Good afternoon. Welcome to Diodes Incorporated's Third Quarter 2018 Financial Results Conference Call. At this time, all participants are in listen-only mode. At the conclusion of today's conference call, instructions will be given for the question-and-answer session. If anyone needs assistance at any time during the conference call, please press the star key followed by the zero on your touchtone telephone. As a reminder, this conference call is being recorded today, Tuesday, November sixth, 2018. I would now like to turn the call over to Leanne Sievers of Shelton Group Investor Relations. Leanne, please go ahead.
Good afternoon. Welcome to Diodes' Third Quarter 2018 Financial Results Conference Call. I'm Leanne Sievers, president of Shelton Group, Diodes' Investor Relations firm. Joining us today are Diodes President and CEO, Dr. Keh-Shew Lu, Chief Financial Officer, Richard White, Vice President of Worldwide Sales and Marketing, Emily Yang, and Director of Investor Relations, Laura Mehrl. Before I turn the call over to Dr. Keh-Shew Lu, I'd like to remind our listeners that the results today are preliminary as they are subject to the company finalizing its closing procedures and customary quarterly review by the company's independent registered public accounting firm. As such, these results are subject to revision until the company files its Form 10-Q for its third quarter 2018. In addition, management's prepared remarks contain forward-looking statements which are subject to risks and uncertainties. Management may make additional forward-looking statements in response to your questions.
Therefore, the company claims the protection of the safe harbor for forward-looking statements that is contained in the Private Securities Litigation Reform Act of 1995. Actual results may differ from those discussed today. Therefore, we refer you to a more detailed discussion of the risks and uncertainties in the company's filings with the Securities and Exchange Commission, including Forms 10-K and 10-Q. In addition, any projections as to the company's future performance represent management's estimates as of today, November sixth, 2018. Diodes assumes no obligation to update these projections in the future as market conditions may or may not change. Additionally, the company's press release and management statements during this conference call will include discussions of certain measures and financial information in GAAP and non-GAAP terms. Included in the company's press release are definitions and reconciliations of GAAP to non-GAAP items, which provide additional details.
Also, throughout the company's press release and management statements during this conference call, we refer to net income attributable to common stockholders as GAAP net income. For those of you unable to listen to the entire call at this time, a recording will be available via webcast for 90 days in the investor relations section of Diodes' website at www.diodes.com. Please see the company's press release for more information. Now I'll turn the call over to Diodes President and CEO, Dr. Keh-Shew Lu. Dr. Keh-Shew Lu, please go ahead.
Thank you, Leanne Sievers. Welcome, everyone, and thank you for joining us today. The third quarter marked Diodes' best quarterly performance in the company's history, achieving record financial results and the sixth quarter of sequential organic revenue growth in the past seven quarters. Our consistently strong growth reflects our aggressive past design win activity and the continued market share gains at the new and existing customers, which also contributed to record automotive revenue growing 27% year-over-year, as well as record industrial revenue increasing 32% over the same time period. This above average corporate growth has resulted in those two end market combined reaching 36% of the total revenue, bringing us closer to our goal of 40%.
Diodes' solid positioning with the customers, diversified product line and the end markets, as well as continued advancement in technology and the packaging innovation, has generated exceptional performance across multi-product categories, including continued growth from our Pericom products. Worth highlighting is Diodes' significant earning power and the cash generation as we drive revenue growth with non-GAAP operating expense at our target model of 20% of revenue, which we achieved in the third quarter. In fact, our trailing 12-month non-GAAP earnings per share exceeds the two years combined total for 2016 and 2017. As we look to the fourth quarter, we expect to further extend our better than market performance as a result of our strong past design wins and the strong POS driving ongoing market share gains.
Strength in Asia is anticipated to largely offset the typical seasonality in U.S. and Europe, resulting in our guidance for revenue being down only 1.9% sequentially at the midpoint. Based on our current expectations, we are on track to reporting one of the best performing year in Diodes' history. With that, let me now turn the call over to Richard White to discuss our third quarter financial results and our fourth quarter guidance in more detail.
Thanks, Dr. Keh-Shew Lu. Good afternoon, everyone. As part of my financial review today, I will focus my comments on the sequential change for each of the line items and would refer you to our press release for a more detailed review of our results, as well as the year-over-year comparisons. Revenue for third quarter 2018 was a record $320.9 million, a 5.5% increase from $304.1 million in the second quarter of 2018. Gross profit for the third quarter 2018 was also a record at $115.2 million or 35.9% of revenue, representing a 7.4% increase on a dollar basis from $107.3 million or 35.3% of revenue in the second quarter 2018. The increase in gross margin was due primarily to favorable product mix, as well as improved capacity utilization and the continued eight-inch ramp in SFAB.
GAAP operating expenses for third quarter 2018 were $69.4 million or 21.6% of revenue, and $65 million or 20.3% of revenue on a non-GAAP basis, meeting our target model of 20% of revenue. Third quarter non-GAAP operating expenses exclude $4.4 million of amortization of acquisition-related intangible asset expenses. This compares with GAAP operating expenses in the second quarter 2018 of $69.4 million or 22.8% of revenue, and $64.2 million or 21.1% of revenue on a non-GAAP basis. Total other expenses net amounted to approximately $1.4 million for the quarter, including $2.3 million of interest expense. Income before taxes and non-controlling interest in the third quarter 2018 amounted to $44.4 million compared to $36.4 million in the second quarter 2018. Turning to income taxes, our effective income tax rate for the third quarter 2018 was approximately 29.7%.
GAAP net income for the third quarter 2018 was a record $30.9 million or a record $0.61 per diluted share, compared to GAAP net income of $25.1 million or $0.49 per diluted share in the second quarter 2018. The share count used to compute GAAP diluted EPS for the third quarter 2018 was 51.1 million shares. Third quarter 2018 non-GAAP adjusted net income was $34.5 million or $0.68 per diluted share, both of which are records. The adjusted net income excluded net of tax, $3.6 million of non-cash acquisition-related intangible asset amortization costs. This compares to non-GAAP adjusted net income of $29.3 million or $0.58 per diluted share in the second quarter 2018. We have included in our earnings release a reconciliation of GAAP net income to non-GAAP adjusted net income, which provides additional details.
EBITDA was a record $72 million or 22.4% of revenue in the third quarter 2018, compared with $64.5 million or 21.2% of revenue in the second quarter 2018. We have included in our earnings release a reconciliation of GAAP net income to EBITDA, which provides additional details. Cash flow generated from operations was $35.5 million for the third quarter 2018. Free cash flow was $16.4 million for the third quarter, which included $19.2 million of capital expenditures. Net cash flow was negative $2.7 million, including the paydown of approximately $21.7 million of long-term debt. Turning to the balance sheet. At the end of the third quarter, cash and cash equivalents plus short-term investments totaled approximately $158 million. Working capital was $386 million, and long-term debt, including the current portion, was $166 million.
At the end of the third quarter, inventory decreased by approximately $4 million from the second quarter 2018 to approximately $219 million. The decrease in inventory reflects an $11 million decrease in finished goods, a $2 million increase in work in process, and a $5 million increase in raw materials. This is the second quarter of finished goods inventory decreases, reflecting our focus on reducing finished goods inventory. Finished good inventory days were 30 in the quarter compared to 38 in the second quarter. Total inventory days were 99 in the quarter, down from 106 days in the second quarter 2018. Capital expenditures on a cash basis for the third quarter were $19.2 million or 6% of revenue and within our target model of 5%-9% of revenue. Turning to the outlook.
We expect revenue in the fourth quarter 2018 to be approximately $315 million ±3%. At the midpoint, this represents growth of 17.3% over the prior year period and down 1.9% sequentially, which is better than our typical seasonality. We expect GAAP gross margin to be 36% ±1%. Non-GAAP operating expenses, which are GAAP operating expenses adjusted for amortization of acquisition-related intangible assets, are expected to be approximately 21% of revenue ±1%. We expect interest expense to be approximately $2 million. Our income tax rate is expected to be 29.5% ±3%, and shares used to calculate diluted EPS for the fourth quarter are anticipated to be approximately 52.2 million. Please note that purchase accounting adjustments of $3.5 million after tax for Pericom and previous acquisitions are not included in these non-GAAP estimates.
With that said, I will now turn the call over to Emily Yang.
Thank you, Richard White, and good afternoon. As Dr. Keh-Shew Lu and Richard White highlighted, third quarter revenue was up 5.5% sequentially and up 12.5% year-over-year, setting a new quarterly record. Q3 distributor POS increased by 3.3%, and POP was up by 3%. Channel inventory increased 2.2% sequentially in support of POS. In fact, we had record POS results in both Asia and North America. During the quarter, customer activity remained strong across all regions as we continue to penetrate our key customer base with an expanded sales footprint. We set revenue record in 12 product categories, collectively representing 76% of our total revenue, including AC-DC, Bipolar, CMOS, LDO, ERIS, Interface, LED, MOSFET, Power Protection, SASP, Signal Integrity, Standard Linear and Switch, along with continued strong momentum in Battery Management, Connectivity ASIC, and TPMS, driven by recent design wins on new products.
Going forward, we expect to make continuous progress with expanded revenue growth, new product introductions, and design wins. Looking at global sales in the third quarter, Asia represented 78% of the revenue, Europe 11%, and North America 11%. In terms of our end markets, industrial was once again our largest representative end market at 27% of revenue. Consumer represented 25%, communication 23%, computing 16%, and automotive 9% of revenue. Starting with our automotive market, which remains a key focus area for Diodes, we achieved record revenue in the quarter, increasing 6% sequentially and 27% year-over-year. Our consistent growth in this end market is underpinned by our continued design win momentum across all application areas, particularly our three focus areas of connected driving, comfort, style, and safety, and powertrain.
In connected driving specifically, we saw continued demand for USB Type-C charging and packet switches, as well as our high demand for protection product as our growing automotive protection family offers high reliability and high performance for ESD protection, which is an important factor in today's connected cars. This portfolio includes CAN bus, LIN bus, high-speed data line protector that covers the full spectrum for connected driving applications. Diodes also continues to secure an increasing number of MOSFET designs on brushless DC motor, electric power steering, water pump, power window, electric horn, infotainment, Battery Management, and advanced driving assistant applications. Standard and application-specific products, including diodes, bridges, Zener, and TVS, also saw strong demand within automotive. Diodes' proprietary SBR technology continues to penetrate a diverse range of automotive applications, such as running daylight, Battery Management System, and infotainment.
We also saw significant revenue growth in Hall sensor design-in activities for power window, sunroof, door, tailgate, seat belts, and gear shift applications. Turning next to our industrial market, we also achieved record revenue in this end market, growing 6% sequentially and 32% year-over-year. We continue to have strong demand in our product driven by a broad range of applications, such as e-meter, smoke detectors, surveillance, lighting, solar, and power tools. We are also seeing increasing design wins for LDOs, audio, Hall sensors, and SASP product, along with SBR products. Our SBR products are ideally suited for industrial applications as they have excellent performance in high-temperature operating environments due to the proprietary SBR structure providing low and stable leakage under these conditions. For the same reasons, solar is our fast-growing target market in regions where high-temperature operation and ruggedness in the harsh environment is critical.
Turning to communication market, related to the cell phone market, our AC-DC product line has seen growing market share in mainstream smartphone charger applications. At the same time, high-end AC-DC product line has gained traction in emerging USB PD 3.0 quick chargers or power adapter applications. We also continue to see ongoing success in this market with strong designing activities, especially our MOSFET, Zener, diodes, protection products, SBR, Schottky, and Hall sensor products. We are also seeing strong demand for MUX switches to support multiple cameras in the new generation smartphone. In the consumer market, we achieve solid designing momentum across a broad range of applications such as panels, earphones, wearables, portables, smart speakers, chargers, and set-top boxes. We also continue to expand design-in and design win activity with major customers for our LED lighting products, including MR16 LED drivers and linear drivers for halogen lamp replacement.
Additionally, our PCIe Gen 2 packet switch are gaining traction in applications like office printers, and our USB Type-C ReDrivers are gaining momentum in tablets applications. Lastly, in the computing market, we continue to expand our opportunities, especially for our PowerConn products. Our SAS, SATA, USB DisplayPort, HDMI, PCIe ReDrivers, clock buffers, and signal switches, including video and USB Type-C MUX, have been exceptionally strong. We also saw strong design-in activity with our USB Type-A, USB Type-C, and DisplayPort ReDriver products as we've maintained our leading position in the PC and notebook applications. The growing demand for our USB Type-C interface on mobile internet devices and computing platforms has greatly expanded the USB-C PD interface opportunities for Diodes. As one example, our latest 3A power switch and USB PD switch are gaining increasing traction in the notebook and PC segment.
In summary, we are very pleased with our achievement of record results once again this quarter. Our product initiatives and aggressive past design win momentum has led to our above-market growth and continued market share gains. Additionally, our contact and customer expansion effort, specifically in the automotive industrial market, have resulted in this end market growing at a higher rate than our corporate average and reaching 36% of total revenue. We expect to gain increasing traction in this market as we continue to serve as key contributors to our current and future growth. With that, we'll now open the floor to questions. Operator?
Certainly. Ladies and gentlemen, if you have a question at this time, please press star then one on your touch tone telephone. If your question has been answered and you'd like to remove yourself from the queue, please press the pound key. Our first question comes from the line of Tristan Gerra from Baird. Your question please.
Hi, this is Maggie Sims on for Tristan Gerra. Thank you for taking our question. The midpoint of gross margin guidance is about flat year-over-year, yet it's on a revenue guidance midpoint implying 17% growth, presumably better mix than ASPs. Are higher raw material costs the offset to gross margin guidance, or what are other factors preempting that year-over-year growth? Should we expect that year-over-year gross margin growth to resume?
Just a second, please.
Well, I think that we continue improve our product mix. Therefore, even the revenue due to the seasonality or actually better than the seasonality, we only guide 1.9% down. We still able to maintain our gross margin at 36% or improve from 35.9- 36. We believe next year, if the 1Q could be down due to seasonality, we're hoping we'll continue improve our gross margin, especially when we start to ramp our 8-inch fab and continue improve our product mix. I'm hoping all those will be able to.
Helping us to maintain the gross margin, even we still have guidance constantly price going down, ASP decrease. I believe by those effort, ramp the 8-inch product mix and the new product, with all those effort and the cost reduction, all those efforts, I believe we should be able to maintain at least and maybe improve our gross margin.
Okay. Thank you. Given a more measured outlook into 4Q in the supply chain, do you see any impact on pricing for your products? Also, if you could talk about wafer availability and pricing with that.
Well, we typically put in 1.5% ASP reduction per quarter. That's our motto. Sometimes, we improve that ASP erosion by product mix. Currently, we still see the 4Q, we should be able to maintain our gross margin by continually improve the product mix. The utilization do not improve because our revenue actually guiding down. We don't expect our utilization going up.
Up significantly.
Yeah. Wafer fab, our eight-inch fab will continue to ramp. I think in the end of September, we are running about 6,000 wafer per month now on our eight-inch fab. We expect to about 9,000 wafer per month by end of December. In 4Q, we will still expect the ramping of our eight-inch fab.
Okay. Thank you very much.
Thank you. Our next question comes from the line of Gary Mobley from Benchmark. Your question, please.
Hi, everyone. Happy election day. I want to start with a follow-up question about the gross margin. If I recall correctly, the gross margin was negatively impacted in the second quarter because of some efforts to reduce some internal inventory. Perhaps you overshot there on your internal inventory. How much of an impact did that have on the third quarter gross margin? I'm assuming it's no longer a headwind looking into the fourth quarter.
Yeah. In the second quarter, our margin went down from 35.9 in the first quarter to 35.3. In the third quarter, it's back to 35.9. We think the impact on the margin from the effort to reduce finished goods inventory is basically done. We're holding that in the fourth quarter at 36% in the guidance.
Okay.
Basically, the SFAB inventory, we reduced it in second quarter, position us, for the inventory reduction, and it's already done. Right now, our inventory is at a very good position, and we don't see a need to continue reduce that internal inventory.
Okay. All right, just shifting gears on to the top line. As you guys are well aware, the performance of your competitors has been uneven, to say the least. It's obvious that you've got to be taking share. I guess one of the questions I wanted to pose is, which company or group of companies do you think you're taking the most share from? Are you seeing any pockets of weakness as we are wrapping up calendar year 2018?
Well, I think several times I did mention before, we have a very strong automotive growth. If you look at our CAGR in the last five years of automotive, it's like 28% a year. Even this time, you can see our automotive is at the 27% or something above last year. You can see we continue to grow faster than market growth. I think last time, I always said, it's not just say we take the market from so and so. It's really due to the automotive content increase, and we are able to get in there when the new content was put in. Since the diode was qualified for automotive, our customer can just go ahead using our product, and they increase their content. Therefore, it's very difficult for me to say we get it from so and so, we get it from this.
That's not really the case. It's since the customer increased the content, our product is available for that, and so we are able to significantly gain the design win. Okay, that's in automotive side.
Industrial, we have been continuing improve our industrial positions. Now you can see our industrial is at 27% of our total revenue. If you remember, I want to do is automotive and industrial grows to 40% of our total revenue. We are in full toward that direction, and we will continue introduce the new product, introduce the correct product for industrial and automotive need. Okay? We don't want to say we get it from which company. We just gain it from the market growth. We gaining it from the increase of the market. Even the market is flat or cool down, we will still continue gaining more market share.
Right. We really focus more on extending the content and also more dollar per box. That has been our focus.
Got you. Another one is the total solution.
We are now with Pericom, with DCD. Now we are able to offer a total solution for our customer. When we working with our customer, we are able to offer them more product portfolio than before, that's why we gain in the market share.
Last topic for me, and then I'm finished, is can you give us some updated thoughts on the impact of tariffs? That's it. Thank you.
Everybody remembers there were two tariff lists. One was in the first part of July, and the second tariff list was at the end of August. We have basically all of our products covered by tariffs now when they're imported into the United States. We are billing those tariffs, charging them to our customers, and we will continue to do that in the fourth quarter and going forward. Emily's been dealing with the customers, and it seems to be going okay right now.
All right. Thanks, guys.
Yeah.
Thank you. Our next question comes from the line of Edgar Roesch from Sidoti & Company. Your question, please.
Good evening. Congratulations.
Thank you.
Wanted to ask about, first of all, European autos. There was, to my understanding, some market disruption related to new fuel economy standards being implemented in that market. I was wondering if you felt any impact or might in the coming quarter.
Yeah. We definitely understand the change of the policy in Europe. It actually created more opportunity for us because they are a lot more focused on the electric cars and these kind of applications. From the content point of view, it created more opportunity for Diodes to engage with our partners and customers. We definitely understand what you are talking about. We actually see it more on the positive side for us.
Okay. It sounds like no production disruptions were impacting you, that is good. The second one, will the six-inch KFAB complete qualifying its customers by the end of Q4? Could you update us on that? This is the KFAB that was moved over to Shanghai.
Yeah.
KFAB to SFAB one, is what he's asking.
Well, actually, KFAB transport to SFAB one is actually completed about the end of first quarter. Fully ramped is about end of second quarter this year. Basically, that's behind us now, and that's why if you look at our SFAB one volume, it's pretty good. So far, we don't see any problem or interruption to our customer support.
Right. The majority of the customers have been transferred over to the SFAB. That, I would say, pretty much completed.
Okay, great. Just one last one. I know you've spoken about your capital spending, putting in place enough capacity to get you through the second half of 2018, if growth were to continue at its current pace, let's say, when would the decision be upon you to ramp up more? How are you feeling about that at this point?
We do not have a plan to aggressively put up the capacity. We only put up the capacity when we see very tight supply. Okay. We do not, like in the past, crazily eating up the capacity. We are now at the stage we want to gradually improve our capacity, but not significant increase. If you look at that's why we keep putting our CapEx is at 5%-9% of our revenue, and we're going to continue and keep in that area. Except our CAT, our Chengdu Assembly Site. Our Chengdu Assembly Site, if you remember our phase one, we built a building and the plating room, plating area, and office area. The manufacturing site is going to be fully utilized, the space, probably for another two years. We will be fully occupied.
We are doing now for the design, and we probably wait for another year. Next year this time, we'll start our construction and probably take one more year to finish it up. We are talking about finishing up by end of 2020 and ready for more expansion.
What we would do there is like we did in CAT 1, in the first building, we would fill it up as it's needed. We won't go just fill up the building with assembly test equipment. We'll put in a minimum line and start running that and gradually increase it over time. There won't be this huge increase in capacity that's underutilized.
That's really helpful. Thank you very much.
Thank you. As a reminder, ladies and gentlemen, if you have a question at this time, please press star then one. Our next question comes from the line of Shawn Harrison from Longbow Research. Your question, please.
Hi, evening everybody, congratulations on the results.
Thank you.
I guess, Dr. Keh-Shew Lu, as you look at the guidance into the fourth quarter being better than seasonal, are there any market verticals sequentially where you're seeing the greater strength out of Asia than you would normally see, something that you could point to to highlight this growth?
Well, actually, we're still seeing, somebody said automotive is going to slow down, but we still see a strong growth for us in the automotive area due to the content increase and due to the past design win. If you look at the last several quarter, our announcement, we always say we are very strong design win, we are very good POS, and all those result in a better than seasonality for 4Q. We don't see any particular area. We see communication has increased, automotive has increased, and industrial probably not, but communication, consumer, and industrial, we all see a good growth, or better than seasonality growth.
Got you. On the other side of that spectrum, you said industrial maybe is not growing. Are you seeing anything with maybe Chinese or Asian distribution partners getting a little bit more cautious given the uncertainty caused by the tariff situation, maybe not seeing the same level of order strength as you've seen in prior months?
Always. Actually, doesn't matter they are caution or not, always in the 4Q, by end of the 4Q or in the 4Q, this team typically don't want to carry the inventory, except Asia. U.S. and Europe, this team, for sure, no one would like to carry the inventory over the year. Now, China typically, a little bit different because Chinese New Year is in early February. Therefore, they're going to be much stronger in January. The activity in China typically will carry a little bit more inventory by end of fourth quarter to support their strong need in January, and then slow down during the Chinese New Year.
Okay. Last question. Richard White, the SG&A leverage in particular was impressive on the sequential sales growth this quarter. Was there anything specific to that other than good cost control? I guess is my question.
No, I don't think there's anything specific. If you look at the SG&A plus R&D, it's been fairly stable around the $64 million-$67 million. In the first quarter, it was $67 million. Second quarter, it was $64 million. Third quarter, $65 million. If you look at our guidance, the 21% is around $66 million in the fourth quarter. SG&A plus R&D this year has been just fairly stable every quarter.
Okay. Helpful, once again,
Remember, our business model is R&D and SG&A will be 20%-21%. Our old model is 20%, we say if we start to increase our gross margin from 35%-40% model, we might allow R&D increase a little bit. We have been stick to that business model, we are currently, it's at 20%, slightly over.
20.3%.
20.3%. We are maintaining that kind of business model.
Does that answer your question?
Thank you. This does conclude the question and answer session of today's program. I'd like to hand the program back to Dr. Keh-Shew Lu for any further remarks.
Thank you for your participation on today's call. We're looking forward to providing an update on our business next quarters. Operator, you may now discontinue.
Thank you. Thank you, ladies and gentlemen, for your participation in today's conference. This does conclude the program. You may now disconnect. Good day.