Good day, ladies and gentlemen, and welcome to the ON Semiconductor Second Quarter 2018 Earnings Conference Call. At this time, all participants are in a listen only mode. Later, we will conduct a question and answer session and instructions will be given at that time. As a reminder, this conference may be recorded.
I would
now like to turn the conference over to Parag Agarwal, VP of Corporate Development and Investor Relations. You may begin.
Thank you, Sonia. Good morning and thank you for joining ON Semiconductor Corporation's Q2 2018 quarterly results conference call. I'm joined today by Keith Jackson, our President and CEO and Bernard Gutmann, our CFO. This call is being webcast on the Investor Relations section of our website at www.awnsemi.com. A replay of this broadcast, along with our earnings release for the Q2 of 2018, will be available on our website approximately 1 hour following this conference call and recorded broadcast will be available for approximately 30 days following this conference call.
The script for today's call and additional information related to our end markets, business segments, geographies, channels and share count are also posted on our website. Our earnings release and this presentation include certain non GAAP financial measures. Reconciliation of these non GAAP financial measures to most directly comparable measures under GAAP are in our earnings release, which is posted separately on our website in the Investor Relations section. During the course of this conference call, we will make projections or other forward looking statements regarding future events or future financial performance of the company. The words believe, estimate, project, anticipate, intend, may, expect, will, plan, should or similar expressions are intended to identify forward looking statements.
We wish to caution that such statements are subject to risks and uncertainties that could cause actual results or events to differ materially for projections. Important factors which can affect our business, including factors that could cause actual results to differ from our forward looking statements are described in our Form 10ks, Form 10 Qs and other filings with the Securities and Exchange Commission. Additional factors are described in our earnings release for the Q2 of 2018. Our estimates may change and the company assumes no obligation to update forward looking statements to reflect actual results, changed assumptions or other factors, except as required by law. As announced earlier, we will host our 2019 LNS Day on March 8 in Scottsdale, Arizona.
If you would like to attend the event and haven't received an invitation, please let us know. During the Q3, we will attend Citi Technology Conference in New York on September 6 and Deutsche Bank Technology Conference in Las Vegas on September 12. Now, let me turn it over to Bernard Gutmann, who will provide an overview of Q2 2018 results. Bernard?
Thank you, Farag, and thank you everyone for joining us today. We delivered yet another quarter of strong financial results, which exceeded our guidance and Street consensus on all key metrics. Near to mid term outlook for our business remains strong and overhang related to trade policy and tariffs has not had any meaningful impact on our business or outlook. Long term outlook for our business continues to strengthen driven by our accelerating momentum in automotive, industrial and server markets. Our margin performance remains strong and continuing expansion in both gross margin and operating margins.
Global microeconomic environment remains favorable and we are seeing strong demand for most geographies and end market. Customers are upbeat about near to midterm outlook. However, the sustained strong demand has strained the semiconductor industry supply chain, As we indicated in the previous call, to further accelerate our revenue momentum and margin expansion, we are making prudent investments in our manufacturing infrastructure. Now, let me provide you additional details on our Q2 2018 results. Total revenue for the Q2 of 2018 was $1456,000,000 an increase of 9% as compared to revenue of $1338,000,000 in the Q2 of 2017.
GAAP net income for the 2nd quarter was $0.35 per diluted share as compared to $0.22 in the Q2 of 2017. Non GAAP net income for the Q2 was $0.46 per diluted share as compared to $0.36 in the Q2 of 2017. GAAP and non GAAP gross margin for the 2nd quarter was 38.1%. On a GAAP basis, our 2nd quarter gross margin improved by 130 basis points year over year and on a non GAAP basis, gross margin improved by 120 basis points year over year. The strong gross margin performance was driven by solid operational execution and improving mix results from higher contribution from our automotive, industrial and server business.
2nd quarter gross margin was negatively impacted by the rise in certain input costs. We anticipate ramping additional internal wafer capacity towards the end of the year. We'd expect to partially offset the impact of increased input costs. With tailwinds from additional manufacturing synergies, ramp of internal raw wafer capacity and continuing mix improvement, we expect to make strong progress towards our target model in the current year. GAAP operating margin for the Q2 of 2018 was 13.5% as compared to 11.5% in the Q2 of 2017.
Our non GAAP operating margin for the Q2 of 2018 was 16.3%, an increase of approximately 160 basis points over 14.7% in the Q2 of 2017. On a year over year revenue increase of 9% for the Q2 of 2018, our non GAAP operating income increased by 21%. This strong operating income performance demonstrate the leverage and strength of our operating model. GAAP operating expenses for the Q2 were $358,000,000 as compared to $338,000,000 for the Q2 of 2017. Non GAAP operating expenses for the Q2 were $318,000,000 as compared to 2.97 in the Q2 of 2017.
We expect non GAAP operating expenses as a percent of revenue to decline for the remainder of the year and we expect to make strong progress in 2018 towards our target non GAAP operating expense intensity of 21%. 2nd quarter free cash flow was $117,000,000 and operating cash flow was $270,000,000 Capital expenditures during the Q2 were $153,000,000 which equate to capital intensity of 10%. Recall that to meet accelerating demand for our products and to mitigate the impact of steep rise in prices of raw wafers, we expect to a higher level of capital intensity in the current and next year. We continue to delever our balance sheet and in the Q2 we used $80,000,000 to pay down our debt. We exited the Q2 of 2018 with cash and cash equivalents of $850,000,000 as compared to $925,000,000 in the Q1 of 2018.
We used $40,000,000 cash to repurchase 1,700,000 shares of our stock. At the end of the second quarter, days of inventory on hand were 122 days, down by a day as compared to 123 days in the first quarter. Inventory increased in absolute terms in the second quarter as compared to the Q1. As part of the increase a part of the increase was driven by strategic build of inventory of certain raw materials. As I indicated earlier, the semiconductor supply chain is strained and we're making prudent investments to ensure continuity of timely supply of our products to our customers.
We intend to continue to build strategic inventory of raw material till supply situation stabilizes. We expect our internal inventories to continue to decline in terms of days in the 3rd quarter. Distribution inventory declined quarter over quarter in the second quarter. We expect distribution inventories to remain within our normal range of 11 to 13 weeks in the near term. To mitigate the risk of excessive inventory in the channel, we are proactively managing inventory in the distribution channel.
We have implemented systems to ensure that distributors don't carry more inventory than is needed to support 11 to 13 weeks of resales. For the Q2 of 2018, our lead times were up quarter over quarter. Our factory utilization for the Q2 was down quarter over quarter. Now let me provide you an update on performance of our business units, starting with the Power Solutions Group or PSG. Revenue for PSG for the Q2 was $748,000,000 Revenue for the Analog Solutions Group for the Q2 of 2018 was $513,000,000 and revenue for the Intelligent Sensing Group, formerly known as Image Sensor Group, was $195,000,000 Now, I would like to turn the call over to Keith Jackson for additional comments on the business environment.
Keith? Thanks, Bernard.
The Q2 of 2018 was yet another strong quarter for ON Semiconductor. We delivered strong revenue growth and robust margin expansion, which culminated in strong earnings performance for the company. Our momentum continues to accelerate, driven by strong traction of our products in automotive, industrial and server markets. Our design win pipeline continues to expand as customers increasingly engage with us for power, analog and sensor semiconductor solutions for the most demanding applications. We continue to strengthen our position as a key provider of enabling technologies for newly emerging and disruptive applications in automotive and industrial end markets.
With tailwinds from increasingly favorable macroeconomic conditions and strong momentum in our business, we continue to make strong progress towards our target financial model. While we are benefiting from our leadership in key segments of automotive, industrial and server markets, Overall, business conditions remain favorable and demand continues to be strong across most end markets. Pricing continues to be benign as compared to historic trends. Overhang related to trade policy and tariffs hasn't impacted the demand environment in any meaningful manner, and customers are upbeat about near to midterm outlook for their businesses. As I've indicated in recent earnings calls, our business today is driven by sustainable secular growth drivers in the fastest growing semiconductor end markets, as opposed to being driven by macroeconomic and industry cyclicality a few years ago.
Through our investments over the last many years in high growth segments and in highly differentiated products in automotive and industrial end markets, we have radically transformed the nature of our business. Customers are increasingly relying on us as a key provider of enabling technologies for newly emerging and disruptive applications in automotive and industrial end markets. Along with strong revenue momentum, our execution on operations front has been outstanding. Our operating model has shown strong operating leverage. As Bernard mentioned earlier, on a year over year revenue increase of 9% for the Q2, our non GAAP operating income increased by 21%.
Despite increases in certain input costs, which has negatively impacted the pace of our margin expansion, our margin drivers remain intact. With the ramp of our internal raw wafer capacity later this year, we should be able to partially offset the increase in input costs. At the same time, mix shifts towards margin rich automotive and industrial end markets should drive additional margin expansion. I'll provide details of the progress in our various end markets for the Q2 of 2018. Revenue for the automotive market in the 2nd quarter was 4 $54,000,000 and represented 31% of our revenue in the 2nd quarter.
2nd quarter automotive revenue grew by an impressive 10% year over year. For the Q2, we again saw strong broad based demand for most product lines and our momentum in the automotive market continues to accelerate, driven by robust design win pipeline and leadership in the fastest growing segments of the automotive market. During the Q2, we saw strong demand for our image sensors for ADAS applications. Our traction in ADAS image sensors continues to accelerate. With a complete line of image sensors, including 1, 2 and 8 megapixels, we are the only provider of a complete range of pixel densities on a single platform for the generation ADAS in autonomous driving applications.
We believe that a complete line of image sensors on a single platform provides us with significant competitive advantage, and we continue working to extend our technology lead over our competitors. Demand for power products for automotive applications continues to grow. With one of the broadest power portfolios in the automotive applications, we continue to see strong growth in our power related revenue for automotive applications. Other growth drivers for the 2nd quarter automotive revenue included power management for ADAS and instrument clusters, LED lighting, start stop alternators and 48 volt systems. Also, we are seeing strong growth for our silicon based power products in the EV HEV market.
Our silicon carbide development remains on track, and we expect to seek silicon carbide related revenue from automotive market in the second half of this year. Recently, we announced formal launch of our silicon carbide diodes for the automotive market. Our silicon carbide related design win pipeline is expanding at an impressive rate. We are well positioned to benefit from the transition to 48 volt electric systems from 12 volt in automobiles. Due to the proliferation of electric systems such as ADAS, infotainment, connectivity, etcetera, the 12 volt automotive electro system is being burdened by technology.
Furthermore, due to ever tightening global CO2 emission regulations and increased demand for improved fuel economy, light vehicles are in need of more power as electro mechanical systems transition to highly efficient full electric systems. The need for higher power in light vehicles is driving transition to 48 volt electric systems. ON Semiconductor offers an expanding portfolio of 48 volt products, including a full line of MOSFETs, integrated power modules, current sense amplifiers, gate drivers and eFuse devices. Revenue in the Q3 for the automotive end market is expected to be up quarter over quarter. The industrial end market, which includes military, aerospace and medical, contributed revenue of $402,000,000 in the 2nd quarter.
The industrial end market represented 28% of our revenue in the 2nd quarter. Our 2nd quarter industrial revenue grew by a solid 14% year over year and strength in the industrial market was very broad based with all the sub segments posting robust year over year growth. With a broad range of power products for complete spectrum of voltages starting from low voltage to high voltage, we have one of the most comprehensive portfolios power devices and modules. We have clearly emerged as a credible alternative to the current leader in power semiconductor market and consequently, customers are engaging with us in an increasing rate. We expect the demand for our power products for the industrial market to continue to accelerate.
While the EVHEV market is a key driver for our automotive business, we are also seeing complementary growth in our IGBT business driven by charging stations for EVHEV. Along with our power products, machine vision is rapidly emerging as a key driver of our industrial revenue. As we've indicated earlier, according to independent research firms, On Semiconductor is a leader in image sensors for industrial applications. We continue to leverage our expertise in the automotive market to address most demanding applications in industrial and machine vision markets. Both of these markets are driven by artificial intelligence and face similar challenges such as low light conditions, high dynamic range and harsh operating environments.
Revenue in the Q3 for the industrial end market is expected to be down quarter over quarter. The communications end market, includes both networking and wireless, contributed revenue of $249,000,000 in the 2nd quarter. Communications end market represented 17% of our revenue in the 2nd quarter. 2nd quarter communications revenue declined by 3% year over year due to weakness in the smartphone market. While smartphone market has slowed down during the last few quarters, our content in smartphones has been increasing with every generation of new devices.
We expect continued growth in our content on new smartphone devices in the near to mid term. Revenue in the Q3 for the communications end market is expected to be up quarter over quarter due to normal seasonality, increased content and the launch of new device models. The computing end market contributed $147,000,000 in the 2nd quarter. The computing end market represented 10% of our revenue in the 2nd quarter. 2nd quarter computing revenue grew by 17% year over year.
The year over year growth was driven primarily by a ramp in our cloud and server business. We are seeing strong traction in our server business. We are engaged with leading cloud and server players and we are working with leading CPU providers on their next generation platforms. Our engagement with customers in cloud servers and server ecosystem continues to grow. We expect continued growth in our server business in the near to midterm.
In addition to onboard power management, we are seeing acceleration in demand for our mid voltage and high voltage power products for server power supplies. Revenue in the Q3 for the computing end market is expected to be up quarter over quarter due to normal seasonality and a continuing ramp in the server business. The consumer end market contributed $203,000,000 in the 2nd quarter. Consumer end market represented 14% of our revenue in the 2nd quarter. Q2 2018 consumer revenue was up 7% as compared to consumer revenue in the Q2 of 2017.
Strength in white goods was a key driver of year over year growth in the consumer end market in the Q2. Revenue in the 3rd quarter for the consumer end market is expected to be up quarter over quarter due to normal seasonality. In summary, demand for our products is accelerating, driven by strong customer acceptance of our power, analog and sensor products for automotive, industrial and server end markets. In face of strong demand environment and constrained supply conditions in the semiconductor industry, our execution remains solid on all fronts. We're investing to increase our manufacturing capacity and further strengthen our industry leading cost structure.
We have established leadership in highly differentiated power, analog and sensor semiconductor solutions. Customers are increasingly relying on us as a key provider of enabling technologies for newly emerging and disruptive applications in automotive and industrial end markets. Along with strong revenue performance, we are driving significant margin expansion. We continue to make solid progress towards our target financial model. Now, I'd like to turn it back over to Bernard for forward looking guidance.
Bernard?
Thank you, Keith. Based on product booking trends, backlog levels and estimated turn levels, we anticipate that toll on semiconductor revenues will be $1,485,000,000 to $1,535,000,000 in the Q3 of 2018. For the Q3 of 2018, we expect GAAP gross margin to be in the range of 38% to 39% and non GAAP gross margin in the range of 38.1 percent to 39.1 percent. Factory utilization in the Q3 is likely to be flat as compared to that in the Q2. We expect total GAAP operating expenses of $348,000,000 asset impairments and other charges, which are expected to be $29,000,000 to $33,000,000 We expect total non GAAP operating expenses of $319,000,000 to $333,000,000 We expect our non GAAP operating expenses as percentage of revenue to decline from current levels during the remainder of the year.
We anticipate 3rd quarter GAAP net other income GAAP net other income and expense, including interest expense will be $32,000,000 to $35,000,000 which includes non cash interest expense of $9,000,000 to 10,000,000 dollars We anticipate our non GAAP net other income and expenses, including interest expense, will be in the $23,000,000 to $25,000,000 Cash paid for income taxes in the Q3 of 2018 is expected to be $11,000,000 to 15,000,000 dollars We expect our 2018 cash tax rate to be lower than 10%. We expect total capital expenditures of $120,000,000 to $140,000,000 in the Q3 of 2018. We also expect share based compensation of $19,000,000 to $21,000,000 in the Q3 of 2018, of which approximately $2,000,000 is expected to be in cost of goods sold and the remaining amount is expected to be in operating expenses. This expense is included in our non GAAP financial measures. Our GAAP diluted share count for the Q3 of 2018 is expected to be in the 445,000,000 to 447,000,000 shares based on current stock price.
Our non GAAP diluted share count for the Q3 of 2018 is expected to be 432,000,000 shares based on the current stock price. Further details on share count and earnings per share calculations are provided regularly in our quarterly and annual reports on Form 10Q and Form 10 ks. For the full year 2018, we expect to generate free cash flow of approximately 800,000,000 dollars With that, I would like to start the Q and A session. Thank you. And Sonia, please open up the lines for questions.
Thank Our first question comes from Ross Seymore of Deutsche Bank. Your line is now open.
Hi, guys. Thanks for letting me ask a question. Keith, first one for you. At the high level, demand sounds strong across the board and I know you talk about the secular drivers versus the cyclical drivers. But when you're putting this much CapEx to work, how do you think about the magnitude
of capacity you want to bring online and the duration
of the elevated CapEx of capacity you want to bring online and the duration of the elevated CapEx versus an industry that is cyclical and the macroeconomic expansion that a lot of people will argue is long in the tooth.
Understood. Yes, we have been investing specifically to match the growth we've had for the last couple of years, looking in the high single digits, low double digits, has put a strain in our overall capacity. And frankly, we're looking at economical ways to extend that capacity. So we're not getting ahead of things. We're certainly not putting capacity in place that we expect to be idling.
The other piece of it is all of the work we've been doing is going to lead to further cost reductions over time with more automation as we've been investing. So net net, we're expecting at least another year of high single digit growth. We're investing for that, and then we should return to a much more normal 6% to 7% growth.
Great. And then as my follow-up one for you, Bernard, on the OpEx side of things. You talked about the OpEx intensity falling through the back half of the year. Obviously, we can do the math on what you just guided to in the Q3. But in the Q4, typically, your revenues go down a little bit seasonally.
Is your OpEx guidance that you're actually going to be able to get better OpEx leverage even into the Q4? And then how should we think about next year on that same metric?
The only clarification there, thanks, Ross, is on the Q4, we have a few extra days. So that's something that will have to play into the equation. But nevertheless, we still expect to be coming down from the 22% level we had last year and the 21.8% we had in the first half.
Thank you. And our next question comes from Chris Sarnia of Citi. Your line is now open.
Hey, thanks guys. Just a follow-up on OpEx.
In Q1, it was at the high end
of the range you guided for. In this quarter,
I think it was either the high end
of the range or above it. So can you just talk about why it's kind of missed the middle of expectations or I guess what's gone wrong so far and what you're doing to fix it going forward?
So we have been within the range. We were also slightly below the high end of the range, but still within the range in the Q2. We have targeted to increase our investments in R and D in certain areas that have talked about, things like silicon carbide, lidar, all of the power discrete stuff has we have decided to invest a little bit more in that. We have also had some higher litigation costs. So in the Q3, we expect in absolute dollars to still go up, although as a percent of revenue will be coming down.
So those are the main causes. It's mostly R and D investments.
Yes. And then on the tightness in the industry, can you just talk about what your lead times are doing or what lead times are doing at the competitors as well?
We believe lead times are extended across the board everywhere. We did have a slight increase ourselves in the last quarter. I'm not sure that, that will continue to expand. I expect that it will start to normalize quickly as capital expenditures finally catch up in the second half.
Thanks, Keith. Just a clarification, can you just tell us what the lead times were and what is normal?
So normal is kind of low teens, and we are above that at this time.
And our next question comes from Vivek Arya of Bank of America Merrill Lynch.
Congratulations on the good growth and execution. Keith, on the wafer capacity investment, is this something that helps you meet your 40% gross margin target? Or can you actually see that investment driving a beating of that target? I think we sort of know what the cost is of all these investments, but what and when and how much is the benefit that we should see?
Yes. On the actual wafer growing side, it's offsetting a lot of increased costs. But frankly, we need that to handle increased demands right now. So it's kind of moderating the overall cost in the supply chain as opposed to offering real reductions in total because again, we need all the capacity there. I
see. And then when the year started, your top line growth was expected to be about 3% to 4%. You're growing closer to 9%. Is this macro? Is this your specific product cycle?
And just how is your visibility to maintain this kind of growth over the next handful of quarters?
Yes. We're very encouraged, and it's being driven by specific high growth applications in our target markets. So it's not just a strong economy. It's frankly the acceleration of electronic usage in automotive for safety and automation, in industrial for power savings and new applications to support things like charging stations in the marketplace. So very encouraged.
It's a design win pipeline that is accelerating faster than we expected and not just a strong economy.
And just one last quick one clarification. Bernard, can you remind us how much is left in the buybacks and what would be the trigger to become more aggressive on the buyback side? Thank you.
So the buyback, we had it for about $1,000,000,000 we have used. We have still around $600,000,000 plus available. We did $40,000,000 in the second quarter, which represented about 1,700,000 shares. Now we are still also paying down our debt. As we mentioned in the prepared remarks, we did reduce our debt by about $80,000,000
Thank you.
Thank you. Our next question comes from Shawn Harrison of Longbow Research. Your line is now open.
Hi, good morning and congrats on the results. Is there a way to maybe clarify how much margin pressure you're seeing right now from the input cost or profitability that you're leaving on the table that will begin to mitigate in the second half of the year?
We've had price increases on substrates from 25% to 40 percent increase year over year and in the lead frame area around 15% year over year. So those are very significant pressures. We've been able to partially offset that with some good pricing on our side, not having the declines that we normally see there being able to maintain that has partially offset that.
Okay. And then maybe a question for you Bernard. Getting to the $800,000,000 of free cash flow for the year requires a big step up in the second half. Maybe if you could just speak to the components of the acceleration in free cash flow knowing it's typically a little bit back end weighted?
Yes, Sean. Thank you. Definitely, historical pattern shows us that the free cash flow generation is substantially back end loaded and we expect that that will that pattern will continue. We did step up our CapEx in the Q2 even beyond where our 8% to 9% model is. So we expect that will be normalizing to that 8% to 9%.
And we had some investments as we talked about in working capital. Some of those will be slowing down in the 3rd Q4. But we expect the operational performance will also help us lift those numbers.
Thank you. Our next question comes from Tristan Gerra of Baird. Your line is now open.
Hi, good morning. Just wanted to follow-up on a earlier question. So you mentioned price increase in substrates and wafers. What was the bit impact on your gross margin? And what will be the percentage change in your own ASPs embedded in the Q3 guidance?
So taking reverse order, our ASP expectations in the guidance is relatively benign compared to normal, not increasing, still a slight decline, but not very much. As far as contributions or margin pressure in our results, The raw material side of the equation represents roughly 40% or more of the costs for the products. So if you use the percentage that I gave you, you get a rough idea of how much pressure there was.
Okay, great. And then could you tell us, unless I missed it, what the point of sale was sequentially in Q2 and what is the percentage change embedded in your Q3 guidance?
Meaning resales? Tristan, can you repeat the question please?
I was looking at the percentage change in point of sale, the cell flow due to sequentially and what you're seeing?
Okay. So the resales in the channel were substantially up and that allowed us to reduce the number of weeks of inventory. It was definitely higher up even than our own internal revenue printout.
And for Q3?
We expect it to be in the season up and about seasonal.
Great. Thank you very much.
Thank you. Our next question comes from Chris Caso of Raymond James. Your line is now open.
Hi, thank you. Good morning. The first question is on the communication space. It looks like that came in a little better than your expectations. Can you talk about what you're seeing in that space and the expectation as you move into the September quarter?
September quarter, as you would guess, sees new phone launches, which is the bigger piece of the revenue there. And so we are expecting a continued sequential increase there per normal. Again, year on year comparisons, which we gave in our prepared remarks for Q2, certainly things were down. Q3 should see something returning to very similar levels to last year.
Okay. Thank you. And just a follow-up, you mentioned in your prepared remarks, silicon carbide. Just a couple of questions on that. Can you talk about when that becomes material in terms of revenue?
I guess the expectation about the second half of this year into 2019. Maybe talk a bit about what you expect to differentiate on in the silicon carbide space?
So basically, there it is performance based. In most of our sales, we expect to happen in modules, where we get to match performance with our full portfolio. And so therefore, we do think there's going to be a competitive edge on total efficiency in the marketplace. That growth, again, starts here in the second half, but we expect that it will accelerate significantly in 2019 and by second half of next year provide significant revenue.
Thank you.
Thank you. Our next question comes from Rajvindra Gill of Needham and Company. Your line is now open.
Yes, thanks and congrats on good results and momentum. You talked about capacity constraints and that's kind of plagued the industry and a lot of other competitors as well. I was wondering if you could kind of explain why that is happening? Did the entire industry underestimate the level of demand that's happening? Any thoughts on the capacity constraint environment and what are the reasons?
Well, there's several levels of reasons for constraints. I think the raw material piece of it, frankly, is underinvestment that occurred in the both silicon substrate markets and leadframe markets for the last number of years. Again, under calling, if you will, the future demands. And so that's creating a lot of pressure on the supply chain side. And then frankly, the on the product side, if you can get through that, some of the disruptive applications have taken off much, much faster than people expected.
So that combination has provided quite a few constraints in the market.
And Bernard, you had mentioned that you believe you'll be able to reach your target model this year. Were you talking about with respect to gross margins? I believe your gross margin target was 40% achieved in 2020.
We have basically said we're going to make good and nice progress towards it. The target model is still out for 2020 and we are working in Accelerate and doing some good progress towards it, but do not expect that we'll need it in 2018.
Okay. Thank you.
Thank you. Our next question comes from Kristin Seja of Nomura Instinet. Your line is now open.
Good morning. Thanks for taking my question. In the prepared comments, you mentioned that industrial is expected to be down sequentially in the 3rd quarter, albeit up meaningfully year over year. Is this just the effects of normal or typical seasonality or is there something else in play here? It's mostly seasonality.
Okay, great. And then keeping on that kind of track of seasonality, we've heard from some other peers that typical seasonality has been almost altered over the past couple of years. Have you seen that in your businesses as well or do you are you still sticking to generally historical trends?
I think the our company specifically with the M and A that we've done, we've had a changing profile. But directionally that seasonality is still correct.
I would say that in general terms, the Q2 to Q3 has moderated a little bit and it's now around 4%, 3% to 4%, used to be more because you had more computing and consumer and communications in the number and now with automotive and industrial, it's a little bit more front loaded, but hasn't changed materially.
Great. Thank you.
Thank you. Our next question comes from Craig Ellis of B. Riley FBR. Your line is now open.
Yes. Thanks for taking the question and congratulations on the execution guys. Keith, I wanted to follow-up on one of the Q and A comments. I think it was in response to Ross' question about CapEx. I think you mentioned that some of the investment that is being made now is because there's a view that high single digit growth could persist into 2019.
I wanted to understand better where that visibility might exist across product groups and is that really related to the strategic groups like industrial and auto or the business overall?
Yes, it's driven mainly by industrial and auto and the design wins that we have secured there and have strong visibility on. The server market also same situation where we know what those design wins are next year. And then in addition to that, I mentioned in the last call, we're getting long term agreements for supply, and those are adding up quickly. So we have much more confidence than we normally would have looking at a year ahead.
And then the follow-up is for Bernard. Just housekeeping item, Bernard. Tax rate, should we still expect 10% for this year and the next couple of years? Or is it coming in lower than that?
I expected for 2018 to be lower, and that's what I said in the prepared remarks. And for the 2019 20%, 10% is still a good number.
Thanks guys.
Thank you. Our next question comes from Christopher Rolland of Susquehanna International Group. Your line is now open.
Hey, guys. Thanks for the question. So I know you guys in your prepared remarks said you didn't think there were any effects from tariff fears out there. But one of your competitors actually mentioned that in the white box market, you guys are obviously doing pretty well there. But for them, they said that customers were reluctant to hold finished goods inventory.
Perhaps you could talk about that. Are you seeing any sort of effects at all from that? And just talk about maybe tariff fears and how you view that more broadly?
No, we have not seen that in any of the businesses yet. The white goods piece, you may recall the tariffs got implemented on the consumer white goods some time ago, several quarters ago. And so I'm not sure how that plays out. And in the air conditioner market, we have not seen any of those concerns. So quite frankly, we've seen no lack of demand and no hesitation from customers ordering to their run rates.
Great. And one for Bernard. So I noticed you changed your range. You narrowed it for gross margin guidance and was just wondering what gives you more confidence there and should we expect that narrow range moving forward?
No, we were just looking at our historical patterns and we feel confident that we don't need as wide as a range for guiding purposes. Historical performance tells us that we should be able to be within that range.
Thanks guys.
Thank you. Our next question comes from Kevin Cassidy of Stifel. Your line is now open.
Thank you and congratulations on the great results. Keith, you had mentioned in your prepared remarks in computing higher power supply interest in higher voltage power supply. Are you seeing any trend at all? I know Google has mentioned it of 48 volt coming into the data center for better power efficiency. Are you seeing
Yes. Definitely planning around that, not a lot of revenue today.
Okay. Would the same products that you're developing for automotive be able to play into that?
Same technologies. The products are actually different, but the technologies are the same.
Okay. If I
could ask one other. On the internal wafer, I think last quarter you had said it was slightly or it's less than 50% of your total usage. What's the target? How high of a percentage of internal use do you expect to have internal wafers?
We're expecting to bring it up to about that 50% point, and that's kind of our target unless the industry continues to experience difficulties.
Thank you.
Thank you. Our next question comes from Mark Delaney of Goldman Sachs. Your line is now open.
Yes, good morning. Thanks for taking the questions. My first question is a follow-up on that same topic about the internal raw wafer supply. Are you assuming any benefit from increased internal supply in your 3Q 2018 guidance? And when would you expect to have that full 50% from in house wafers?
Yes. The equipment doesn't really get up and running until the Q3, which means those substrates won't flow through our P and L until the 4th. So we should start seeing benefits in the 4th quarter and full benefit by Q1.
That's helpful. And a follow-up question on the industrial market. In the prepared comments, you mentioned share gain. And of the strong year over year growth, do you have a sense about how much is just product cycles and just end demand? And then how much of it's coming from that share gain that you spoke to?
You can look at the, I guess, the industry numbers to figure out what the year over year market gains would be and all the delta would be from share gains. So I don't know if it's half and half, but it's something in that order of magnitude.
Thank you.
Thank you. Our next question comes from Harlan Sur of JPMorgan. Your line is now open.
Good morning and great job on the quarterly execution. ISG was down about 2% year over year when your industrial business combined is growing about 12%. I know that you guys have talked about some of the headwinds as you move out of some of the more commodity segments of the market that might be hiding some of the growth of the focus areas. I know you guys had previously talked about auto image sensor market growing about 20% kind of on a longer term CAGR. Is that how fast auto ISG revs are kind of trending right now?
Yes, it is. They're better than 20% growth in the automotive sector, and that was offset by getting out of the consumer and handset markets. So it is somewhat masked at the total level, but we're getting the performance from automotive we expect.
Great. Thanks for the insights there. And consumer has been a bright spot, right? It's been healthy driving high single digits year over year growth actually for the last few quarters and this is versus your long term view of kind of mid to high single digit year over year declines. Help us understand what's been driving the strong year over year growth rates?
And do the trends here and your design win pipeline suggest a better longer term outlook versus what you guys put out at your last Analyst Day?
Yes. So most of it's been driven by better than expected white goods. And that market has been good for us. And it looks like people there are going for much more efficient solutions on a percentage of their total bills than they used to be doing. So we're getting good traction on our modules there.
Great. Thank you.
Thank you. Our next question comes from Harsh Kumar of Piper Jaffray. Your line is now open.
Hey, guys. Congratulations on solid numbers and solid guidance. I had two quick questions. Your industrial business sort of exploded up to 14% growth year over year, coming down seasonally in 3Q. I guess, if you don't mind giving us some insight into what's driving that, what drove that 14% growth?
And if there's a delta part that's falling for you in 3Q guide? And then I have a follow-up.
Yes. So it was that year on year stuff was driven by many factors, mostly power products and being used for increased efficiency across the entire industrial market. One of the areas that this caused some flattening is a slowing down in the solar market, particularly in China as some of those subsidies have been relaxed. And so that's creating a little bit of the down. But in general, the market remains robust.
And we expect, again, very strong growth on a yearly basis.
Thanks, Keith. And then for my follow-up, a couple of the companies that have reported have basically given us some idea of how much of their product is manufactured in China, front and back end. Is there some way for us to think about or some color you can provide us to help us think about that number?
So we do assembly test operations in China. And I don't have specific numbers with me today, but it's probably in the 3rd range on a dollar value of our
total. Thanks.
Thank you. Our next question comes from Craig Hettenbach of Morgan Stanley. Your line is now open.
Yes, thank you. Keith, just a follow-up question on lead time. The comment around normalizing quickly as capacity comes online, do you think that's a Q3 or Q4 event in terms of lead times coming in?
No, I think the expansion will start slowing. What happened to us and I think has happened across the industry is that lead times for equipment expanded quite rapidly. So things you ordered last year just now coming into the 3rd Q4. What I'm expecting is that, that growth rate will be offset by equipment actually arriving. And so I'm looking for a stop to the growth in the lead times in the 3rd quarter with some opportunity for reduction towards Q4, Q1.
Got it. Thanks. And then just a question on the computing market, just kind of resurgence of growth there and you talked about kind of data center. Any context in terms of legacy Fairchild portfolio in terms of contribution there and as you going forward?
Well, a significant growth in the server arena is really from the legacy or not legacy, but from the Fairchild acquisition. There was PowerStage that they developed are what's growing the fastest in servers right now.
Our next question comes from John Pitzer of Credit Suisse. Your line is now open.
Yes. Good morning, guys. Thanks for letting me ask the question. Keith, someone asked about the industrial guidance in Q3 relative to seasonal. I'll guess I'll ask the same question on the auto, which I think is the only end market you didn't reference relative to seasonal.
I think 2 out of the last 4 years it's been down, 2 out of the last 4 years it's been up, you're guiding up. How are you doing that seasonal versus content growth versus other drivers for September?
Yes, for us, it's all content growth because most of the automotive makers take their lines down and convert them for the new models in Q3, which normally causes the disruption and the down part. And this year, the content piece has overwhelmed that.
That's helpful. And then Bernard, I just want to go back to the free cash flow question asked earlier. The full year guide of $800,000,000 just suggests that the second half is going to be up over 100% over the first half. And I know there is some seasonality to your free cash flow and you should get some tailwinds from CapEx coming down in the back half of the year versus what looks like a peak in the June quarter. But are there any other one offs we should be thinking about?
And just given the real acceleration in free cash flow in the back half of the year, how are you guys thinking about use of cash in Q3 and Q4?
So indeed, there is no additional things except just the P and L generated as well as moderating working capital as well as CapEx that will generate that will help us generate the $800,000,000 The use of free cash flow, we do have our share buyback program. We did $40,000,000 in Q2 and we did pay $80,000,000 of debt. We will continue along the same path with similar approach. Perfect. Thanks guys.
Thank you.
Thank you. And ladies and gentlemen, this does conclude our question and answer session. I would now like to turn the call over to Parag Agarwal for any further remarks.
Thank you, everyone, for joining the call today. We look forward to seeing you at various conferences during the Q3. Thank you and bye bye.
Ladies and gentlemen, thank you for participating in today's conference. This concludes today's program. You may all disconnect. Everyone, have a great day.