Good afternoon, and welcome to Diodes Incorporated second quarter 2018 financial results conference call. At this time, all participants are in a 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, August seventh, 2018. I would now like to turn the call over to Leanne Sievers of Shelton Group Investor Relations. Leanne, please go ahead.
Good afternoon, and welcome to Diodes second 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. Lu, I'd like to remind our listeners that the results announced today are preliminary as they are subject to the company finalizing the 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 second quarter 2018. In addition, management's prepared remarks contain forward-looking statements which are subject to risks and uncertainties, and 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, and 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 Form 10-K and 10-Q. In addition, any projections of the company's future performance represent management's estimates as of today, August seventh, 2018. Diodes assumes no obligation to update these projections in the future as market conditions may or may not change, except to the extent required by applicable law. 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. And now I'll turn the call over to Diodes President and CEO, Dr. Keh-Shew Lu. Dr. Lu, please go ahead.
Thank you, Leanne. Welcome everyone, and thank you for joining us today. Diodes achieved a number of key milestones in the second quarter, reaching record level across multiple financial metrics, driven by continuous revenue growth, market share gain, and further traction of our Pericom product. Our exceptionally strong performance reflect record sales in both our automotive and industrial end markets, which contributed to new record revenue level being achieved across all regions. Our automotive revenue was up 50% year-over-year, and our industrial revenue at 27% of total revenue was the first time that industrial was our largest representative end market. Additionally, through revenue growth, we continued to decrease in operating expense as a percent of the revenue, also contributing to our achievement of record EBITDA and record non-GAAP earnings per share in the quarter.
In fact, EBITDA increased over 40% and the non-GAAP net income over 60% as compared to the prior year period on revenue growth of 15%. This further demonstrate the significant leverage in our operating model. As a result, we generated strong cash flow that enabled us to further pay down our long-term debts. Also, highlighting those solid results is our expectation for continued growth in the third quarter, where we expect to again set new records across our business. Our strong results and the growth this year has positioned us with the potential to achieve our most profitable year in the company's history. With that, let me now turn the call over to Rick to discuss our second quarter financial result and our third quarter guidance in more detail.
Thanks, Dr. 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 the second quarter 2018 was a record $304.1 million, a 10.8% increase from the $274.5 million in the first quarter of 2018. GAAP gross profit for the second quarter 2018 was also a record at $107.3 million, or 35.3% of revenue, representing an 8.8% increase on a dollar basis from the $98.6 million or 35.9% of revenue in the first quarter 2018. Pricing improved in the second quarter versus first quarter, which offset some lower margin inventory sales due to our inventory reduction efforts.
GAAP operating expenses for the second quarter 2018 were $69.4 million or 22.8% of revenue, and $64.2 million or 21.1% of revenue on a non-GAAP basis, which excludes $4.7 million of amortization of acquisition-related intangible asset expenses and approximately $500,000 of KFAB restructuring costs. This compares with GAAP operating expenses in the first quarter 2018 of $71.7 million or 26.1% of revenue and $64.7 million or 23.6% of revenue on a non-GAAP basis. First quarter included $2.6 million of officer retirement expenses, which were not repeated in the second quarter. Total other expenses amounted to approximately $1.4 million for the quarter, including $2.5 million of interest expense. Income before taxes and non-controlling interests in the second quarter 2018 amounted to $36.4 million, compared to $26.3 million in the first quarter 2018. Turning to income taxes. Our effective income tax rate for the second quarter 2018 was approximately 29.5%.
GAAP net income for the second quarter 2018 was a record $25.1 million or $0.49 per diluted share, compared to GAAP net income of $18.5 million or $0.37 per diluted share in the first quarter 2018. The share count used to compute GAAP diluted EPS for the second quarter 2018 was 50.8 million shares. Second quarter 2018 non-GAAP adjusted net income was $29.3 million or $0.58 per diluted share, both of which were records. The adjusted net income excluded net of tax, $3.8 million of non-cash acquisition related intangible asset amortization costs and $400,000 of restructuring expenses. This compares to non-GAAP adjusted net income of $24.2 million or $0.48 per diluted share in the first 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, which represents earnings before net interest expense, income tax, depreciation, and amortization, was a record $64.5 million, or 21.2% of revenue in the second quarter 2018, compared with $54.2 million or 19.7% of revenue in the first quarter 2018. Cash flow generated from operations was $34.4 million for the second quarter 2018. Free cash flow was $13.1 million for the second quarter, which included $21.4 million of capital expenditures. Net cash flow was a negative $30.1 million, including the paydown of approximately $36.1 million of long-term debt. Turning to the balance sheet. At the end of the second quarter, cash and cash equivalents plus short-term investments totaled approximately $160 million. Working capital was $380.8 million, and long-term debt, including the current portion, was $185.8 million. At the end of the second quarter, inventory decreased by approximately $14 million from the first quarter 2018 to approximately $223 million.
The decrease in inventory reflects an $18.7 million decrease in finished goods, a $900,000 increase in work in process, and a $4.1 million increase in raw materials. The decrease in finished goods inventory reflects our focus on reducing finished goods inventory after four consecutive quarters of finished goods increases. Finished goods inventory days were 38 in the quarter, compared to 44 in the first quarter. Total inventory days were 106 in the quarter, compared to 116 days in the first quarter of 2018. Capital expenditures on a cash basis for the second quarter were $21.4 million or 7% of revenue. This CapEx was to put capacity in place for the expected strong revenue growth in the second half of 2018. We expect CapEx for the full year 2018 to return to our target model of 5%-9% of revenue. Turning to our outlook.
After growing 10.8% sequentially in second quarter, for the third quarter 2018, we expect continued strong growth with revenue increasing to a range of $313 million-$329 million or up 2.9%-8.2% sequentially. At the midpoint, this represents a 12.5% growth versus third quarter 2017. We expect GAAP gross margin to be 35.8% ±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 $2.5 million. Our income tax rate is expected to be 29% ±3%, and shares used to calculate diluted EPS for the third quarter are anticipated to be approximately 51.4 million. Please note that purchase accounting adjustments of $4 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, Rick, and good afternoon. As previously highlighted, second quarter revenue was up 10.8% sequentially and up 15.1% year-over-year. Q2 distributor POS increased by 15%, and POP was up by 14%. All regions reach new record revenue levels on record POS results. Channel inventory decreased 1.3% sequentially. During the quarter, we set revenue records on 10 product categories, including AC-DC, Battery Management, BTRx, Connect ASIC, DP/NS, Interface, LED, MOSFET, Standard Linear, and Switch. We also achieved continued strong momentum in CMOS LDO, Eris, Power Protection, Sensor and Signal Integrity, driven by recent design wins on new products. Our consistently strong revenue growth is evidence of our success over the past several quarters with new product introductions, design win momentum, and expanding content at customers. We expect to continue making additional progress in the second half of 2018.
Looking at global sales in the second quarter, Asia represented 78% of the revenue, Europe 13%, America 9%. In terms of our end markets, industrial represents 27% of the revenue, consumer 25%, communication 23%, computing 16%, and automotive 9% of the revenue. This was the first time that industrial was our largest representative end market as a result of a continued expansion effort in this growing market. Starting with industrial market, Diodes continues to see strong demand for LDOs and LED drivers in the civilian lighting, as well as increasing demand for audio products in the smoke detector, alarm-related applications with audio alarming features. We also continue to penetrate the industrial space using normal density trench MOS technology in key MOSFET applications, such as brushless DC motor and LED lighting.
Also, during the quarter, we introduced new products in our high-performance Hall effect latch products that are specifically designed for commutation of brushless motor, flow meters, linear encoders, and position sensors in the industrial application. Turning to our automotive market, which remains a key focus area for Diodes and was up 50% year-over-year. Our design win momentum continues in the three application areas I discussed in detail last quarter. Connected driving, which consists of ADAS, telematics, and infotainment systems. Comfort, style, and safety, including lighting and brushless DC motor control. Powertrain covers conventional hybrid electric vehicles. Contributing to our growth was the successful ramping of past design wins for power transistors for driving LEDs in the car lighting.
There is also increasing demand for USB Type-C product in the automotive applications like infotainment, connected driving in the newer models, along with strong interest in Packet Switches in telematics applications. Additionally, with rapid increase of electronics in today's highly connected cars, robust ESD protection is also important. We expect to see strong growth for our protection products in automotive applications in the coming quarters. We're also seeing new design-ins for Hall sensor product with a focus on window, sunroof, door, tailgate, seat belt, gear stick, and motor applications. Additionally, market growth for automotive MOSFET continue to be strong, especially in China, where we've seen significant demand for automotive semiconductors. Significant MOSFET design wins are being achieved on brushless DC motor, water pump, power windows, electric horn, infotainment, Battery Management system, and ADAS.
In the consumer market, we continue to see growth in charging applications such as quick charger, direct charger, and wireless power charging, as well as in IoT applications such as smart devices and smart audio and wireless speakers. In addition, we see growing demand for USB Type-C Interface in mobile and IoT devices. The accessory market is responding to customers' demand regarding multi-port USB chargers, and we expect strong demand for our USB PD decoder devices that have passed USB PD device certification. Our large selection of protection devices are also gaining momentum in the panel market: mobile, TV, monitor, and notebook panels, as well as earphone, wearable, portable, and smart speakers applications. Turning next to communication market, we continue to see new design wins in mobile market for charging, power management, and discrete products.
We are seeing strong demand for high voltage charging using USB 2 Interface in mobile and smartphone segments. We have secured an increasing number of design wins for our MIDAS switch solution, driven by increasing demand for camera module in mobile phones. Specifically, in smartphones, power density remains a key concern for both manufacturers and consumers. Diodes has been actively addressing this area of the market with its comprehensive small footprint DFN and CFP MOSFET portfolio. In addition, Diodes continue to expand our portfolio of Battery Protection MOSFET with our most recent new product release in Q2. Lastly, in the computing market, we have continued to see strong growth momentum for data centers, server, storage, AI, and deep learning, along with PCs and notebooks. We have launched several new products, including PCIe Packet Switch, PCIe clock generators, buffers, and ReDrivers that are suitable for this application.
We are also seeing increasing interest in our protection devices in the computing market as well, since USB Type-C is a major growth engine for these devices. Our existing solution to protect all pins on Type-C connectors is being well received by customers. We have new design wins for our USB Type-C crossbar MUX, the DP switches in notebook docking applications beyond our current success in PC host side. In summary, we are very pleased with our performance in the quarter, reaching record levels across a number of financial metrics as well as end markets, target geographies, and product categories. These achievements are underpinned by our market share gain, customer contact expansion initiatives, as well as continued traction with our Pericom products. With continued growth expected in the third quarter, we anticipate once again setting new records across our business. With that, we now open the floor to questions. Operator.
Thank you. Ladies and gentlemen, if you would like to ask a question at this time, please press star then one on your touchtone telephone. If your question has been answered or you wish to remove yourself from the queue, you may press the pound key. To prevent any background noise, we ask that you please place your line on mute once your question has been stated. Our first question comes from the line of Tristan Gerra from Baird. Your line is now open.
Hi. Good afternoon. Looks like end demand trends remain very strong, but also that the industry is seeing some pressure in terms of manufacturing costs. Could you quantify perhaps the gross margin impact embedded in your Q3 guidance from those higher manufacturing costs, and the plans you have to mitigate those higher costs going forward?
Yes. Hang on just a second, Tristan Gerra.
Hey, Tristan Gerra. Number one, if you see the guidance for our third quarter, our gross margin actually from 35.3 increased to 35.8. Okay. Even some of our material costs went up, but we still, due to the cost reduction effort, due to the mix improvement effort, we still able to increase our gross margin by 50 basis points.
Okay. I appreciate the feedback. Perhaps we can take it offline. Also, you've mentioned the inventory reduction. That was expected. Is that something pretty much completed, or do you expect to further reduce channel inventories in Q3?
Yeah. Tristan, the inventory reduction, let me comment about the Diodes inventory reduction.
I'll comment.
Emily can talk about the distributor inventory. From a Diodes perspective, we had a plan to reduce the inventory. We had noted that it had gone up over the last year. Every quarter was just up a little bit. We had a plan internally to reduce that inventory, and you can see that we reduced it to about $19 million from a finished goods perspective. In the third quarter, I think we're going to have an additional inventory reduction, but it's not going to be as significant as it was in the second quarter.
Right. Tristan, for the channel inventory, as you noticed that we have a record POS records in Q2, and our inventory actually went down in Q2. I think the key focus is really keeping a healthy inventory profile in the channel to support and sustain our growth. We monitor this very closely. I think the key is really healthy inventory.
To support.
Yeah.
Okay, great.
our disti, typically our disti would like to have more inventory when the revenue going up in the future. We actually, you can see the effort we put in the second quarter. In the second quarter, even they thinking third quarter revenue will be up, their inventory actually went down, and that's because POS is very strong.
We are not pushing the POP. We try to reduce the inventory, their inventory, and keep it healthy such that we don't need to worry about double ordering, worry about inventory too much in the disti side.
Right. Our goal is that inventory days in the channel will not increase.
Okay. That's very useful. Just last one for me. In the context of the tariffs, how much of Diodes business is silicon shipped to the U.S.? Not final end product sold to U.S. OEMs, but silicon sold to distis and EMS and therefore, subject to potential tariff. I'm just trying to get a sense of your potential exposure there.
Yeah. Let me answer that. Diodes, the products that we import into the U.S. from China, all of those products are going to be ultimately affected by the tariffs. Right now, there are two tariff lists. The first tariff list was a smaller list, and it was effective on July 6th. We think that the impact of that is about $1.1 million per quarter of tariff cost. There's another list that hasn't been actually put in place yet, but the list is out there, and we've looked at that, and we're uncertain about the implementation date. Based on the estimate, we think that that impact is going to be about $2.5 million a quarter. If you take the total of those two, it's about $3.6 million per quarter.
We plan to pass these tariff charges on to our customers.
Okay, great. Very useful. Thanks so much.
Okay.
Okay.
Thank you. Our next question comes from the line of Gary Mobley from Benchmark. Your line is now open.
Hello, everyone. Thanks for taking my question. In the quarter, in the second quarter or even embedded in your outlook for the third quarter, were there any supply chain constraints that restricted your revenue? If so, can you speak about them and what revenue could have been if you weren't capacity constrained?
Okay. We really, the epi and in certain degree affect the wafer, do have some shortage. Not all the product line have the shortage. The shortage is most coming from the MOSFETs, and that is really start with epi shortage, then cause a certain degree of the MOSFETs wafer shortage. It affect us, but a lot of customer is a hand-to-mouth type of situations. I do not, or I cannot give you the forecast. If there are no shortage, what will be the revenue? We just driving our best we can to support the customer demand, but fortunately, we are able to keep their line to not have a rundown situation. Okay. That's really limited to certain product lines.
Okay. Typically, in the fourth quarter, you see sequential revenue decline somewhere in the neighborhood of mid-single digit % sequentially. Would you, based on your visibility sitting here today, would you call the fourth quarter as typical or atypical as a matter of seasonality?
Well, I don't know very clear yet, but so far, I'm hoping it's not typical. Okay. Would be better than typical, but I really don't know. Okay. Right now, I'm focused on the third quarter, and we do seeing a very strong third quarter above the cyclical. Typically, second quarter to third quarter is about 5% or between 0%-5% growth, and we are able to guide above 5% growth. We see better than cyclical cycles. Now in the fourth quarter, right now, not very clear, but we watch out, okay, and hoping it's still better. Cyclical is a 5% down, and I hope it's better than that, but I don't know yet.
Very good. I'll let others ask questions. Thanks, everyone.
Okay.
Thank you. Our next question comes from the line of Shawn Harrison from Longbow Research. Your line is now open.
Hi, everybody, congrats on the results.
Thank you.
The first question has to do with the gross margin performance for the June quarter. If there is a way to delineate maybe how much of a negative impact the inventory drawdown represented on gross margin, as well as the incremental CapEx investment from prior quarters, and how much of that maybe rolls off into the September quarter.
I probably cannot give you the exact number, but if you look at, we dropped the finished good, $17 million. If you think about $17 million, assume this is not the high GP stuff. Assume this is the average. If you are talking about, let's say, 10%, that means you're going to reduce $1.7 million of the GP to the average. You can figure it's big numbers. Even in the third quarter, we still intend to reduce more. Basically, what I want to do is, by end of third quarter, the inventory level will be equal to last year third quarter, end of third quarter levels. With the revenue, if you compare this year third quarter versus last year third quarter, the revenue is going to grow quite a bit, we're hoping, we try to drive in is that our own inventory is less.
The same level, that means as a percentage will be much less. That's the goal.
Okay. That's helpful, Dr. Lu. As a follow-up, I was hoping you could speak on the ramping of the 8-inch capacity as well as the transferring of equipment from the KFAB closure into existing sites and where you're at on progress with both.
Let's talk about 8-inch equipment. We continue ramp it up. I think last time we were talking about in Q1, we only ramped up this 800-something wafers, less than 1,000 wafers. In Q2, I think that we are now somewhere, end of Q2, we are somewhere around 5,000 to 6,000 wafers per month run rate. We ramped it up to probably the end of the second quarter to about 5,000-6,000 wafers per month. You go to the third quarter, we are continuing to ramp it up. I don't know what the size is, it has not yet come out, but we will continue to ramp it up. By the end of the fourth quarter, hoping we are running somewhere around 9,000 wafers per month. We continue to ramp it up.
From a 6-inch perspective, we've moved all of the KFAB equipment to SFAB1. It's in the process of being qualified and ramping up. KFAB has been closed. All of the equipment and everything has been moved. It's basically finished.
Last, if I may. I know last quarter there were some, I think the term may have been equity investments in Chengdu that could limit your ability to pay down debt in the back half of the year. Given the increased profitability, do you think you'll be in a net cash position exiting 2018 now?
We will make that investment in Chengdu probably in the next four or five months. We hope to be able to fund that internally, which would preclude us probably from paying down the debt as much as we would like. We're still in the process. You can see the results are good, and the operating cash flow is $35 million. If that can continue, then we should be in a pretty good position to at least continue to pay down some debt.
Okay, perfect. Thank you very much.
Thank you. As a reminder, if you would like to ask a question, please press star then one. Our next question comes from the line of Edgar Roesch from Sidoti & Company. Your line is now open.
Thanks and congratulations.
Thank you.
Thank you.
Thank you.
To lead off, earlier in the year, industrial saw a lot of strength from Europe. I think that led the gains. Did you see that broaden out, or is that really still a center of activity for your business?
This is Emily. We actually are seeing across the board strength in the industrial segment, not only in Europe, but also in North America as well as in Asia. This is across the board. That's how we can achieve a 27% overall to the end market percentage.
Okay, got it. Do you have any exposure to home appliances, and can you remind me which category and which that would fall?
Yes, we do. I think home appliance would be under the consumer segment, that we include that over there.
No, industrial, like a tool, hand tool.
Right. home appliance is actually under consumer. We also have a lot of industrial applications, similar stuff, but that would be under the industrial.
Yeah.
Okay, thanks. I think you recently, or earlier this year, you launched some higher voltage products, IGBTs and some other products. I was wondering, do you feel like you have, on the power management side, a pretty good range of voltages covered, or is that an area where you will have some new product activity to augment your portfolio?
I think we have overall good coverage from the product. When you really look at across the product line, there's quite a number of products we cover in the higher voltage area, but there's still room for us to expand. One of the things that we'll be working aggressively is actually continue to develop new products targeting higher voltage areas.
Yeah. Well, IGBT, we just started. That is, in the past, is not our focus area. With the gate driver and our MOSFETs, we think we are on the position now to get into the IGBT areas. We start with buy and resell for the IGBT parts, but eventually we'll get from the super junction to IGBT. Right now, that's very beginning of our actions.
Okay, that's helpful. All right, I think that does it for me. Thanks.
Thank you.
Thank you.
Thank you. That concludes our question and answer session for today. I'd like to turn the call back over to Dr. Lu for closing remarks.
Thank you for your participation on today's call. We're looking forward to providing an update on our business next quarter. Operator, you may now disconnect.