Good afternoon, everyone, welcome to Diodes Incorporated's first quarter 2023 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 star followed by zero on your touch-tone telephones. As a reminder, this conference call is being recorded today, Tuesday, May 9th, 2023. I would now like to turn the floor over to Leanne Sievers of Shelton Group Investor Relations. Leanne, please begin.
Good afternoon, and welcome to Diodes first quarter 2023 financial results conference call. I'm Leanne Sievers, President of Shelton Group, Diodes investor relations firm. Joining us today are Diodes Chairman, President, and CEO, Dr. Keh-Shew Lu, Chief Financial Officer, Brett Whitmire, Senior Vice President of Worldwide Sales and Marketing, Emily Yang, Chief Operating Officer, Gary Yu, and Director of Investor Relations, Gurmeet Dhaliwal. 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 its closing procedures and customary quarterly review by the company's independent registered public accounting firm. As such, these results are unaudited and subject to revision until the company files its Form 10-Q for its fiscal quarter ending March 31st, 2023.
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, May 9, 2023. 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 N on-GAAP terms. Included in the company's press release are definitions and reconciliations of GAAP to Non-GAAP items, which provide additional details. 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 this time, a recording will be available via webcast for 90 days in the investor relations section of Diodes' website at www.diodes.com. Now, I'll turn the call over to Diodes Chairman, President, and CEO, Dr. Keh-Shew Lu. Dr. Lu, please go ahead.
Thank you, Leanne. Welcome, everyone, and thank you for joining us today. Our first quarter results were highlighted by continued strength in our gross margin performance, which was at the high end of our guidance despite the seasonally low revenue and economic slowdown in the consumer, communication, and computing market. In fact, gross margin has remained over 41% of the past four quarters and above our target model of 40%, underscoring our execution on new product initiatives and the product mix improvements. A key contributor to our improved mix has been our success expanding into the automotive and industrial markets, which together represented a record 47% of total product revenue in the quarter.
Another contributing factor to our consistent margin improvements is our manufacturing cost reductions and operational efficiency, which has also allowed us to maintain healthy margins despite the COVID-related disruptions and the Chinese New Year holiday during the quarter. Over the past several years, we have taken significant steps to transform our business as well as our customer and the market position based on a total solution sale approach, extensively pipeline of new product introductions and the design wins. Today, Diodes has a diversified business across product groups, end market, and applications, as well as geographics that are further supported by a flexible manufacturing model and team that is highly focused on consistent execution and a sustainable quarterly performance. Those fundamental factor position us well to not only sustain our margin profile during an economic slowdown, but also continue driving even higher profitability and cash flow in more favorable economic environment.
With that, let me now turn the call over to Brett to discuss our first quarter financial results and our second quarter guidance in more detail.
Thanks, Dr. Lu, and good afternoon, everyone. Revenue for the first quarter 2023 was $467.2 million, decreasing 3.1% from $482.1 million in the first quarter of 2022, and down 5.8% from $496.2 million in the fourth quarter of 2022. Gross profit for the first quarter was $194.5 million or 41.6% of revenue, compared to $196.7 million or 40.8% of revenue in the prior year quarter, and $206.2 million or 41.6% of revenue in the prior quarter.
GAAP operating expenses for the first quarter were $108 million or 23.1% of revenue, and on a Non-GAAP basis were $101.3 million or 21.7% of revenue, which excludes $3.9 million of amortization of acquisition-related intangible asset expenses and $2.8 million related to officer retirement. This compares to GAAP operating expenses in the first quarter 2022 of $103.6 million or 21.5% of revenue, and in the fourth quarter of 2022 of $109.7 million or 22.1% of revenue. Non-GAAP operating expenses in the prior quarter were $105.9 million or 21.3% of revenue.
Total other income amounted to approximately $2.2 million for the quarter, consisting of a $3.9 million unrealized gain on investments, $1.8 million of interest income, $530,000 of other income, partially offset by $2.1 million in interest expense and a $1.9 million foreign currency loss. Income before taxes and non-controlling interest in the first quarter 2023 was $88.6 million compared to $90.8 million in the prior year quarter and $94.8 million in the previous quarter. Turning to income taxes, our effective income tax rate for the first quarter was approximately 18.8%.
GAAP net income for the first quarter of 2023 was $71.2 million or $1.54 per diluted share, compared to $72.7 million or $1.59 per diluted share in the first quarter of 2022, and $92.1 million or $2.00 per diluted share in the fourth quarter of 2022. The share count used to compute GAAP diluted EPS for the first quarter of 2023 was 46.2 million shares.
Non-GAAP adjusted net income in the first quarter was $73.4 million or $1.59 per diluted share, which excluded net of tax $3.1 million of acquisition-related intangible asset costs, $2.3 million in officer retirement expenses, and a $3.1 million gain related to an LSC investment. This compares to $80.3 million or $1.75 per diluted share in the first quarter of 2022, and $79.6 million or $1.73 per diluted share in the prior quarter. Excluding non-cash share-based compensation expense of $7.7 million net of tax for the first quarter, both GAAP earnings per share and Non-GAAP adjusted EPS would have increased by $0.17 per diluted share.
EBITDA for the first quarter was $121.8 million or 26.1% of revenue, compared to $118.1 million or 24.5% of revenue in the first quarter of 2022, and $129.6 million or 26.1% of revenue in the prior quarter. We have included in our earnings release a reconciliation of GAAP net income to Non-GAAP adjusted net income and GAAP net income to EBITDA, which provides additional details. Cash flow generated from operations was $99.8 million for the first quarter. Free cash flow was $51.8 million, which included $48 million for capital expenditures. Net cash flow was a negative $15.2 million, including the paydown of $60.8 million in total debt.
Turning to the balance sheet, at the end of first quarter, cash equivalents, restricted cash, plus short-term investments totaled approximately $335 million. Working capital was $731 million. Total debt, including long-term and short-term, was $125 million. In terms of inventory at the end of first quarter, total inventory days were approximately 116, compared to 117 last quarter. Finished goods inventory days were 31 compared to 33 last quarter. Total inventory dollars decreased $18.3 million from the prior quarter to approximately $341.9 million. Total inventory in the quarter consisted of a $13.7 million decrease in raw materials, a $3.1 million decrease in finished goods, and a $1.5 million decrease in work in process.
CapEx on a cash basis were $48 million for the first quarter or 10.3% of revenue. First quarter CapEx was higher than our target model due to the strategic expansion of our JK wafer fab in Hsinchu Science Park in Taiwan. Without this investment, we would have been within our target model of 5%-9%. We expect to be in that range for the full year 2023. Turning to our outlook. For the second quarter 2023, we expect revenue to be approximately $467 million, ±3%. With a slower than expected recovery in the consumer, computing, and communications markets, we are guiding flat sequentially at the midpoint to reduce 3C channel inventory. The automotive and industrial markets are expected to remain strong.
We also expect continued driving our strategy of improved product mix and are guiding GAAP gross margin to be a record 41.8%, ±1%. Non-GAAP operating expenses, which are GAAP operating expenses adjusted for amortization of acquisition-related intangible assets, are expected to be approximately 22% of revenue, ±1%. We expect net interest expense to be approximately $1 million. Our income tax rate is expected to be 20%, ±3%, and shares used to calculate EPS for the second quarter are anticipated to be approximately 46.5 million. Not included in these Non-GAAP estimates is amortization of $3.1 million after tax for previous acquisitions. With that said, I will now turn the call over to Emily Yang.
Thank you, Brett. Good afternoon. In the first quarter, revenue decreased 5.8% quarter-over-quarter due to typical seasonality related to the Chinese New Year holiday, combined with a slowdown in the 3C markets. Looking more closely at the first quarter revenue, POS was a record in Europe. Distributor inventory in terms of weeks increased sequentially and is higher than our defined normal range of 11-14 weeks. This increase is mainly due to slower than expected recovery in China and in the 3C market segment. The good news is that we started to see signs of recovery in the computing and consumer markets. Our plan is to decrease some channel inventory in the second quarter, which is reflected in our guidance.
We believe our channel inventory position are strategically for the expectation of our continuous recovery so that we can address dynamic demand and faster on business. Automotive industrial market segment are expected to remain strong in the second quarter. Looking at the global sales in the first quarter, Asia represented 68% of revenue, Europe 17%, and North America 15%. In terms of our end markets, industrial was a record 29% of DIO's product revenue. Automotive was also a record at 18%, computing 22%, consumer 18%, and communication 13% of product revenue. Our automotive industrial end markets combined reach a record 47% of the product revenue, which is the fifth consecutive quarters above 40% and is seven percentage points above our 2025 target. This achievement underscore the ongoing success of our content expansion strategy and market share gain.
Let me review the end market in greater details. Starting with our automotive end market, as I mentioned, revenue reached a record 18% of product revenue and represented a growth of 33% year-over-year. In our first focus area of connected driving, our PCI Express 3.0 packet switches, PCI Express clock generators, clock buffers, crystal oscillators, USB switches, USB power delivery controllers, voltage level shifters, and I/O expanders are being designed into ADAS, infotainment, telematics, domain control units, and electric control units applications. We're also seeing strong demand for DC-DC buck converters, LDOs, ideal diode controllers, bipolar transistors, and TVS product in the same end applications. In the comfort, style, and safety, we continue to gain traction for ReDrivers and crossbar switches as USB Type-C adoption continues to increase in the vehicles. Our solution selling approach is a key driver to this momentum.
Additionally, we have been winning designs for our power delivery solution that include power delivery protocol decoder, along with our USB muxes, ReDrivers, and TVS for the in-vehicle USB charging devices. We're also seeing an increasing number of design wins in wireless chargers, fans, blower, thermal management system with our current monitor products, regulator transistors, and SCR products. Our linear LED drivers, ideal diodes controllers, bipolar junction transistors, and LDOs are being designed in several stoplight, tail light, headlight, and cluster lighting systems. In the powertrain, which covers conventional hybrid electric vehicles, our switching diode product helps support conventional applications such as drivetrain electronics and towing, tailing, and cargo management system. SBR IntelliFET products are also seeing traction in battery management system and in production control applications for battery electric vehicles, as well as plug-in hybrid electric vehicles.
We also recently introduced a number of new automotive compliance, SBR IntelliFET MOSFETs and NPN transistors that have been designed into battery management systems. In the first quarter, we introduced 68 new automotive compliance products. This is a good demonstration of our focus on various automotive applications and product mix improvement. In our industrial market, revenue grew 7% year-over-year to also reach a record percentage of total product revenue at 29%. Our buck converters, LDOs, and sensors continue to see strong demand for applications such as DC fans, power tools, power supplies, circuit breakers, e-meters, embedded systems, and precision control systems. Our newly released industrial latch switches are gaining traction from low voltage to high voltage applications required in the harsh environments.
Our SBR product also being widely used in Power over Ethernet and embedded applications, while our 36 channel linear LED drivers are being adapted in the robotic applications. Our gate driver ICs have won new sockets in power supply units for servers and energy storage, as well as in lighting for the Digital Addressable Lighting Interface control boards. Our high-performance transistors and high voltage switching diodes have also won designs in solar inverters for green residential energy generation and transmission systems. Additionally, we are gaining increased traction for our switching diodes and functional array products that are utilized in numerous control systems for applications, including HVAC controls, LED lighting, digital printing press machines, printed circuit boards, assembly test systems, and imaging circuits for medical and aviation security systems.
Early in the first quarter, we were pleased to release our first set of silicon carbide Schottky barrier diodes that includes a series of 11 product rated at 650 volts and other series of eight product rated at 1,200 volts. We also released our first silicon carbide MOSFET to address the demand for high efficiency and high power density applications such as industrial motor drivers, solar inverters, data center, and telecom power supplies, DC-DC converters, as well as electric vehicle battery chargers. Despite the softness in global computing market, our design-in momentum continues across our portfolio of products. This include wins for our USB Type-C charging detectors, high-speed switches, ReDrivers, ReTimers, MOSFET, SBR, and TVS product in the broad applications including servers, desktops, notebooks, graphic cards, add-in cards, and USB data line protection.
New designing activities continue for our contact image sensors in multifunction printers. We saw adoption of HDMI 2.0, 12 Gbps ReDrivers, eMMC muxes in gaming consoles, as well as 8.0 and 10 Gbps bidirectional ReTimers in active cable docking and dongle applications. In the communication market, we continue to win new designs in 5G applications for audio switches, I/O expanders, USB switches, high PSRR LDOs, and Schottky products. Additionally, our small signal Diodes products gain traction in the rapid growing field of industrial communication system and cybersecurity. While bipolar transistor gain new design wins in IP cameras, GPON, and router applications. Lastly, in the consumer market, we've been securing new design wins for USB switches, MOSFETs, current limit power switches, bridge rectifier in sports camera, adapters, gaming consoles, and Power over Ethernet devices.
Manufacturers of panels of TV and displays continue to adapt our bipolar transistor in their new models. We also continue to see solid growth for our SBR, LED drivers, piezo sounder drivers, USB Power Delivery sink controllers, switching diodes, and TVS products in the tracker applications, displays, wearable, personal care, healthcare devices, and the health and safety monitor system, as well as in fire and carbon monoxide sensors. In summary, Diodes performance this quarter highlights the progress we have made increasing our content and market share gains in automotive industrial markets, contributing to our overall product mix improvement. Our total solution sales approach and operating efficiency have been a key factor to our success as we continue to drive growth and sustainable margin performance. With that, we now open the floor to questions. Operator?
Ladies and gentlemen, at this time, we'll begin the question-and-answer session. To ask a question, you may press star and then one using a touch-tone telephone. To withdraw your questions, you may press star and two. If your question has been addressed or you would like to withdraw your question, you may press star and two. Again, if you would like to ask a question, please press star and one. We'll pause momentarily to assemble the roster. Our first question today comes from Matt Ramsay from Cowen. Please go ahead with your question.
Yes, thank you very much. Good afternoon, everybody. I think for the team, my first question, obviously there's a lot of moving parts here in the macro environment, and great to hear about the auto and industrial strength and the momentum the business has there. I guess I'm trying to get a gauge on how you guys are seeing the potential recovery in China. I mean, it's anybody's guess as to when that happens, but is a return to year-over-year growth for your company sort of predicated on a recovery on sell-in into a lot of these consumer markets in Asia? How do we think about that relative to the design win momentum and the content growth that you're seeing across the business?
I'm just trying to gauge sort of expectations for the next few quarters and the levers macro-wise versus sort of secular content-wise for your company. Thanks.
Yeah. Hi, Matt. This is Emily. Let me address your questions first. I think overall, like I mentioned earlier, right, we do start to see some recovery in the computing as well as communication area and also consumer. It's very, I would say, slower than our expectation, but the good news is we start to seeing signs of recovery. You know, I mean, usually for Q3, it is the peak of all these market segments, so that's also part of our assumption as well.
Got it. No. Thank you, Emily. Thank you for that very much. As my follow-up question, I think the some of the longer term financial model metrics that you guys have shared are a bit older now, and the company's done much, much better than some of those metrics. One of them is around getting the business mix to be 40% or more of revenue coming from auto industrial, and you've far passed that. I think we're at 46%, 47% of the business now. You just put up a really strong growth margin quarter and then guided up sequentially.
I'm just trying to figure out if the team thinks about this mix of business and this margin profile in sort of the 41%-42% range, is that sort of the new way that we should be thinking about the business? If in fact the 3C markets come back at some point in the mix that the margin would move up or down with that. Great margins. I'm just trying to figure out if this is sort of the level we should think about for the foreseeable future. Thank you.
Okay. Matt, let me just answer, you know, number one, the overall market situation, okay? We see some recovery on the 3C market, but the industrial and automotive are still very strong. Therefore, you know, we're hoping that second half of this year after the channel inventory, or I should say our customer as they're building up and their inventory of the 3C product start to decrease, then, you know, the second half, the business should be come back stronger. Okay. That is in general for this year. I believe, you know, first half versus second half could be, you know, more than 50-50. It should be probably somewhere, you know, much higher-
Yeah.
in second quarter or second half than first half.
Right.
Okay, that's this year. After that, you know, next year we believe will be a typical growth year for the semiconductor business. If you look at semiconductor business, traditionally when you go down, it probably won't go down more than two years. Since this down is already start at second half of last year. I think by end of this year will be one and a half year, then I think, you know, next year, 2004, should be a growth year for the semiconductor total business point of view.
Right.
Okay.
Let me maybe add one more comment related to the margin improvement that you just mentioned. Product mix improvement has been a big initiative for Diodes for the last few years, right? We definitely would continue to focus. The total solution sales approach as well as manufacturing efficiency. With combined of all these three, we are confident that we'll continue to drive the margin overall improvement. If you look at the Q1 result, auto plus industrial, 47% total of our product revenue is a good demonstration of this result. As well as our guidance for Q2, 41.8%. I think, you know, the focus will not change for the company, and that will continue to be the direction. If we continue to execute all this initiative and focus, we believe the margin improvement will continue.
Yeah. When you're talking about the 3C market coming back up, are we able to sustain the gross margin improvement? My answer is yes, because even, you know, the two things, the automotive and industrial continue their growth, okay? They are in a much better margin. Even the consumer or 3C market come back, I think Emily keep mention about we are get away from the commodity-
De-commodity.
De-commodity type of product. We are carefully to grow our 3C market, more concentrate on the high-end PC data center, IoT, and the 5G type of, you know, communication product. Therefore, if you look at, we are intentionally get away from the commodity or de-commodity product and compete the price competition. We grow in the area we believe we have differentiation. We have, you know.
Premium product.
Premium stuff. That is the way we have been able to continue improve our gross margin in addition to operational excellence, okay? We are not that focused on the rolling and manufacturing rolling to get us to the gross margin. We are more focused on cost reduction, operational efficiency, plus product mix improvement.
Right. Well, thank you very much for all the color, Dr. Lu, Emily. I really do appreciate it. I'll jump back in the queue. Thank you.
Thank you.
Our next question comes from Gary Mobley from Wells Fargo Securities. Please go ahead with your question.
Good afternoon, everybody. Thanks for taking my question. The comments by Dr. Lu that the second half of the year should be better than the first half, I guess indicates that you're gonna expect the normal seasonal uptick in the September quarter. Correct me if I'm wrong there. I wanted to get my arms around the impact on the reduction in distribution inventory, with the understanding that presumably you're above the normal 11 - 14 weeks, and each week of distribution inventory is worth what? $22 million in revenue. How many weeks of distribution inventory digestion or reduction are we talking about here that is influencing the sub-seasonal guide for the June quarter?
Gary, let me answer that question. We don't really disclose the detail about the number of weeks, but in my speech, I did mention it's higher than our 11-14 weeks range that we define as normal. Our goal is actually expect the POS channel will grow in second quarter, and at the same time, we want to deplete some of the channel inventory. We do believe the number of weeks will come down, you know, that's based on what we see based on the market and the information we have so far.
Yeah. It is very, very difficult to just look at the overall inventory, okay? Or channel, overall channel inventory week, okay? Because the automotive, industrial, they're still very strong. The channel inventory build-up is really due to the 3C business, which most is in Asia, okay? We already see the sign, and we guide flat on this quarter is really intentionally to reduce the 3C channel inventory, okay? We're still looking very strong on automotive, industrial, and that's the area we do not want to reduce the channel inventory. But the 3C, that's the area we especially, I always said those commodity, de-commodity, we don't want to compete. Therefore, we intentionally want to decrease that area of the channel inventory.
Okay. Thank you for that. As my follow-up, I wanted to ask about your operations in China. You know, during COVID, you were operating for so many years in a closed-loop environment. Can you give us an update on whether that's still the case? If not, you know, whether there's any anticipated or already realized cost benefit from that?
No. Actually, Gary, this is Gary. The operation in our China, no matter the fab or assembly, are normal right now, okay? That's why we will say, okay, the operation for the China we want to drive is the cost reduction and more operational excellency, okay? There's no any special lockdown or closed loop operation at this moment.
All right. Thank you, Gary.
No problem.
Our next question comes from David Williams from Benchmark. Please go ahead with your question.
Hey, thanks so much. Congrats on the execution and navigating this challenging backdrop. I guess one of my questions is, if you kind of think about the margin, and you touched on this a bit earlier, but I guess I'm kind of curious how you think about that. If we saw automotive come down a bit, or maybe back off and you start to see the 3C really improving, what would you expect to see from the margin impact? Do you think you'd see a significant or would that be moderate? What leverage do you have there, I guess, to control that margin profile in an automotive environment that's maybe a little less strong?
With the automotive, we actually still seeing pretty strong momentum, in general, right. There is a little bit inventory adjustment, if we look at the overall growth, right, we actually have a record percentage of 18% at the end of Q1. That actually represented a 33% year-over-year growth. We continue to gain market share. We're pretty confident with the pipeline that we have in place, with all the opportunities we have in place, we're in pretty good shape. With the three Cs, I think Dr. Lu mentioned a little bit earlier, we really focus on the premium portion within the three Cs, right. We're definitely not chasing the deep commodity or commodity business. We're really focusing on the higher end of the applications, the servers, the storage, the data center, whether it's 5G or even with the consumer.
We really focus more on the IoT block, the power block or the timing block. With this focus and continue to drive, you know, the product mix improvement, you know, we're actually confident that we continue to drive the improvement over the margin over the years to come.
Yeah. One more thing I want to add it because, you know, people start thinking automotive business, you know, it's very hard, but it's going to be slowed down. Are you able to continue maintain your growth? My answer is, since 2013, that is almost 10 years ago, we established automotive business focused. You know, we still CAGR 30% a year of the growth. We are not really counting on the market growth. We counting on additional to the market growth. We counting on the dollar value for each modules. That is what our focus in the automotive business is module, dollar module growth.
Mm-hmm.
Because of that, we are able to, you know, do much better than automotive business growth. Therefore, I believe we will still continue increase our automotive revenue as a % of Diodes total business. Okay. Emily always say 18% in 1Q, and, you know, you go back 2013, 3%. Okay? That is how we're driving the automotive business, is not just counting on volume growth. We're counting on the dollar module growth.
Okay, excellent color. Thank you for that. Then maybe secondly, just, Diodes has outperformed over the last several quarters, and maybe even more so over the last couple of quarters relative to peers. What do you think has given you the improved inventory dynamics where you're not seeing the same magnitude of digestion that we've heard from others? Is it more of the managing of the channel, or is it just the growth that you're still seeing? Any color there around why you're outperforming the market would be very helpful, I think. Thank you.
Well, I think, you know, Dr. Lu kind of mentioned earlier, right? Each of the markets, we actually focus really more on the content expansion, right? That's really the key, especially in the automotive area. I also think the total solution sales approach help us to really sell the value and proposition to the customers, solving their problem. Remember, we also talk about price increase for the last two, three years. We actually strategically choose to build a relationship with the customers, but not to just purely gauge the price up. I think, you know, there's a lot of long-term strategy, including the product mix improvements, initiatives, right? Of course, manufacturing efficiency has always a sweet spot for us overall.
When you combine all this focus and initiative and the direction overall, I think that's actually a good demonstration of the result that we deliver to you so far, right? With the Q2 guidance on the 41.8% margin, I think that again is a different way of demonstrating, you know, our confident of the overall margin dollar or margin percentage improvement.
Yeah. Even the revenue spread, it tell us we our margin is not just pure coming from the loading, coming from the utilization. Our coming is a big portion is product mix, which is, you know, what we are focused on. Okay. Another one is the new product initiative.
Mm-hmm.
Okay. You know, Emily already mentioned just for automotive, we announced sixty-
Eight.
Yeah, new product in one queue. You can see we're driving a lot of focus on new product in this state.
Mm-hmm.
We even measure the revenue generated by the new product, and that is the one we believe we can continue improve our gross margin.
Our next question comes from Tristan Gerra from Baird. Please go ahead with your question.
Hi. Thank you. Maybe a little tweak on Gary's question earlier on this call. Is it fair to assume that without the reduction of inventories in the channel that you're implementing in Q2, there's maybe a 3% impact on the revenue if I look at kind of normal seasonality, your top line normally would be up about 3% sequentially? Is that in the ballpark, and do you expect that inventory reduction dynamic to be a one quarter issue, or do you expect this to linger into Q3? Finally, what's the delta with the other shipping that you previously expected into distis in Q2 in anticipation of a China recovery?
Well, I think, Tristan, you know, we did mention, the good news is, we start seeing some of the signs, right, in, you know, especially in computing and consumer market. That's the good news. We also mentioned that, slower than expected recovery in China and also the 3C Market settlement kind of costing the channel inventory higher than our expectation, right? We definitely plan to deplete some channel inventory in the second quarter, but unfortunately we don't really provide guidance how many weeks or anything like that. We're confident that, you know, with the guidance that you see a flat, with the expectation of improvement in the POS in the second quarter, you will see the channel inventory start depleting some. That's pretty much what we can share at this moment.
From a capacity standpoint, you've been able to gain market share as a result of having less supply constraint than your competition, notably last year. Do you think that your peers are still supply constrained? Obviously, I can, you know, I can ask them the question, but just interested in your view on the whole industry supply demand dynamic and whether you think that, you know, at some point we get in the supply demand equilibrium in analog and what does that mean for you guys in terms of capacity management, particularly if end demand trends were to weaken further?
Okay. Tristan, when you're talking about capacity, we do, you know, have enough capacity...
Right.
If we want to grow.
Yeah.
Okay? The key thing capacity is really cannot just say on I can use it for anything. Okay. Automotive capacity versus consumer capacity sometimes is the same, but most of the time it's different. You need to spend the effort to convert. From strategic point of view, we already decided we are getting away from commodity or deep commodity 3C type of, you know, product. We gradually, when we need it, we convert our capacity from 3C for industrial and automotive. Okay. I'm looking at the market, look at the demand, and we will spend the money and gradually convert to the need. Okay. We will not just get the capacity sitting there idle waiting for the 3C business come back.
We intentionally convert to support long-term strategy, higher growth margin business, and our focus business, which is automotive and industrial. Now as a 3C, we have three areas we are focused on. We will support that. We try to get away from the competition very strong, especially the China supplier. We are getting away from that.
Right.
You can continue to see our gross margin will continue improve even the 3C business come back.
I think from the supply point of view, not everything equal at this moment. All in all, I think it's still a little bit dynamic. There's still a lot of pockets of shortage, versus we mentioned deep commodity, there's more supplies, right? Which is not a focus in the area that we're chasing after. I would say not everything equal at this moment, still pretty dynamic.
Great. Thank you very much.
Our next question comes from William Stein from Truist Securities. Please go ahead with your question.
Great. Thank you. I had a question about your inventory management. You've done certainly very well on your own balance sheet, but you've taken, it seems to be, a different approach from what many others have taken in this regard. What we've seen in most of semis in the last couple of quarters is, you know, pretty significant balance sheet inventory builds and real restraint at shipping anything into the channel. Diodes seems to have done, you know... I don't know if it's exactly the opposite, but you've managed on-balance sheet very, you know, conservatively, but you've built in the channel, certainly I recall last quarter that was a change. I think this quarter sounds like you built a little bit again.
I'm sure there's a great reason for this approach, but I'm hoping you can explain it to us a little bit. Thank you.
Yeah. I think, you know, last quarter we mentioned, the reason we start building more channel inventory is the expectation of the China recovery, also the expectation of the 3C market segment recovery. I think we overestimated the recovery speed, that's actually what we start seeing channel inventory getting increased a little this quarter as well. That's also the reason we strategically decided to really deplete some of the channel inventory in the second quarter. We still believe the channel inventory position overall for Diodes is actually in a very good position. You know, we do actually have the good product on the shelf, and we also believe the recovery is gonna happen. It just matter the speed. Once the recovery happens, we're confident that the channel inventory will be depleted.
Also keep in mind, the market is still really dynamic. We believe having the right product on the shelf, it actually position us better to support the dynamic demand as well as the fast term business, right?
In additional, what Emily talking about, you know, we actually intentionally to doing that, right? I think one of the reason I look at it, okay, if we want to maintain our operation very smoothly, because if you are way underloaded, your cost, your gross margin going to be get hit quite a bit. If you build it and then build another inventory, internal inventory, then again, your cost, inventory cost is there too. Therefore, a best way is building consistently. You don't get the revenue up, down so much. You get your manufacturing smoothly produce intentionally the number, and you get your gross margin flat, okay? You don't want to be lay off the people, you don't want to be spend so much time over time, and you don't want to have depreciation eating your gross margin.
Therefore, we carefully manage the operation. That's why I keep to say operation excellence, our execution, because that way we have a very smooth margin or very smooth revenue, don't get up and down so much. At the same time, we are able to maintain our gross margin, the full quarter above 41%. Even this quarter, we guide flat manufacturing, but we still have the record gross margin, okay? This is a really excellent of operational control to make the output, the loading very smoothly, such that you have the best cost reduction, balance the cost from the manufacturing over cost to the inventory cost. You try to balance that cost to get the best gross margin. We continue to do that.
Yeah. Both of those were very helpful in clarifying. I appreciate it. If I could follow up with one. I think there have been a few questions about this. I just wanna make sure I understand what's going on. Historically, I think we've sort of been trained to think about two major drivers of the margin improvement. Well, maybe three drivers of the margin improvement. Operational excellence, I'll acknowledge, is one of them, but I think the two that we've been more focused on is end market mix, shifting more towards industrial and automotive, and then product mix, which is a lot harder for us to measure, but we know that you're leaning into more unique, specialized, higher end, however you wanna describe it, products and less in what Emily calls deep commodity.
It sounds like on this call, what you're trying to communicate is that the end market mix will matter less going forward because operational excellence continues and there's more room to go, and perhaps the product mix is maybe a bigger driver. Am I over-interpreting what you're saying?
Yeah.
is that-
Yes, you are over-interpret.
Okay.
I'm trying to explain is the last four quarters. Plus the second quarter this year guidance. You can see it go through up and down in the revenue, but we are able to maintain very steady and even a record of the gross margin. That is coming from product mix and operational, you know, excellence. It's coming both. When the revenue go down, we are maintained. That is probably product mix give us. Okay. But when we have the better rolling business going up and, like we say now, okay, assume, you know, when 3C start going up, we are able to continue, maintain or improve, then it coming from operation. I think what we want to do is focus on how to continue improve the gross margin regardless of the market up and down.
We prove we can do that due to start, we already know the first two quarter of last year, business good, very good. Second half of last year, business starts to slow down. Even this year, first quarter and second quarter, business slow down. We are able to continue maintain the gross margin, even setting a new record. It tell us that's the right thing for us to do, and that's what we are doing.
Thank you.
Ladies and gentlemen, with that, we'll be concluding today's question and answer session. I'd like to turn the floor back over to Dr. Lu for any closing remarks.
Thank you for your participation on today's call. Operator, you may now disconnect.
Ladies and gentlemen, with that, we'll conclude today's conference call. We thank you for joining today's call and presentation. Please have a great day.