance for revenue, gross margin, operating expenses, and cash, although inventory was higher than guided. We completed the first phase of our three-step plan to transform AMD, the reset and restructure phase, and we are performing well in the second phase, accelerating our business and executing on our 2013 product roadmap. In the third quarter, we made progress towards our goal of diversifying our product portfolio as we successfully ramped our semi-custom products. Specifically, our semi-custom and embedded revenue accounted for more than 30% of total company revenue, exceeding the target of 20% of revenue by the fourth quarter of 2013. Financially, we returned to profitability both in operating and net income, met our target of reducing operating expenses to $450 million, and generated positive free cash flow ahead of plan.
Significant change is underway at AMD as we continue our transformation into 2014 and beyond. Let me turn to the specifics of the quarter. Revenue for the third quarter of 2013 was $1.46 billion, an increase of 26% from the second quarter and an increase of 15% year-over-year. This represents the highest sequential revenue growth in the past five years. The increase was driven by a more than doubling of our graphics and visual solutions segment revenue quarter-over-quarter, primarily from the ramp of our semi-custom SOCs. Gross margin was 36%, down four percentage points sequentially and in line with our expectations as we grew our semi-custom business, which has lower than corporate average margins, but significant revenue and earnings power as volumes ramp.
You will recall that the semi-custom NRE operating model drives significantly lower operating expenses for this business with the majority of its gross margin dollars falling through to operating income. The third quarter result includes a $19 million benefit or approximately one percentage point from the sale of inventory previously reserved in the third quarter of 2012 as compared to an $11 million benefit or approximately one percentage point in the second quarter of 2013. Non-GAAP operating expenses were $443 million, slightly below our targeted level of $450 million, primarily due to the timing of certain marketing related expenses. Non-GAAP operating income was $78 million, and non-GAAP net income was $31 million, both of which exclude a gain of $22 million from the real estate transactions in the quarter. Non-GAAP earnings per share were $0.04, calculated using 764 million diluted shares.
Adjusted EBITDA was $153 million, an increase of $99 million from the prior quarter, primarily due to improved operating income. Turning to the business segments. Computing solutions segment revenue was $790 million, down 6% sequentially due to lower notebook and chipset unit shipments, partially offset by higher desktop unit shipments. Computing solutions operating income was $22 million, up from $2 million in the second quarter, despite the sequential 6% decline in revenue driven by lower operating expenses. Graphics and visual solutions segment revenue was $671 million, more than double last quarter's level, driven by shipment of game console semi-custom SOCs. Graphics and visual solutions segment operating income was $79 million, compared to breakeven in the prior quarter, primarily due to the semi-custom business.
Operating margin for the semi-custom business was in the mid-teens, primarily due to higher revenue and a very smooth ramp in our first full quarter of production. Moving forward, we expect semi-custom operating margin performance to continue to improve as the business gains traction, volumes increase, and costs improve. Turning to the balance sheet. Our cash equivalents, and marketable securities balance, including long-term marketable securities, was $1.2 billion. Third quarter real estate transactions generated cash proceeds of $56 million. We remain committed to operating and funding the business appropriately and continue to have a number of liquidity bolstering opportunities available. Inventory, as I stated earlier, was higher than guided at $922 million, largely driven by next-generation game console product ramps and preparation for fourth-quarter shipments of our new graphics products. Debt as of the end of the quarter was $2 billion, flat from the prior quarter.
Accounts payable at the end of the quarter were $574 million, up $172 million from the second quarter due to the timing of purchases and payments. Depreciation and amortization was $52 million, down $2 million sequentially. Lastly, we generated positive free cash flow of $6 million in the quarter. Turning to the outlook. For the fourth quarter of 2013, AMD expects revenue to increase 5% sequentially, ±3%. Non-GAAP gross margin is expected to be approximately 35% as our semi-custom business continues to represent a greater portion of our overall revenue. We expect to continue to maintain quarterly non-GAAP operating expenses in the $450 million range and expect to be profitable at the net income level. Inventory is expected to be flat from third-quarter levels, and cash is expected to be approximately $1.2 billion.
Capital expenditures for the full year 2013 are expected to be approximately $110 million, down from our prior guidance of $150 million. In summary, our execution and product diversification strategy is showing results as evidenced by our return to profitability in the third quarter of 2013. We are pleased to have delivered on our financial commitments so far this year, some ahead of schedule, and expect to continue these positive trends in the fourth quarter. With that, I'll turn it back to Ruth. Ruth?
Thank you, Devinder. Operator, we'd be happy for you to poll the audience, please, for some questions.
Sure thing. Ladies and gentlemen on the phone lines, to queue up for a phone question, you may press star, then one on your touch-tone phone. If your question has been answered or wish to remove yourself from the phone queue, you may press the pound key. Again, if you would like to queue up for a phone question, you may press star, then one on your touch-tone phone. Our first question in queue will come from the line of David Wong with Wells Fargo. Please go ahead. Your line is open.
Thanks very much. I think in your CFO commentary, you pointed out that graphics would decline because of the transition to the new products. You also said that the new products have transitioned. Do we expect a jump in graphics revenue in the fourth quarter? Also, what does your guidance assume in terms of microprocessor revenue sequential growth? Is it up or down in the fourth quarter?
Hi, David, this is Lisa. Let me take the graphics question. First, we've talked about graphics as a multi-quarter growth strategy for us in terms of market share, and we're certainly seeing that we're executing on that path. When we look at the third quarter relative to the fourth quarter and where we're going, we have built a very strong product portfolio. We just announced our full lineup for the R7 and R9 series, and those were launched in September and shipping in October. We did see a little bit of a transition at the end of the third quarter, but we do expect to gain share in the fourth quarter with our graphics business.
From a CPU standpoint, David, I think you'll see that the market continues to be in transition. There's no doubt for 2013, we see the market down 10%. We see that continuing into 2014. As we manage our portfolio into the fourth quarter, we want to keep a long view to the quarter. We know that 1Q and 2Q are going to be seasonally light. That's just how it is, and we want to make sure we're managing inventory and positioning properly. I would expect we'll continue to see the market feel pressure down year-to-year, and I would expect that we'll manage this and not lean into it to make sure we have a more consistent revenue path as we go into 2014.
Okay, great. One final one. I think you noted your semi-custom business operating margin was in the mid-teens, that was quite a bit better than you'd expected initially. Can you improve it from here, or is this the right operating margin for us to think of for the current console semi-custom business?
I think, David, you're right. The operating margin, when we discussed this last quarter, I had said low double digits. It came in at the mid-teens, really that's credit to the higher revenue that we had in the quarter and the successful execution of a very steep ramp in a product in the first full quarter of production. As you know, as we gain traction and get more volume and cost improvements, the operating margin could improve from the mid-teen level.
I think it's also important to see the kind of execution that we delivered in semi-custom in this ramp. This is one of the most complex ramps that we've seen with this set of SOCs. What's really encouraging is how our customers are looking at this in terms of the innovation that we've created here, as well as our execution. That's driving some serious interest in terms of our pipeline and opportunities in the semi-custom space that are moving through at this time.
Great. Thanks.
Thank you.
Thank you, sir. Our next question in queue will come from the line of Hans Mosesmann with Raymond James. Please go ahead. Your line is now open.
Thank you, and congrats on the execution on the semi-custom. Hey, guys. Can you provide a roadmap or some granularity regarding process node transitions in 2014 and 2015 as it relates to FinFET by graphics and APU? Thanks.
Hi, Hans. Thanks for your question. Relative to where we are in terms of process technology node transitions, we are typically at the leading edge of process technology nodes. We are fully top to bottom in 28 nanometer now across all of our products, and we are transitioning to both 20 nanometer and to FinFET, over the next couple of quarters in terms of designs. We'll continue to do that across our foundry partners.
Specifically to FinFET, if you don't mind?
We will do 20 nanometer first, Hans, and then we will go to FinFET.
Okay. Thank you.
Thank you, sir. It looks like our next question in queue will come from Vivek Arya with Bank of America Merrill Lynch. Please go ahead. Your line is open.
Thanks for taking my question. Rory, maybe one more on the PC business now that Intel is starting to become more aggressive in the lower price segments of the market, also in the tablet category with Bay Trail. These are segments where you have traditionally held larger market share on a relative basis. If you are expecting the PC market to decline 10% next year and Intel continues to be aggressive in that lower price segment of the market, how do you think your PC sales will trend next year? Just conceptually. I understand it's too early to make a specific prediction.
Well, from my perspective, Vivek, I think that we've created very interesting product set with the current products and the feedback I'm getting from our customers in terms of the design wins and the ramps, they look solid, where our volume is solid in that space. The next generation products, the silicon's already in shop, that's positioning us well to continue to compete in this segment. Make no mistake about it, the PC industry is clearly in transition and will continue to be in transition as tablet continues to tack, particularly in the consumer segment. We think we can compete well, it will make a significant portion to our business moving forward. Think about it.
Two years ago, we were 90%-95% of our business centered over PCs, we've launched a clear strategy to diversify our portfolio, taking our IP, leadership IP in graphics and CPU, taking it into adjacent segments where there's high growth for three, five, seven years and stickier opportunities. We see that as an opportunity to drive 50% or more of our business over that time horizon. If you look at the results in the third quarter, we're already seeing the benefits of that opportunity with over 30% of our revenue now coming from semi-custom and our embedded businesses. We see it as an important business in PC, its time is changing, the go-go era is over. We need to move and attack the new opportunities where the market is going, that's what we're doing.
Maybe one for Devinder on the cash side. I think, Devinder, in the prepared comments you said that you expect to be at $1.2 billion at the end of Q4, so slightly up sequentially, and then you do expect to be at the $1.1 billion optimal level by Q1. Given the $200 million payment due in Q1, does it mean you expect to generate cash also in Q1, which is seasonally a weaker quarter? Thank you.
Yeah, Vivek, if you look at the last one year, I think that was exactly what we said about a year ago about maintaining cash at the $1.1 billion level, well above the target minimum. As we have seen, despite a very challenging year that we have gone through, we have successfully maintained $1.1 billion of cash without, by the way, getting any external financing. With the ramp in the business that we see here at the level that we came in in Q3, and what we are projecting for Q4, and with any levers available to us if wanted, I'm very confident we can maintain cash at those levels.
Got it. Thank you.
Thank you. Our next question in queue will come from the line of John Pitzer with Credit Suisse. Please go ahead. Your line is open.
Yeah, good afternoon, guys. Thanks for letting me ask the question. Rory, I guess what I'm trying to understand a little bit better is where do you believe the trajectory of the gaming ramp kind of flattens out? You've got some benefits here in the September and December quarter with initial builds. As we look into the first half of next year, what's the right steady state run rate? I guess specifically, now that you've kind of broken through the break-even mark on the P&L, do you think you can stay above break even in what's usually a seasonally soft quarter in calendar first quarter?
Yeah. We won't be giving guidance on first quarter at this point, but clearly it's our objective to get back in black in third quarter and continue to deliver that in fourth quarter. This year is the tale of two halves, the first half and improving second half. As we look to 2014, we need to look at the full year and drive a business that drives revenue growth and profitability for the full year. That needs to be the next step in our transformation. In terms of the question about gaming is going to be an important driver of the business. If you think about consoles traditionally, that's a 5-plus year business. It generally peaks in the third year.
It will have some seasonality in the first half of the year, but we think there's strong demand and opportunity for us to continue to have very good business. We'll share the specifics of that as we give the guidance for 1Q next quarter. I think it's important to think about it, as we continue to go after this pipeline and semi-custom, we'll look to close additional deals over the next two years, one year and two years, that will allow us to continue to fill out that business with this nice sticky flow of revenue, both in embedded and semi-custom. While we're in the early phases of this transformation, as you move out and take the long view, you'll see the portfolio drive a much more consistent level of revenue moving forward.
Again, it's our objective, as we stated before, to get back in black, which we did in the third quarter, and then to move forward in the fourth quarter to continue to accelerate. For 2014, it's to drive a business that's profitable for the full year and drives revenue growth for the full year.
Thanks, Rory. As my follow-up, Devinder, do you have an inventory target for the December quarter? Can you just bring us up to speed on where we stand with the wafer supply agreement with GlobalFoundries for this year relative to your obligations that you had in Q3, Q4?
As I said in my prepared remarks, I expect inventory levels to remain essentially flat from where we ended Q3. I recall that it's a steep ramp in the business. We introduced the semi-custom products, the new products that Lisa referenced earlier, the Radeon R7, Radeon R9 series. I expect that in the Q4 timeframe, when we report the results, we'll be essentially flat to Q3. Talking about the WSA from GlobalFoundries, we are on track to meet the commitment for the 2013 WSA. On the 2014, if that's what you're referring to, we are in discussions to figure out the pricing and the wafer volumes for 2014, I expect those to close within the next 30 to 60 days.
Thanks, guys.
Thank you, sir. Our next question in our queue will come from the line of Ross Seymore with Deutsche Bank. Please go ahead. Your line is open.
Hi, thanks for letting me ask a question. One clarification from the prior question. Do you expect seasonality in the gaming console business in the first half of 2014, or is the early stage at which we are in the ramp and the geographic distribution expanding for those launches something that could offset that seasonality?
Yeah. Hi, Ross. This is Lisa. Let me answer that question. Again, the game console business is consumer business, we do expect some level of seasonality. You're absolutely right. It's the first year of launch, and there's pent-up demand. We'll see some seasonality as we go into the first half of the year, but probably a little bit different than normal years.
One other clarification for Devinder. On the gross margin guidance of 35%, what does that assume as far as sales of previously reserved inventory? Are you going to get that one point again?
Yeah, actually, that's not included. I think, as we've said earlier, we remain opportunistic. If an opportunity comes along, we go ahead and sell the parts, there are no plans to go ahead and do that at this point. We have about $40 million left of the previously reserved inventory, which we took in Q3 of 2012 to the tune of $100 million.
I guess the final question, more of a structural one as we look forward into next year. You did a great job of getting down even under the $450 million in OpEx that you've talked about. If we think about next year conceptually, how should we expect the company's OpEx to change alongside of revenues? Do you think $450 is something you can hold throughout the year? What are the puts and takes from a bigger picture perspective?
I think the key I would leave you with is, we've been very disciplined from an OpEx management standpoint. We actually beat the target of $450 that we set, and projecting to be around $450 for Q4. The thing you're going to see about AMD with the mix in the business and the changing model is we're very focused on operating margin. Obviously, if revenue goes up significantly, there's a possibility that OpEx might go up. I think you're going to see us being very disciplined from a viewpoint of how OpEx modulates against a revenue increase or decline.
Ross, I want to add a little something here to get a perspective on how we see this business evolving over time. Look at the semi-custom business and how we're reusing IP in a series of high-growth segments. semi-custom is an NRE model where there's an investment around engineering. In the quarter, we drove $300 million of additional revenue, up 26%. At the same time, we had expense decline almost 10%, following a year we've driven down 25%. Clearly, that says we're getting a strong leverage in that model. As we consider that in some of our core businesses, they'll continue to see pressure. They're at a different point in their maturity. We'll drive for higher efficiencies in those segments. At the same time, look for opportunities to make investments to capture the new growth segments, like growth businesses, like pro graphics, embedded, and semi-custom.
Overall, I think it's fair to say we will look for more efficiencies as we move forward, but it will be balanced.
Thank you.
Thank you, sir. Our next question on the phone queue will come from Romit Shah with Nomura. Please go ahead. Your line is open.
Hi, thanks for letting me ask a question. The computing results are my biggest concern looking at the quarter. Rory, you chalked up the weakness to just general softness in consumer notebooks. If I look at your numbers, the computing business was down 6% sequentially. You said desktops were up, which means notebooks were probably down more than 10%. I compare that to Intel, whose PC business was up, I think, mid-single digits, and IDC and Gartner were also up. How do we reconcile the difference between AMD's consumer business, notebook business and Intel and just the general market?
I think you kind of summed it up properly. The consumer market is feeling more pressure, All parts of the PC market are down. This market, this industry, is down 10%, and at rates it's never experienced before. It's going to continue. From our perspective, AMD is over-indexed to client notebook. We've always been. We've had, just like we have to diversify our portfolio across high-growth segments, we need to diversify this core business. We need to move stronger into desktop. As we talked about a year ago, we worked on the inventory in the desktop segment, and we built and repaired that, and we've seen two quarters of consistent revenue growth in that segment. We believe that we have the right product stack to continue to make progress in that part of our business as well.
There's no doubt that the PC client segment, particularly at the entry level, will feel pressure from tablets, it's a competitive space. We're going to be in there, we're going to compete because we have very good products. That is a key driver why we're moving in the direction of this transformation, this multi-year strategic transformation. We'll invest in those growth markets, we'll attack these base businesses around efficiency and where we can diversify the portfolio and gain revenue.
I would add from a financial standpoint, just to level set with what we saw coming and what the reset and restructure and the acceleration and transformation is all about. If you look at that particular segment from a revenue standpoint, year-over-year, revenue is down about $140 million, profitability is up about $36 million. Quarter-on-quarter, revenue is down about $51 million, the profitability went from essentially break even to what we ended up in Q3 at $22 million. That is essentially the power of the expense model, how we are deploying the resources from a transformation standpoint into what we call the growth businesses, including the semi-custom and the PC business, which obviously is under pressure.
All right, that's helpful. Then, sorry if I missed this, in Q4, embedded in the 5% sequential growth, are you assuming that computing is stable or growing?
I think from a computing standpoint, I think there's no doubt that that market will continue to see pressure, I think at the industry level as well as in the consumer segment. We're planning not to lean into that, but to manage the inventory because we'd much more like to see a consistent revenue through that weak part of 2014 where seasonality affects it. We don't want to kind of get a bumpy move there. I think we'll see it continue to trend slightly down, I think as we move into 1Q and 2Q, we can continue to build off that base as we add the new revenues as part of our strategy.
All right. Thanks, Rory.
You're welcome.
Thank you, sir. Now our next question in queue will come from the line of Joseph Moore with Morgan Stanley. Your line is open.
Great. Thank you. I wanted to go back to the wafer supply agreement question with GlobalFoundries. It looked like you had used up 46% of that as of the 2Q 10-Q. The computing solutions business looks like will be down in the second half, and I think you've moved some of that business to TSMC. I guess just some further clarity on why you're confident that you'll use the entirety amount of that.
The total amount that we committed to purchase in 2013 is $1.15 billion. Looking at the numbers that I'm looking at, we are on track to satisfy the obligation for the WSA for 2013.
Okay, great. Thanks. Then the inventory building, why do you need to maintain inventory at this level if your revenues are going only about, looks like, about $75 million in the fourth quarter?
Well, it's the timing, right? You go ahead and have the build in the inventory from a viewpoint of the steep ramp in revenue. You can have the timing from a viewpoint of when the wafers come in and then we have the pods. What we are doing from a management standpoint is over Q3 and Q4, keeping the inventory flat while the revenue has gone up 26% from Q2 to Q3 and projected to go up again in Q4. I think you need to take the longer view in terms of the six-month period, how much the revenue has gone up from the first half to the second half, and inventory essentially has gone from $600 million to $900 million. By the way, the revenue is up significantly in both quarters compared to the prior quarters.
Great. Thank you very much.
Thank you, sir. Our next question in queue comes from the line of Christopher Rolland with FBR. Please go ahead. Your line is open.
Hi, guys. How are you? Back to the op margin, the incremental op margin in graphics, probably implying mid-teens, maybe even a little bit better on the gaming console business. As we think about that going forward, once this product's really on cruise control, even if it's a couple of years from now, what sort of incremental improvements are we talking about when there's really not that much SG&A to support this, R&D to support this? I mean, are we talking maybe another 500 or even 1,000 basis points in op margin improvements at its peak?
Without giving the granularity, I'll let Lisa comment, overall, as you can see, when you have a ramp in revenue for a new business like semi-custom, there's a certain amount of money you spend from an OPEX standpoint. The semi-custom business, in particular the game console business, is built on an NRE model. The R&D costs have been incurred upfront. The gross margins, as we've been very transparent, are lower than the corporate average, the majority of that falls to the operating margin line. In Q3 alone, thinking that we were at the low double digits when we talked about it last quarter, we came in at the mid-teens. As we gain traction, as we extract more efficiencies, as we go ahead and increase the volume and get cost improvements, the operating margin could go up from the mid-teens, higher than where we came in Q3.
I'll let Lisa comment from a business standpoint, too.
The operating margins did come in a little bit better than we had originally planned, and that was primarily because the ramp was actually quite smooth, and it went very well. As we look forward, again, this is a very nice product. It's one of those, each of these products are high volume. They give us a lot of opportunity to optimize yields and costs and other things. We're going to be working hard to improve that operating margin over the next number of quarters, and it's something that we believe there's leverage in.
Chris, one of the things you've really got to think about in this business, these are just the first two wins in this semi-custom space. We have a pipeline of additional products, and it's our intention to win and mix in a whole set of semi-custom offerings as we build out this exciting and important new business. Also, as you think about that NRE model, look at the expense-to-revenue ratio. When we historically ran this business at different margins, it was much higher, the high 30s, even into the 40s. In this quarter, we saw a 10% reduction in E to R with that significant revenue gain, and we're going to drive that efficiency moving forward. Think about building that business and how the power of this model continues to grow over time.
Thank you, guys.
Thank you, sir. Our next phone question will come from the line of Srini Pajjuri with CLSA Securities. Please go ahead. Your line is open.
Thank you. Maybe for Lisa. Lisa, given that the product life in game consoles is quite long, I'm trying to understand how your own product refreshes work. For example, you're starting at 28, will these products stay at 28 forever, or are you going to switch to 20 at some point? When that happens, what happens to, obviously, the costs are going to increase, and I'm just wondering what happens to the margin side of the equation.
Yes. Srini, good question. It is a long life cycle product, over five to seven years. Certainly, when we look at cost reduction opportunities, one of the important ones is to move technology nodes. We will, in this time frame, certainly move from 28 to 20 nanometer. The reason to do that is both for pure die cost savings as well as all the power savings that our customer benefits from. I think we'll see leverage in the model as we continue to improve the cost, and as the cost improve, the volumes will also go up.
You actually expect the cost to go down as you move to 20, not go up?
Absolutely. On a unit basis, yes.
Okay. Great. Just a couple of clarifications. I think there was a mention about SeaMicro winning some designs at Verizon. I'm just wondering if you could give us an update on that business. It's been a while since you acquired that, how that's tracking, and if you could quantify how big that is, that would be great. Thank you.
Yeah, absolutely. The SeaMicro business, we're very pleased with the pipeline that we have there. Verizon was the first major data center win that we could talk about publicly. We've been working that relationship for the last two years, so it's actually nice to be able to talk about it. We do see it as a major opportunity that will give us revenue potential in 2014. We continue to see a strong pipeline of opportunities with SeaMicro as more of the data center guys are looking at how to incorporate these dense servers into their new cloud infrastructures.
Thank you.
Thank you. Our next question in queue will come from the line of Kevin Cassidy with Stifel. Please go ahead, your line is open.
Yeah, thanks for taking my question. Just for a little more granularity on the Verizon, are you only shipping a SeaMicro product with AMD Opteron, or does it also have Xeon and Atom?
Yes. The clarification around SeaMicro servers. As I said, the Verizon engagement has lasted over the past two years, some of the initial deployments were with the Intel processors, we do have significant deployments with AMD Opteron as well.
Okay. Going forward, do you think we'll switch more to Opteron?
We do see the percentage of Opteron processors increasing because that's what we would like to do.
Great. Okay. Thank you.
Operator, we'll take two more questions, please.
Understood. Our next question in queue will come from Ambrish Srivastava with BMO. Please go ahead, your line is open.
Thank you, Lisa. Since you're on a roll, I'll just follow up on the server roadmap. What's the timing for 64-bit and then with Arm? Specifically, give us some insights into, to the extent you can, on how you aim to combine SeaMicro, X86, and Arm. Thank you.
Thanks, Ambrish, for the question. Again, we're very excited about the server space. It's a very good market. It's a market where there's a lot of innovation and change. In terms of 64-bit Arm, you will see us sampling that product in the first quarter of 2014. That development is on schedule, and we're very excited about that. All of the customer discussions have been very positive. Then we will combine both the 64-bit Arm chip with our SeaMicro servers to have a full solution as well. I think we view this combination of IP as really beneficial to accelerating the dense server market, both on the chip side and then also on the solution side with the customer set.
What would be the timing for that release of a SeaMicro plus Arm?
You'll see that in 2014.
Okay. Thank you.
Thank you. We do have time for additional one questioner, and it will come from the line of Patrick Wong with Evercore. Please go ahead. Your line is open.
Yeah. Thanks for squeezing me in. I've just got two questions. First, I guess I'm a little bit confused about the way to think about the consoles to semi-custom contribution in the fourth quarter. It sounds like you guys are saying that graphics with the R7, R9 launch is probably going to be up, CPU down modestly with the market. Then, of course, earlier this morning, we heard TSMC also talk about an expectation that console would be down a little bit in the fourth quarter in terms of wafer starts. Can you just kind of help us, well, maybe give a little bit more color in terms of the type of growth that we should be factoring in into the fourth quarter?
Yes, Patrick. Let me try to help with that. If you look at the combined quarterly shipments for Q3 and Q4, they're very much on track with what we would have expected. If you look at the supply chain cycle, we buy wafers earlier to ship, and the peak months are going to be October, November. I think all of the data is consistent. We did ship a few more units in Q3 than we originally planned, just because of the strength of the production ramp. We will see game console revenue go up Q4 versus Q3, just as both Microsoft and Sony are preparing for their holiday launches.
Okay. It sounds like it's more of a timing thing. Just my second question for Devinder. I know when I take a look at your guidance, the CFO commentary, you talk about positive free cash flow in the fourth quarter. Can you help provide us the timing of your payments to GlobalFoundries? I see a liability on your balance sheet, and I know you've got another $200 million coming up in the first quarter. How does that play out, and how does that work with your positive free cash flow?
I think there are two parts to it, right? We have wafer purchases from GlobalFoundries that we have purchased throughout this year. Earlier this year, we did have some special payments that we made related to the limited exclusivity waiver that we got way back in 2012. We did have the termination payment. We made about $120 million payment of that. There is another $200 million of that left to be paid in Q1 2014. If you relate that from a cash standpoint, we have, as I projected, $1.2 billion of cash. Revenue is going to be up in Q4. When we get to Q1, we collect the cash for the revenue that we're going to have in Q4, pay the $200 million. That's where I'm projecting maintaining at the optimal range of the $1.1 billion from a cash standpoint.
I see. Okay. Thanks so much, guys.
Thank you.
Thank you, operator. That concludes today's call, we'd like you to sign us off, please.
Thank you, presenters, and thank you, ladies and gentlemen. Again, this does conclude today's call. Thank you for your participation, and have a wonderful day. You may now all disconnect.