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 second 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 second 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. Our participants on today's call are Rory Read, our President and Chief Executive Officer, Devinder Kumar, our Senior Vice President and Chief Financial Officer, and in addition, we have Lisa Su, our Senior Vice President and General Manager of our global business unit, who will participate in the question-and-answer session. This is a live call and will be replayed via webcast on amd.com. Before we start, I'd like to highlight a few dates of interest for you.
Matt Skynner, our Corporate Vice President and General Manager of our graphics business unit, will attend the Jefferies Semiconductor and Hardware Summit in Chicago on August 28th. Lisa will present at Citi's Global Technology Conference on September 4th in New York. Our third quarter quiet time will begin at the close of business on Friday, September 13th. Lastly, we intend to announce our third quarter earnings on October 17th, and dial-in information for that call will be provided in mid-September. Please note, we renamed our graphics segment to Graphics and Visual Solutions. This better reflects the growing importance of gaming and semi-custom offerings to AMD. In addition, please note that non-GAAP financial measures referenced during this call are reconciled to their most directly comparable GAAP financial measures in the release and CFO commentary posted on our website at quarterlyearnings.amd.com.
Before we begin, let me please remind everyone that today's 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 cause actual results to differ materially from our current expectations. You can refer to the cautionary statement in our press release for more information. You'll also find detailed discussion about our risk factors in our filings with the SEC, and in particular, AMD's quarterly report on Form 10-Q for the quarter ended March 30th, 2013. Now with that, I'd like to hand the call over to Rory. Rory?
Thank you, Ruth. We are making progress on our three-step strategy to restructure, accelerate, and ultimately transform AMD for growth. This progress allowed us to deliver improved results in the second quarter. Revenue of $1.16 billion was higher than our guidance, as strong demand helped drive sequential unit shipment increases and market share gains across both of our business segments. With our restructuring complete, our focus in the second half of the year is on continuing to accelerate our business. We expect to return to profitability in the third quarter based on the midpoint of our revenue guidance. Our traditional PC business is heading into the typically stronger second half of the year with a competitive portfolio of new products and strong mobile design wins, particularly for systems in the $300 to $600 sweet spot of the market.
Many of these systems will be the first to bring touch capabilities down into the mainstream price points where AMD has traditionally been the most successful. We remain on track to deliver more than 20% of our revenue from our semi-custom and embedded businesses in the fourth quarter, with growth in the second half of the year primarily coming from our semi-custom SoC products for both the Sony and Microsoft next-generation game consoles. These tailored products are great examples of the opportunities we have to quickly diversify our product portfolio and enter into new markets where our IP and design capabilities provide us with a competitive advantage.
Looking more closely at our progress in the PC market, our strategy to gain share by introducing a new set of APUs and winning high-volume notebook designs across key customers by region, price point, and form factor helped drive strong double-digit sequential increases in mobile processor unit shipments. With our mobility APU launches last quarter, we now offer the broadest range of mobile processors in our AMD history. Our new elite mobility APUs scale down below four watts, while more than doubling the performance per watt compared to our previous generation. We are seeing strong adoption of these new APUs. This is particularly true of our high-volume Kabini Which is powering a number of thin and light touch notebooks that will hit the $400 price point.
Acer, Asus, Dell, HP, Lenovo, and Samsung have begun to roll out products based on our latest APUs. We expect many more systems to launch in the second half of the year. We also continue to make progress rebalancing and strengthening our channel business. The introduction of a Richland APU helped drive a sequential increase in desktop processor channel revenue. Turning to our server business. A number of large data center wins in the quarter drove sequential revenue and unit shipment increases. Additionally, we continue to gain momentum in the emerging dense server market as customers are choosing AMD SeaMicro offerings for their data centers based on the industry-leading energy efficiency, density, and bandwidth of our solutions.
We intend to further attack the fast-growing portion of the server market in 2014 by introducing our next-generation x86 APUs and CPUs, as well as our first Arm-based server product. Our years of enterprise design experience and the ability to integrate our industry-leading dense server fabric into the processor provides us with a differentiated product for this new and exciting market. Now turning to our Graphics and Visual Solutions business. Our strategy to make AMD the de facto standard for game developers continues to gain momentum as we launched the industry's fastest desktop and mobile graphics chips and cemented our position as the technology provider of choice for all three next-generation game consoles.
In the high-end enthusiast portion of the desktop GPU market, the combination of our powerful graphics products and the Never Settle game bundle program drove significant share gains and a richer mix in the channel from the previous quarter. Our professional graphics business also recorded its fourth straight quarter of growth, delivering record revenue as we continue to aggressively pursue this lucrative market. Looking at the second half of the year, we believe we have good opportunities for growth based on the PC market strengthening slightly from the first half levels and the ramp of our semi-custom business. Longer term, the 300 million-plus unit traditional PC market remains an important part of our core business, especially as the mainstream $300-$600 system price points that have traditionally been our sweet spot become an even larger portion of the overall PC market.
We will continue transforming AMD, leveraging our design expertise and IP to pursue additional growth opportunities for our semi-custom, ultra-low power client, professional graphics, dense server, and embedded solutions. We expect these high-growth businesses will account for 40%-50% of our revenue in the next two to three years. In summary, we are pleased with the progress we are making to restructure, accelerate, and ultimately transform AMD, as strong demand for our latest products drove improved financial and operational results in the second quarter. We expect to deliver significant revenue growth in the second half of the year as our strong new products position us to gain share in our traditional businesses and our first semi-custom SoC win allows us to participate in new markets.
We are on track to reach our operating expense target of approximately $450 million. We expect to return to profitability in the third quarter based on the midpoint of our guidance. We are excited about the near-term opportunities to demonstrate our efficient business model, disciplined operational focus, and diversified product strategy that will deliver consistent profitability and growth. With that, I'd like to turn it over to Devinder. Devinder?
Thank you, Rory. Phase one of our three-phase turnaround and transformation strategy is largely behind us. We are now pursuing a diversification of our product and revenue portfolio with a focus on high-growth market opportunities. As Rory mentioned, our performance in the second quarter was driven by both traditional PC and new growth opportunities, which support our business model transformation in an evolving PC market. We are on target to generate 20% of our revenue outside of the traditional PC space to semi-custom and embedded products by Q4 2013. The last phase of transformation over the next two to three years is expected to see us transition 40% to 50% of our revenue base to higher growth markets, which include semi-custom, dense server, professional graphics, ultra-low power client, and embedded products. Revenue for the second quarter of 2013 was $1.16 billion.
The 7% sequential increase was driven by a 12% increase in the Computing Solutions segment, which was partially offset by a 5% decrease in the Graphics and Visual Solutions segment. Gross margin was 40%, a decrease of one percentage point sequentially and includes an $11 million benefit from the sale of certain products previously reserved in Q3 2012. You may recall that Q1 2013 gross margin of 41% included a similar benefit of $20 million. Excluding these benefits, gross margin was flat at 39% for both Q2 and Q1 2013. Non-GAAP operating expenses were $479 million, and we remain on track to achieve our operating expense goal of $450 million by the third quarter of this year. Non-GAAP operating loss was $20 million, and non-GAAP net loss was $65 million. Non-GAAP loss per share was $0.09, calculated using 752 million basic shares.
This loss per share includes the $11 million benefit from the sale of previously reserved products. Adjusted EBITDA was $54 million, an increase of $14 million from the prior quarter due to the lower operating loss. Now switching to the business segments. Computing Solutions segment revenue was $841 million, up 12% sequentially due to significantly higher notebook and higher server and desktop unit shipments, primarily driven by demand for our new Kabini and Temash offerings, as well as our latest Opteron 6300 series of products. Client product revenue and server microprocessor revenue increased sequentially. Computing Solutions operating income was $2 million, an improvement from an operating loss of $39 million in the prior quarter. Graphics and Visual Solutions segment revenue was $320 million, down 5% compared to the prior quarter, primarily due to lower game console royalties.
Graphics and Visual Solutions segment operating income was breakeven compared to $16 million in the prior quarter. We continue to diversify our product portfolio into new markets where the competitive dynamics are different. In the semi-custom space, for example, the market is differentiated from the rest of our business as our customers engage with us very early to jointly define and fund engineering development of customized products. Development revenue and the associated costs are incurred during the development cycle of the given products. When the semi-custom products ship to the customer, we generate silicon sales, and the associated ongoing OpEx is significantly lower than our non-semi-custom products due to the upfront funded development.
The semi-custom model has the potential of providing a long-term revenue stream based on high volumes, which results in gross margin that is lower than the corporate average, but has significant revenue and earnings power as volumes ramp. Under this model, the majority of gross margin dollars fall through to operating income, and the operating margin for this business will be in the low double-digit range, more than offsetting the impact of the lower gross margin. In addition, as we transition to shipping silicon products, game console royalty revenue included in the semi-custom business is expected to decrease moving forward, although the decline will be more than offset by our growing semi-custom development and product revenues. Turning to the balance sheet. Our cash equivalents, and marketable securities balance, including long-term marketable securities, was $1.1 billion.
During the quarter, AMD made a $40 million cash payment to GlobalFoundries related to the 2012 wafer purchase commitment reduction and exited the quarter at our target optimal cash level and well above the target minimum cash level of $700 million. Debt as of the end of the quarter was $2 billion, flat from the prior quarter. Inventory was $711 million, up $98 million sequentially, largely driven by semi-custom products and the ramp of new products in the PC space to support growth in the second half of the year. Accounts payable at the end of the quarter was $402 million, up $101 million compared to the end of the first quarter of 2013 due to the timing of purchases and payments.
Depreciation and amortization was $54 million, down from $62 million in the prior quarter, primarily due to the sale and lease back of our Austin, Texas, Lone Star campus. Now turning to the outlook. For the third quarter of 2013, AMD expects revenue to increase 22% sequentially, ±3%. Gross margin is expected to be approximately 36%. Despite expecting revenue to increase significantly, quarterly operating expenses are expected to decline approximately 6% sequentially to around $450 million. Expense management will continue to be a focus area for us as we move forward. At the midpoint of revenue guidance, AMD expects to be profitable at the net income level. Inventory is expected to increase sequentially to approximately $800 million, largely based on semi-custom product builds.
We expect inventory to remain at those levels for the coming quarters, consistent with the ramp of our semi-custom business, and cash is expected to remain flat sequentially at approximately $1.1 billion. In summary, in the third quarter, we will build on the strong foundation we have established as we remain laser focused on execution and returning to profitability in the third quarter and positive free cash flow generation in the second half of the year. With that, I'll turn it back to Ruth. Ruth?
Thank you, Devinder. Operator, we'd be happy to poll the audience for questions now, please.
Yes, ma'am. Ladies and gentlemen on the phone lines, to queue up for a question, please press star then one on your touch-tone phone. If your question has been answered or wish to remove yourself from the queue, you may press the pound key. Again, if you would like to ask a question at this time, please press star then one on your touch-tone phone. One moment for questioners to queue. Our first question in queue will come from the line of Vivek Arya with Bank of America. Please go ahead. Your line is now open.
Thanks for taking my question. First question. Could you help us really differentiate between the growth prospects for your traditional PC and server segments versus the game console opportunity in Q3? If you could give us any initial sense for Q4.
Sure, Vivek. As we look forward, we see a continued opportunity in the PC segment. While we see it only slightly stronger than the first half, and I believe down year-over-year, I think there's an opportunity for us with our stronger product portfolio to continue to build on the momentum that we saw in the second quarter. Clearly, the market is moving down into the entry and mainstream price points where we've played very well, and I think this is a very good opportunity for us to continue to build share. Now, having said that, clearly the momentum and acceleration of revenue will come from the new segments as well as off of that initial base. But those SoCs that we won in semi-custom are going to be a key driver moving forward in 3Q as we've guided.
Just one follow-up on that, Rory. I think yesterday Intel guided to about a 5% or so sequential growth in their PC and server segment. Is that roughly how we should be thinking about your traditional business and then whatever is left is the new opportunity?
Well, I see the overall PC market in the second half growing in that mid-single digit level. What I'd like to do is to achieve that or exceed that so that we could slightly gain share.
Got it. One last one for Devinder. Devinder, I think you mentioned low double-digit operating margin from the new wins that you have in consoles. I assume that is exclusive of the royalties. Is that an initial profitability level and does it get better than that, or is that sort of a run rate level over time?
I think we're giving guidance for Q3 and guiding to the low double digit from a Q3 standpoint. As you can imagine, this business, the semi-custom business and game console in particular, has a long lifeline and over time, the mix between the ASPs and the cost can change. Looking out to the future, it's hard to tell, but at least at the starting point for the next couple of quarters, I'd peg it at the low double digit.
Got it. Thank you very much.
Thank you, sir. Our next question will come from Joseph Moore with Morgan Stanley. Please go ahead. Your line is open.
Great. Thank you. Also on the console questions, how does the pricing work to you guys? Is it on a good die basis? Is there any kind of yield risk to your profitability there? I have a follow-up on that.
Joe, this is Lisa. The game console SoCs are really as we would do. They're wafers that we expect good, solid yields from. We've had very good bring up, we're looking good with the prospects.
Okay, great. Then how do you think about the ASPs in that business over the next number of years? Is that a volume-based thing? Is there a time? Are there times when prices come down, or just how does the price negotiation work over the course of the next few years in that business?
These are long-term deals that we have with the customers, given the range of the length of the design win. These are pre-negotiated.
Joe, what you would expect is you would expect what we've seen in the historical trends around game consoles. These generally run somewhere between five and seven years, and you would expect that over time, the prices would move lower, but obviously expense and cost would move with it. What's powerful about this business is you can see a significant increase in our revenue quarter-to-quarter as we begin to ramp this. At the same time, you see our expense level decline by almost $30 million to the 450 level, showing the benefit of doing that NRE customer-funded development and how it flows through to the bottom line at that double-digit level.
Great. Thank you.
Thank you. Our next question will come from Ross Seymore with Deutsche Bank. Please go ahead. Your line is now open.
Hi, everyone. Congrats on the solid report and guide. First question, looking back just briefly, the upside that you had, can you walk through a little bit of what drove that surprise? I know the Computing Solutions group was up 12%. Was that mainly the Temash uptake? Any more color you can give us there would be helpful, please.
I think we saw strong momentum in the new product segments and obviously Temash and Kabini did well. I think Lisa's seen a good uptick in the graphics arena as well, and in the desktop channel area. We basically saw it in every part of our business, progress quarter-to-quarter. Of course, we're building off of that lower base as we saw the market fracture at the end of last year. That's a good foundation given these new products and the uptake that we've seen there.
Is the ASP decline also driven by the new products, it's a strategic decision and part of addressing those notebook price points that you mentioned earlier, Rory?
Well, from my perspective, what you're going to see is basically a mix discussion. We saw a good performance in our entry and mainstream price points, and I think it's basically a mix area. We're focused on moving up the stack with the Richland offering, as well as balancing that off with the new SoCs from the gaming and server areas. I'd say it was mix, Ross.
Great. I guess one final question on the gaming side of things. How do we think about eventual seasonality in that business? Do we have a good two, three-quarter ramp before we even have to worry about that?
Yeah, Ross, this is Lisa. I think the way to think about game console seasonality is like any consumer business, the first half is usually lower than the second half. Of course, we're in the middle of the ramp process, so the second half of this year will be the ramp of the consoles. I would expect the first half would be weaker as most consumer cycles are.
Even in the first half of 2014, is the ramp probably going to overcome any seasonality at that point?
I would still expect a typical consumer seasonality.
Got you. Great. Thank you.
Thank you, sir. Our next question will come from John Pitzer with Credit Suisse. Please go ahead. Your question, please.
Good afternoon, guys. Thanks for letting me ask a question. Lisa, maybe as a follow-on to that Ross Seymore question, given that we're early in the ramp phase, any way of quantifying the sequential ramp in gaming from Q3 to Q4 to kind of hit some of the unit numbers that are out there in the popular press as to how many of the gaming systems might be built for the Christmas holidays? Any way to give us some sort of color of how much of that's falling in Q3 versus Q4?
Yeah, John, that's hard to say given that the customers are really dictating their ramps. I will say that, as Rory said earlier, a strong part of our guidance in the third quarter is as a result of the semi-custom ramp, and we expect to ship a number of units over both the third quarter and the fourth quarter.
Helpful. Rory, you guys did a good job kind of helping us understand the profitability in the gaming systems. I'm just kind of curious, as we see the launch of new products in the core compute and server market, you're slightly above a break-even operating level in the June quarter. How do we think about profitability in the core business, especially given that you gained market share in the second quarter? Break-even was probably a little bit lower than I would have expected. How does that sort of track through the second half of the year with these new products and market share gains?
Well, I'm actually pleased with the progress to move back to profitability at the midpoint guidance. Driving to that level is something we've talked about over the past three, four quarters. I think we're executing well to deliver that. You're seeing a movement in the revenue up and the control of the expense down and a nice new set of products that are coming out. That I believe we can continue to build on. The PC segment, as I talked about earlier in the call, the market's choppy. There's no doubt that market will continue to be choppy the next 12, 18 months. In spite of that market's over 300 million-plus units. That's a great opportunity for us and a key component to our future strategy. We want to grow, and we want to take share there.
Now, to augment that and to balance off our expense and reuse our IP, let's take that IP and technology and apply it into these new high-growth segments. You're beginning to see the power of that model emerge here in the 3Q quarter. Now we have to execute, we need to execute through the end of the year. That's the fundamental structure of the business model Devinder and I and the team are creating.
Thank you.
Thanks, John.
Thank you, sir. Our next question will come from David Wong with Wells Fargo. Your line is open.
Thank you very much. Given the pre-negotiated pricing patterns you have for the game console chips, once you're at full volumes, do you expect your annual revenues to grow each year, or should we expect them to be fairly flat once you're at full volume, with unit growth being offset by pricing declines?
Yeah, I think what's important to think about, David, is we're talking about third quarter guidance next. As we go through this process, I think what's best for you is to look at the historical game console trends over time. I think that's a pretty good indicator of how this business goes. For us, I think there's a very good opportunity for us to build on this. Of course, Lisa and her team are continuing to build the pipeline in the semi-custom business to attack areas in the server segment, in the home segment, areas where graphics and our technology will play. We want to continue to build out this custom momentum so it becomes a very substantial portion of our business going forward. I think it uniquely positions AMD to create differentiated solutions with our customers, David.
Okay. Sort of related to this, you guys had said low double-digit operating margin for the console chips. Does that put gross margin in the mid-teens?
We wouldn't talk about gross margin at that level of the business. Devinder's got commentary that shows you in the two business segments that we talk about. I think what you're going to see is that that business is a good business for us with significant revenue growth, managing the expense profile moving forward, flowing profitability to the bottom line, that's what we've talked about as part of our strategy to diversify the portfolio.
Okay, great. Thanks so much.
Thanks, David.
Thank you, sir. Our next question will come from Hans Mosesmann with Raymond James. Please go ahead. Your line is now open.
Thank you. Congratulations on the outlook. A comment or a question regarding your positioning with Temash and Kabini with a one or two-quarter lead over the upcoming Bay Trail. What is the competitive positioning or the advantage that you have besides being first to market versus that device that Intel's going to be shipping later in the year? Thanks.
Yeah, Hans, if you look at our Temash and Kabini offerings, I think we're very pleased with overall performance, both on the processing side and the graphics side, and the adoption through the OEMs. We do have a time-to-market advantage, and that proves good when you look at the systems that will be on the shelf both starting this quarter and into the summer. As we go forward, we think we're well-positioned versus Bay Trail as well. I think this is an important segment for us to continue to grow in, and that's our plans.
Thank you.
Thank you. Our next question will come from Christopher Danely with J.P. Morgan. Please go ahead. Your line is open.
Hey, thanks, guys. Can you just maybe comment on the expected trend line of OpEx after this quarter? Then, since you're opening up the kimono on the gaming opportunity, maybe talk about some of your goals for the combined growth and operating margin targets longer term for the company.
I think the way I would look at it, Chris, is the following, right? We are on target to hit the $450 million in Q3 of 2013. Beyond that, we're going to be laser focused to look at the mix between the OpEx and the revenue. As Rory talked about, as the revenue evolves over time, whether it's a semi-custom business or the traditional business that we have, we keep an eye on that. If you take for a moment that there's going to be an uplift in revenue, we're going to watch that very carefully. What I would say is the increase in OpEx, if any, would be significantly lower than the increase from a viewpoint of the revenue, is the way I would look at it. This is really moving to a model which is very different than we have had in the past.
With the OpEx reductions you're seeing in Q3 with a significant increase in revenue, it demonstrates the earnings power of the model, in particular, when you have a business that can drop low double-digit to the operating margin and help, obviously, the bottom line from an overall standpoint.
Chris, on the expense side, very important to think about how we're working on our overall processes and execution. The idea of an ambidextrous architecture and reusable IP, this is what you're seeing. The power of Jaguar as a core showing up in semi-custom offerings into server chips into all the way to client chips. This is the model that we're on the journey that we're taking to dramatically improve the efficiency of how we create SOCs, leverage our IP. We've been investing to go get some of the best industry talent and Mark Papermaster's team and Lisa's team to really build out that technology leadership. It's around that expense part that you want to see us continue to manage this very tightly. We should not be scaling that in a significant way moving forward.
The combined margin target for the company, would you care to update us on that?
It's 36% this quarter. That's the mix of the revenue that we have going from Q2, Q3. We're not giving long-term guidance of our gross margin at this point.
Sure. Then just one housekeeping item. You mentioned that you're ramping the gaming opportunity this quarter. Should we think of the gaming opportunity as being the primary driver for growth in Q4, or will the ramp be done by the end of this quarter?
Q2 to Q3, the gaming opportunity is the primary driver. We're not talking about Q4 at this point.
Got it. Thanks.
Thank you.
Thank you, sir. Our next question will come from Stacy Rasgon with Sanford C. Bernstein. Please go ahead. Your line is open.
Hi, guys. Thanks for taking my questions. First, you said that you have obviously the game console royalties that are there now rolling off. My understanding, that was about, on an annual basis, $100 million-$150 million a year. So if you're running with low double-digit operating margins in the console business, even at $1 billion a year in revenue, that seems to be just enough, basically, over the long term, to offset the loss in game console royalties. Number 1, I guess, is the magnitude of those numbers correct, and is that the right way to think about this?
I can't comment on the magnitude of those numbers, as you can imagine. What I can tell you is, over time, as our business model is transitioning, we're going to be in the silicon and development NRE model in the semi-custom business. What you should look at it from an overall standpoint, whatever you peg the revenue to be for that business, the fall through to the operating margin line, because we're going to be very operating margin focused, as opposed to the traditional historical gross margin outlook that everybody has been focused on the AMD model. Because this is truly a transition, going from one business model that we have had in the history of the company to where it's evolving into more focus on operating margin as opposed to gross margin alone.
Got it. It is fair to say that the loss of royalty revenues is going to impact any gains in operating income from the console business.
That depends. It's all speculation, depending on how much the increase is in the semi-custom and game console business. It's hard to really speculate on that.
Okay, great. I have one more quick question. This has to do with your wafer commitments to GlobalFoundries. I think right now, your current commitments for this year, $1.15 billion. That is flattish to last year in a PC environment that, even according to you guys, is right now kind of anything but flat. Are all of the console chips being made at TSMC, or can any of those console chips actually go to satisfy your wafer commitments to GlobalFoundries? If not, is there a risk of a repeat of last year, where you had a big shortfall? I think you're even still on the hook to pay for about $200 million in wafers that you didn't need in 2012 and pay for those in the first quarter of 2014. What's the risk around the wafer supply agreement giving a difference with Global-
Yes. Many points you made, I think the key thing I would leave you with is, we do have a commitment this year, as you called it, of $1.15 billion. We are on track to meet the commitments. As we finish half the year here, approximately half of those obligations have been extinguished. The $200 million that you referred to is part of the termination that we did for 2012 when the market took a downturn, and that $200 million is due in our Q1 2014.
Does that imply that some of the console chips actually are being made at GlobalFoundries? Because I don't see how you could have flat wafer commitments otherwise.
We don't share level of detail in terms of our foundry strategy or where we make products between the foundries.
Okay. Thank you, guys.
Thanks, Stacy.
Thank you, sir. Our next question will come from Ambrish Srivastava with BMO. Please go ahead, your line is open.
Hi, thank you. I'm just curious, Devinder and Rory, why would you not answer the long-term operating margin question that Chris was asking? I understand it, that the business is in transition and there are a lot of moving parts. Devinder, you said that you are running the business with the operating margin focus. What is that focus? I get it, that the 450, you've just delivered on the 450 and the breakeven. Just trying to understand longer term, what are all the uncertainties that prevent you from giving us a longer-term target? Thank you.
I wouldn't classify it as uncertainty, let's just go through what we have said from an overall standpoint. We are on target to get to 20% of embedded semi-custom by Q4 of 2013. We've also said very publicly that longer term, we are targeting 40%-50% of our revenue to higher growth markets, some of those businesses have higher than corporate average gross margins. You can imagine, as we sit here in Q3, in essentially the first quarter, we are transitioning in a significant manner to a mix of revenue that's very different than what we have had in the past, there is going to be a transition over time because it's 2-3 years to get to the 40%-50% mix. That can obviously has an impact on revenue, ASPs.
It can have an impact on the gross margin, finally, the all-important, from my standpoint, the operating margin, because that's what flows to the bottom line of the EPS. It's a transition, you're asking for the longer-term model to be laid out in the first quarter where the transition is occurring, that's just difficult to do.
Yeah. Remember, we're executing a three-step turnaround strategy. We did the reset and the restructure. We've completed that. We're in the beginning of the turn and the acceleration as we execute the product plan and the move, ultimately, we transform the company to that 40%-50% of the mix in a diversified portfolio on those high-growth segments. We're about four quarters, three quarters into this transition, we're right on track on that strategy.
Okay, that's helpful. Thank you, guys.
Thank you, sir. Our next question in queue comes from Romit Shah with Nomura. Please go ahead. Your line is open.
Hey, thanks for taking my question. Just on gross margin, I want to understand if there's more than one moving part driving gross margins from 39%, 40% down to 36%. Is it just the higher mix of console, or are there other factors as well? Thanks.
Yeah. I think going from Q2 to Q3, primarily it's the higher mix of the game console business that's driving from the 39%, 40% to the 36% guidance that we're providing.
Devinder, for computing, are computing margins going to improve sequentially in the third quarter?
I'm not going to give that level of granularity. I think you can make the assumption that they are generally stable. We've been running at a 39%. If you go back and adjust for the benefit we got from the sale of previous reserve inventory, we've been 39% for the last three quarters. I think if you want to make an assumption, it's pretty stable.
Okay. The final question for Lisa. You referred to the traditional consumer electronics market, I think in reference to a question about seasonality. Do you guys have any clues or insight on how to think about this console business and the ASP declines that you may see in the upcoming year?
Again, if you think about this, these are usually long life products, and over five to seven years, you will see cost reductions go into place. I think we've been clear that the business is a long-term business and we'll continue to service it over that period of time.
All right. Thanks.
Thank you.
Thank you, sir. Our next question in queue comes from Cody Acree with Williams Financial. Please go ahead. Your line is now open.
Thanks for taking the question, and congrats on the progress. Lisa, on the embedded processing side, I know that you guys have been working for quite some time on the console business. Can you just talk about maybe what the next opportunity, maybe applications or end markets that you're targeting and maybe when we might start to see some of those layer in?
Yeah, absolutely. The semi-custom and the embedded are both two important growth markets for us. Semi-custom has been so far dominated by gaming, but we see a lot of other opportunities. We have a strong pipeline that can similarly use our graphics and computing capability. Some of the markets are things like other consumer specialty servers, those types of markets. Embedded processing is also important to us, and we see in those markets, x86 being very valuable in industrial and medical and other casino gaming type opportunities. We've been continuing to build that pipeline as well. Those design wins tend to be longer in nature and take about 12 to 18 months to get into production. That'll be more of a 2014 phenomenon to see growth.
Great. Thanks for the help. On x86, you're moving forward with both an Arm and an x86 strategy. We're seeing Intel do similar on density on x86. In the server side, if x86 can reach a similar density and power savings, do you believe that there's still as large of a need for an Arm alternative?
I think, really, we view Arm and x86 as two important ecosystems that are out there in the industry. x86 will always continue to be very important in both the PC and the server market, but we see Arm being important with new markets, especially new operating systems, as well as some of the high volume data center applications. Yes, there will be a market for both Arm and x86, and I think that's one of the unique things that we can bring over the next few years to the marketplace.
Just following there then, with your multi-pronged server strategy, and the reductions in some of the headcount you've had to go through, how confident are you that you're going to be able to address all of those different tracks without stretching your resources too thin?
Yeah, that's a good question. I think the most important thing for us as a company is, really the focus that we've been working on over the past 12 to 18 months has been around reuse and getting a strong reuse across our IP portfolio. Whether you're looking at our client, semi-custom, embedded, or server markets, they use the same cores technology, the same graphics technology, and we bring that together in the solutions for each market.
Great. Thanks, guys. Good luck.
Thank you, sir. Our next question comes from Jim Covello with Goldman Sachs. Please go ahead. Your line is open.
Great, guys. Thanks so much for taking the question. I appreciate it. I thought that David Wong and Stacy had some good questions. I just wanted to try to follow up on those a little bit, if I could. Maybe another way of asking what they were asking was, if you guys do not get other wins with these APUs, this is a gross margin dollar neutral transition in gaming. Is that correct?
I don't know what you mean by that question.
The point that Stacy is bringing up, you lose in operating income and royalties, what you gain in operating income from APUs. Net, it's a zero operating margin dollar exchange. Theoretically, you have the opportunity to leverage these platforms to gain additional opportunities.
Jim, we have a real significant opportunity in these high growth segments to drive over the next two to three years, to 40%-50% of our revenue. That means these businesses are going to get significantly bigger. I think there's an opportunity for that to create very accretive and consistent profitability as we move forward.
Okay. No ability to get any granularity specifically on the first question I asked?
I think we did.
Okay. Thank you. I appreciate it.
Thanks, Jim.
Thank you, sir. Our next question will come from Christopher Rolland with FBR. Please go ahead. Your line is open.
Hey, guys. Thanks for taking the call and great quarter. Sorry to harp on the OpEx stuff, but, if you could talk about the gaming consoles expenses, either on an absolute basis or at least an anecdotal basis, what are the, call it R&D and SG&A costs involved in supporting a launch like this, and how do we sort of think about that over time? Thanks.
I think I said in my prepared remarks, when you look at the semi-custom model from a game console standpoint, it is a very different model. It's a model where the costs are upfront, funded jointly between the customer and us. You incur the cost, you go ahead and introduce the product, and at the time of product introduction, you get the sales. It's lower gross margin than corporate average, but a majority of the gross margin dollars fall to the operating margin, and that's the benefit that we get at the bottom line from an overall standpoint. As far as the details of the business and how you manage it between the sales marketing G&A and R&D, I'll let Lisa comment in a second on the R&D and G&A.
From a marketing standpoint, I can tell you that there's not much, because essentially we are selling products to captive customers in this case, and they do the marketing for their end product with consumers, and we supply the product. Lisa?
Yes. Maybe to add a little bit more color to that. The way these products are defined, we jointly define it with the customers. We leverage IP that we have across our base businesses, and then there's an engineering recovery done for the specific customization. Really no measurable sales and marketing expense, just given that it's a discrete customer set. The E/R ratio is substantially lower than our corporate average.
Okay. Do you guys see some synergies here, perhaps with these next gen consoles, with PC gaming, sort of driving sales of AMD graphics cards? Like for example, might some game developers optimize specifically for an AMD GPU or APU, or is that sort of a stretch there? Are there any sort of network effects here from gaming consoles across to PC?
Yeah, no, we definitely believe there's a great synergy between the game consoles and the overall PC gaming market. I think gaming is one of the key pillars of AMD and our graphics and APU strategy. Having the game consoles on the same graphics architecture does allow synergies in the software development and the work that we do with ISVs, we're pursuing that quite aggressively.
Yeah, there's no doubt the PC gaming segment is one of the best-performing segments in the overall PC market. With this move of the game consoles, you see the key game developers writing to the technology first, we should expect better performance and better time to market based on that. This is clearly a franchise business that will spread across and create a network effect.
Thanks, guys.
Thank you, sir. Our next question will come from Patrick Wang with Evercore. Please go ahead. Your line is open.
Great. Thanks a lot. My first question, you guided for about $800 million of semi-custom inventory build this quarter. Presumably a good chunk of that ships in time for the holidays. Can you give us some color to help us think about that and perhaps maybe a sense of how much revenue this supports?
Yeah, just to correct it, if that's what we said, that's how we intended. It's not $800 million game console inventory. There is inventory in the traditional business, actually predominantly it is in the traditional business. The growth in the inventory that I talked about going from Q2 to Q3 is primarily in the game console business to support the ramp that we are seeing in the second half of 2013.
Okay, gotcha. I appreciate the clarification. That's the incremental inventory, which ship by the fourth quarter.
With the products that we build for the customers, obviously there's a time lag in terms of getting the wafers and taking to the line and shipping to the customer. When you have a steep ramp in revenue like we are seeing from Q2 to Q3, you are going to have the increase in inventory probably ahead of the time of the ramp. We ship the product essentially after we finish making it through the assembly and test processes.
Gotcha. Thanks for correcting me there. Secondly, it sounds like you plan to be cash flow positive either, I guess, this quarter or in Q4. Great job turning that around. I'm just wondering, is this accurate? How do we think about the timing of your remaining payments to GlobalFoundries this year outside of the $200 million in Q1?
Two things I'll say about cash. We've said even earlier this year, we plan to be free cash flow positive in the second half of 2013, we are on target to do that. The other thing we have been saying consistently is maintaining cash at the $1.1 billion level optimal range. We've done that for the past several quarters. In spite of the payment that's coming up in the Q1 2014 timeframe, I can say that we should be maintaining cash at the $1.1 billion optimal zone level through that timeframe and even in the Q1 2014 timeframe.
Okay, great. Thanks. Last question. Rory, you talked about the dense server focus. Obviously some of the tailwinds you're getting in SeaMicro. Can you talk about the size of that business today that you've got, maybe a few catalysts you see on the horizon, also when you think that could hit maybe, I don't know, 10% of sales?
Patrick, from our perspective, we comment on the overall server business. We saw a good solid quarter out of that. We believe that we took share in that server segment. Key to that growth is that dense SeaMicro solution. We are really focused as well on the traditional server. There's opportunities with APUs in the dense space, and of course our announcement around Arm server. I think this is a nice combination of server offerings to move forward and build on.
Okay, great. Thanks a lot, guys.
Thank you, Patrick.
Operator, we'd be happy to take two more questions, please.
Yes, ma'am. Our next question in queue comes from Shawn Webster with Macquarie. Please go ahead. Your line is open.
Great, thanks. For Q2, you guys said that chipsets were flat, and when I do the bottoms-up with the down ASP quarter for your microprocessors, I'm getting up something like 15%-20% sequential unit growth for Q2 for microprocessors versus the down, let's say, 1% for the global PC market. Can you help us understand or parse through maybe how much of that was your channel inventory rebuilding, which it sound like some of that was happening, some new wins, and anything else, or share gains? It seems like a very strong growth for Q2.
Yeah. As we said, we did have a good quarter in the Computing Solutions Group. When you look at the breakdown, I would say that we had very strong notebook shipments, and that was across our new product portfolio. We also had a little bit of pickup in desktop, but I would say that that was more modest than the notebook side.
Can you characterize how you think inventories are sitting right now at your OEMs and in your channel?
I would say they're typical.
Normal levels? Okay. Just another final quick one. The written-down inventory benefit that you saw in Q2, is most of that out of the system at this point, or are there still parts that you can sell at no cost going forward?
There is some left. We had $100 million that we took as a write-down in Q3 2012. We had $20 million of that sold in Q1. We sold $11 million in Q2, and that's the benefit that I disclosed to the gross margin. We have about $65 million left. We don't see anything on the horizon right now, but as I said previously, we're very opportunistic, and if something comes along and somebody wants those parts, we'll go ahead and sell those parts.
Okay, great. Thanks a lot, guys.
Thank you, sir. Our final question will come from Glen Yeung with Citigroup. Please go ahead. Your line is open.
Thank you. Lisa, a question for you about the mix you're seeing in the PC client business. Just trying to understand if you're seeing any changes in your mix of product, does that tell us something about the mix of the PC market? Specifically, I'm trying to understand if you think there's a downshift to lower price points in PCs.
Yes, Glen. If you look at our mix, we have typically been stronger in those lower price points in the, let's call it the $300-$600 system range. We have seen strength in that area. Overall, I would say our mix has shifted a little bit to the lower end, and I think that's typical of the overall market.
Just as a follow-up to that, Intel now is openly saying that with Bay Trail, they're one, going to allocate a bit more resources to that part of the business. Perhaps more importantly to you, it sounds like they're going to focus more in that mid-range, mid-to-low range part of the market. Is your sense that, one, they'll be more competitive there, then two, what are your thoughts around the implication of that to your share and margins in that part of the business?
I think it's fair to say that that's where the market is focused. The customer focus as we get more Windows 8-based touch systems into that more mainstream price point. I think that's a market shift. Clearly, it's important to stay competitive in that area, and we're continuing with our new product portfolio to do that. I think overall, we'll continue to focus in that area and continue to be quite competitive.
Fair enough. Thanks.
Operator, that concludes our second quarter earnings call, and we'd like to thank everybody for participating, and if you could close the call, we'd appreciate it.
Sure thing. Thank you, presenters, and thank you, ladies and gentlemen. Again, this does conclude today's conference. Thank you for your participation, and have a wonderful day. Attendees, you may log off at this time.