Good day, ladies and gentlemen, and welcome to the ON Semiconductor first quarter 2018 earnings conference call. At this time, all participants are in a listen only mode. Later, we'll conduct a question and answer session and instructions will follow at that time. If anyone should require operator assistance, please press star then zero on your touchtone telephone. As a reminder, this call is being recorded. I would now like to introduce your host for today's conference, Parag Agarwal, VP of Corporate Development and Investor Relations. You may begin.
Thank you, Sarah. Good morning, and thank you for joining ON Semiconductor Corporation's first quarter 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.onsemi.com. A replay of this broadcast, along with our earnings release for the first quarter of 2018, will be available on our website approximately one hour following this conference call, and the 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 events or results to differ materially from 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 Forms 10-K, Form 10-Qs, and other filings with the Securities and Exchange Commission.
Additional factors are described in our earnings release for the first quarter of 2018. Our estimates may change, and the company assumes no obligation to update forward-looking statements to reflect actual results, changed assumption, or other factors, except as required by the law. For all synergies related discussion on this call, we have used fiscal year 2015 results as the base for all comparisons. We will host our 2019 Analyst Day on March 8th in Scottsdale, Arizona. We will send the invitations for the event shortly. Now, let me turn it over to Bernard Gutmann, who will provide an overview of the first quarter 2018 results. Bernard?
Thank you, Parag, 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 midterm outlook for our business remains strong. Furthermore, long-term outlook for our business continues to improve as we are seeing an inflection in long-term demand for our products. We continue to expand our gross margin and operating margins, and we are making prudent investments to drive future revenue growth and margin expansion. With strong revenue growth coupled with margin expansion, our free cash flow generation remains robust. We're making strong progress towards our target financial model. We continue to see solid strength in our business. Indications from our customers and macroeconomic data point to continuing strength in demand for our products in near to midterm.
Our design win pipeline continues to expand, driven by a strong product portfolio for emerging and fast-growing applications in the automotive and industrial end markets. Global macroeconomic environment remains highly favorable, and we're seeing strong demand from all geographies. We see an upwards inflection in long-term demand for our products, especially for automotive and industrial end markets. This inflection in demand is driven by strong traction of our power management products for medium and high voltage applications. We continue to further strengthen our position in imaging market for automotive and industrial applications, and demand outlook for our imaging products continues to strengthen. We have established ourselves as a strategic long-term partner for our customers, and our customers are increasingly relying on us to meet long-term demand for power management and sensor semiconductor products.
With increasing strategic engagement with us, many customers are now asking us to enter into long-term supply agreements. Accelerating long-term demand for our products and customer requests for long-term supply agreements necessitate us to increase the level of investments in our manufacturing capacity. We continue to invest to drive our revenues and margins. We are also increasing our investments in our captive raw wafer manufacturing capacity in the Czech Republic. The primary objective of our increased investment in our raw wafer manufacturing capacity is to offset the impact of steep rise in market prices for raw wafers. This investment should help us expand our margins, as we don't expect any moderation in raw wafer pricing for the foreseeable future. I must point out that we're among a very few semiconductor companies with the capability to manufacture their own raw wafers.
As a result of our increased capital investment, our capital intensity for 2018 and 2019 will likely be in the 8%-9% range, as opposed to our target of 7%. As I indicated earlier, the increase in capital expenditure is driven by the need to make investments to adjust to higher growth environment and to further improve our manufacturing cost structure. We believe that after making higher capital investments in 2018 and 2019, our long-term capital intensity should come down to 7%. Free cash flow generation remains a key priority for the company. Despite higher capital investments, we expect to generate approximately $800 million of free cash flow in 2018. We intend to use this free cash flow for deleveraging and share repurchases. I am very pleased to announce that we have reinitiated our stock repurchase program in the second quarter.
Given our accelerating momentum in key strategic markets and our roadmap for margin expansion and free cash flow generation, we are very upbeat about our future outlook. We believe that repurchase of our share at current price level is a very attractive use of our cash. Let me provide you with additional details on our first quarter 2018 results. Total revenue for the first quarter of 2018 was $1.378 billion, a decrease of 4% as compared to GAAP revenue of $1.437 billion in the first quarter of 2017. Our revenue for the first quarter increased by 7% as compared to non-GAAP revenue of $1.28 billion in the first quarter of 2017. Recall that in the first quarter of 2017, we had a one-time benefit of $155 million to our revenue due to the change from sell-through to sell-in revenue recognition.
GAAP net income for the first quarter was $0.31 per diluted share as compared to $0.18 in the first quarter of 2017. Non-GAAP net income for the first quarter was $0.40 per diluted share as compared to $0.27 in the first quarter of 2017. GAAP and non-GAAP gross margin for the first quarter was 37.6%. On a GAAP basis, our first quarter gross margin improved by 260 basis points year-over-year. Our non-GAAP basis gross margin improved by 220 basis points year-over-year. The strong gross margin performance was driven by solid operational execution and improved mix, resulting from higher contribution from our automotive, industrial, and server businesses. With tailwinds from additional manufacturing synergies from Fairchild, mix improvement and portfolio optimization, we expect to make strong progress towards our target model in the current year.
GAAP operating margin for the first quarter 2018 was 13.5% as compared to 12.7% in the first quarter of 2017. Our non-GAAP operating margin for the first quarter of 2018 was 15.7%, an increase of approximately 250 basis points over 13.2% in the first quarter of 2017. On a year-over-year non-GAAP revenue increase of 7% for the first quarter of 2018, our non-GAAP operating income increased by 28%. This strong operating income performance demonstrates the leverage and strength of our operating model. GAAP operating expenses for the first quarter were $332 million as compared to $320 million in the first quarter of 2017. Non-GAAP operating expenses for the first quarter were $301 million as compared to $285 million in the first quarter of 2017.
Operating expenses for the first quarter were higher than the midpoint of the guidance due to higher revenue and increased R&D investments to support newly emerging opportunities in automotive and industrial end markets. We expect our non-GAAP operating expenses as a percent of revenue to continue to decline for the remainder of the year. We expect to make strong progress in 2018 towards our target non-GAAP operating expense intensity of 21%. First quarter free cash flow was $127 million. Operating cash flow was $226.5 million. Capital expenditures during the first quarter were $100 million, which equate to a capital intensity of 7%. We continue to delever our balance sheets. In the first quarter, we used $136 million to pay down our debt. We exited first quarter of 2018 with cash and cash equivalents of $925 million as compared to $949 million in the first quarter of 2017.
At the end of the first quarter of 2018, days of inventory on hand were 123 days, up by eight days as compared to 115 days at the end of the fourth quarter of 2017. The increase in inventory was driven by expectation of continuing strong demand for our products in the near to midterm. Semiconductor industry supply has been strained in recent months due to a strong demand environment. By maintaining an adequate level of inventory in line with expected demand, we want to ensure that we are able to meet our customer requirements. We expect our internal inventories to decline in terms of days during the second quarter of 2018. After successive declines in the last three quarters, distribution inventory went up in the first quarter. This increase was driven by expectation of strong distribution sell-through 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 do not carry more inventory than that is needed to support 11 to 13 weeks of resales. For the first quarter of 2018, our lead times were up slightly quarter-over-quarter. Our global factory utilization for the first quarter was slightly up quarter-over-quarter. Now let me provide you with an update on performance of our business units, starting with Power Solutions Group or PSG. Revenue for PSG was $693 million. Revenue for Analog Solutions Group for the first quarter of 2018 was $496 million, and revenue for the Image Sensor Group was $189 million.
Now, I would like to turn the call over to Keith Jackson for additional comments on the business environment. Keith?
Thanks, Bernard. First quarter of 2018 was another successive quarter of strong results and solid all-around performance. We continue to deliver strong revenue growth, along with solid margin expansion and robust free cash flow generation. Our momentum in key strategic markets continues to accelerate, driven by new products and our exposure to the fastest-growing subsegments in automotive and industrial markets. We are seeing strong ADAS, LED lighting, machine vision, and energy efficiency applications. With tailwinds from increasing favorable macroeconomic conditions and strong momentum in our business, we are well positioned to make strong progress towards our target financial model in 2018. Business conditions remain favorable, and demand continues to strengthen across most end markets. Pricing continues to be benign as compared to historic trends. We are seeing strong demand for our products in automotive and industrial end markets.
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, industrial, and communications 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. The sustained demand for semiconductors over the past several quarters has put pressure on the industry's ability to meet demand. We expect this strengthened demand to continue for the foreseeable future, driven primarily by structural changes in the end-market dynamics and a strong global macroeconomic environment.
We expect demand for semiconductors from automotive and industrial end markets to continue to grow at a steady pace for the next few years. Furthermore, revival of computing end market by Artificial Intelligence and data centers and emergence of new applications such as IoT should result in strong demand for a broad array of semiconductor products. Given the increasingly strategic nature of our engagement with our customers and generally tight semiconductor industry supply environment, many customers now want to enter into a long-term supply agreement with us. To ensure that we are well positioned to address our customers' demand, we intend to put in capacity to address areas of strategic thrust in automotive and industrial end markets. We're also making strong progress in expanding our capacity in our eight-inch joint venture fab in Japan.
As Bernard noted in his remarks, prices for raw wafers have increased substantially in the last few months. We are among the very few semiconductor device manufacturers with captive wafer manufacturing operations. We've been able to moderate the impact of rise in cost of raw wafers. Given our outlook for semiconductor industry growth for the next few years, we believe that prices for raw materials for semiconductor manufacturing will continue to be a challenge for the semiconductor industry. We are raising our investment to further extend our competitive advantage from our captive raw wafer operations. With higher level of investments in strategic capacity for fast-growing products and in our captive raw wafer manufacturing operations, we expect to see a rise in our capital intensity for 2018 and 2019. We expect capital intensity of 8%-9% for 2018 and 2019, slightly higher than our target model of 7%.
As Bernard indicated in his remarks, this higher level of capital intensity is driven by the need to make investments to adjust to better expected demand for our products. We expect capital intensity to subside to 7% after 2019. Our margin performance continues to be stellar. Our operating model has shown strong operating leverage. As Bernard mentioned earlier, on year-over-year revenue increase of 7% for the first quarter of 2018, our non-GAAP operating income increased by 28%. Insourcing of Fairchild's back-end operations remains on track, and this insourcing should drive meaningful margin expansion in 2018 and 2019. At the same time, mix shift towards margin-rich automotive and industrial end markets and further divestiture of non-core businesses should drive additional margin expansion, despite increases in prices for raw material. Now I'll provide details of the progress in our various end markets for the first quarter of 2018.
Revenue for the automotive market in the first quarter was $445 million and represented 32% of our revenue in the first quarter. First quarter automotive revenue grew by 8% year-over-year. For the first quarter, we again saw strong, broad-based demand for most product lines. We continue to see strong demand for our image sensors for ADAS applications. With a complete line of image sensors including one, two, and eight megapixels, we are the only provider of complete range of pixel densities on a single platform for the next generation of ADAS and 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. Our design win pipeline for ADAS continues to grow at a rapid pace.
We are actively engaged with our ecosystem partners for development of next generation ADAS systems. We remain the primary image sensor partner for leading ADAS and autonomous driving technology leaders. Driven by our technology lead, we are seeing strong traction for our image sensors for ADAS applications in China. Our silicon carbide development remains on track. We expect to see silicon carbide related revenue from automotive market in the second half of this year. In addition to image sensors, we experienced strong growth in our mixed signal ASIC power modules and MOSFETs. Growth in our LED lighting business continues to accelerate, driven by the ramp of design wins and increased penetration of LEDs in automotive lighting. Our design win momentum continues to be strong in the automotive market.
As car makers are increasing focus on reducing carbon dioxide emissions, they're relying us to provide highly efficient IGBTs and other power management devices. Revenue in the second quarter 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 $362 million in the first quarter. The industrial end market represented 26% of our revenue in the first quarter. Our first quarter industrial revenue grew by a solid 11% year-over-year. The strength in the industrial market was very broad-based, with all the sub-segments posting robust year-over-year growth. We continue to benefit from demand for our power modules and power management semiconductor solutions for the industrial markets.
Our power module business for industrial applications continues to grow at a tremendous pace. We expect this momentum to continue for the next few years as we launch new products with higher efficiency. The focus on energy efficiency around the globe, our design win pipeline for our power modules continues to expand at a rapid rate. We expect power modules to be a long-term driver for our industrial business. We believe that we have one of the most comprehensive industrial power management portfolios comprising a broad range of devices across the power spectrum. This portfolio of devices is further complemented by a rapidly expanded portfolio of power modules for a broad range of applications, ranging from alternative energy to commercial air conditioning. Customers are increasingly relying on us as a credible alternative to the current market leader for medium to high voltage power semiconductor solutions.
In the machine vision market, we continue our momentum with our PYTHON line of image sensors. According to Yole Développement, a leading market research firm, ON Semiconductor is the leader in image sensors for industrial applications. With leadership in industrial and automotive markets, ON Semiconductor has emerged as a powerhouse for most demanding and challenging imaging applications. As I indicated on previous earnings calls, we continue to develop synergies with our expertise in the automotive imaging market to accelerate our growth in the machine vision market, as both of these markets are driven by artificial intelligence and face similar challenges, such as low light conditions, dynamic range, and harsh operating environments. Revenue in the second quarter for the industrial end market is expected to be up quarter-over-quarter. The communications end market, which includes both networking and wireless, contributed revenue of $240 million in the first quarter.
The communications end market represented 17% of our revenue in the first quarter. First quarter communications revenue declined by 3% year-over-year due to weakness in the smartphone market. With higher content and increasing penetration at large global OEMs, we were able to mitigate the impact of softness in the overall market. Revenue in the second quarter for the communications end market is expected to be flat to down quarter-over-quarter due to softness in the end market demand. The computing end market contributed revenue of $149 million in the first quarter. The computing end market represented 11% of our revenue in the first quarter. First quarter computing revenue grew by 20% year-over-year. This year-over-year growth was driven primarily by the ramp in our cloud and server business and generally healthier client PC market. Momentum in our server business continues to accelerate.
As we indicated earlier, we expect our server business to be a meaningful part of our computing business in 2018. We are engaged with the leading cloud and server players and are working with leading CPU providers on their next generation platforms. Revenue in the second quarter for the computing end market is expected to be up quarter-over-quarter due to normal seasonality and continuing ramp in our server business.
The consumer end market contributed revenue of $182 million in the first quarter. The consumer end market represented 13% of our revenue in the first quarter. First quarter 2018 consumer revenue was up 7% as compared to the consumer revenue in the first quarter of 2017. Revenue in the second quarter for the consumer end market is expected to be approximately flat quarter-over-quarter. In summary, demand for our products continues to strengthen, and we are putting in additional capacity to ensure that we are able to meet customer demand for the next few years. At the same time, we are making investments in our captive raw wafer manufacturing capacity to extend our competitive advantage. Our execution remains solid on all fronts to establish 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 solidly remain on track to make strong progress in 2018 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 turns levels, we anticipate that total ON Semiconductor revenues will be between $1.405 billion to $1.455 billion in the second quarter of 2018. For the second quarter of 2018, we expect GAAP and non-GAAP gross margin in the range of 37%-39%. Factory utilization in the second quarter is likely to be down as compared to that of the first quarter. We expect total GAAP operating expenses of $333 million-$351 million. Our GAAP operating expenses include the amortization of intangibles, restructuring, asset impairments, and other charges, which are expected to be $28 million-$32 million. We expect total non-GAAP operating expenses of $305 million-$319 million. The quarter-over-quarter increase in operating expenses in the second quarter is driven primarily by the seasonality of our stock-based compensation grants.
We expect our non-GAAP operating expenses as a percentage of revenue to continue 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%. We anticipate second quarter GAAP net other income and expense, including interest expense, will be $32 million-$35 million, which includes non-cash interest expense of $8 million-$9 million. We anticipate non-GAAP other income and expense, including interest expense, will be $24 million-$26 million. Cash paid for income taxes in the second quarter of 2018 is expected to be $11 million-$15 million. We expect our 2018 cash tax rate to be 10% or lower. We expect total capital expenditures of $130 million-$150 million in the second quarter of 2018.
We also expect share-based compensation of $24 million-$26 million in the second quarter of 2018, of which $2 million 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 second quarter of 2018 is expected to be 445 million-447 million shares based on the current stock price. Our non-GAAP diluted share count for the second quarter of 2018 is expected to be 432 million 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 Forms 10-Q and Form 10-K. For the full year 2018, we expect to generate free cash flow of approximately $800 million.
With that, I would like to start the Q&A session. Thank you. Sarah, please open up the line for questions.
Thank you. Ladies and gentlemen, if you have 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, please 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. We ask that you please limit yourself to one question and one follow-up. One moment for questions. Our first question comes from Chris Danely with Citi. Your line is now open.
Hi, guys. This is Philip Lee on behalf of Chris Danely. Just wanted to ask you on the higher capital investments for the next calendar 2018 and 2019, what is the impact on the model in terms of gross margins, operating margins, and other changes to your long-term model? Thanks.
It basically should have no impact to that. As a matter of fact, it will enable us to have more strength and power for revenue growth, we're not changing any of our models in terms of margins.
Got it. Thanks. As a follow-up, can you talk about the pricing environment now and how it trended last quarter and how you expect it to trend for the rest of the year?
Yeah, it was much better than normal Q1s that we saw. It's very benign, and we expect that to continue for the rest of the year.
Great. Thanks for the color.
Thank you. Our next question comes from Ross Seymore with Deutsche Bank. Your line is now open.
Hi guys. Thanks for letting me ask a question. Keith, I wanted to talk about the cycle dynamic. Investors seemingly are increasingly concerned about the semi cycle once again. I know you talked about in your script that you believe ON is exposed to a lot more secular and a lot less cyclical dynamics, whether it be because of mix or some of these long-term agreements that you alluded to today. Can you talk a little bit more about why you think you're more secularly exposed, and what does that mean? That the cycle won't impact you, or is it just a lot less than it did in the past?
Yeah. We're not predicting the end of cycles in the industry. There are a couple of dynamics now that were not present in the last two decades, and that really is the acceleration of dollar content for power in automotive and industrial. The advantages that are being given in those two markets are really significantly increasing the amount of content per unit, which we think gives us a lot of moderation in any cycles that may be coming. What we're seeing is just a stronger overall demand for power semiconductors going forward.
Great. I guess this is my follow-up one for you, Bernard. Basically, both questions are going to be on inventory, internal and external. If I remember right, you guys thought, at least on the internal side, you'd be flat to down on your days of inventory, and it went up. I just want to see how is inventory going up as demand is so tight, and then why did utilization go up in the first quarter, but now it's going down in the second? It seems like there's a lot of mixed messages there.
The inventory position is we're really trying to position ourselves to have to be able to take advantage of demand, and as such, we basically ran our factories at very high during the first quarter to really position ourselves to have the inventories to serve the markets. When we talk about the utilization in the second quarter, it's marginally down. It's virtually flat. I don't see that as a statistically meaningful change. It's pretty much about the same level.
Great. Thank you.
Our next question comes from, excuse me, Vivek Arya with Bank of America. Your line is now open.
Thanks for taking my question. Keith, on automotive, your Q1 growth year-over-year was quite decent, up 8%. On a sequential basis, it was up about 2%, which I think has been somewhat below the seasonal trends that you have seen. Any specific reason for that? I think as part of that, we also saw image sensors only grow 2% or 3% year-over-year, but you have seen that as a strong growth opportunity for ON. If you could give us some more color on what's happening in autos and then in image sensors in terms of these growth rates, that will be very helpful.
Yeah. The image sensor piece, overall, we've been managing the consumer part down as a margin play. Growth in total was much higher for the automotive image sensors than is reflected there in the division. The actual sequential for automotive, 20%-
Year over year.
Year over year. Yeah. That's actually substantially higher for that piece of the business. Sequentially, there's nothing significant. There's some shifts in customer patterns that happens from time to time, but there's no significance overall to the sequential.
Also noteworthy is that the fourth quarter sequential was very high, so we're coming off a very high base where normally fourth quarter is modestly up. It was about 6% up sequentially.
I see. For my follow-up, another one on end markets and communication. I think it's generally well understood that there is a weakness in some high-end smartphone demand. Do you think June is sort of the bottom of this cycle, and we should start to see more seasonal patterns in the back half? If you could also give us some color in terms of where do you think the rebound could come from. Could it come from your U.S. customers or Korean customers or Chinese customers? Any color on geography would also be very helpful. Thank you.
We do expect the second half to resume growth very significantly. We have new model launches from most of the cell phone manufacturers occurring in Q3. Therefore, we actually should see a nice pickup in the second half.
Thank you.
Our next question comes from Chris Caso with Raymond James. Your line is now open.
Yes, thank you. Good morning. A question on wafer capacity that you're building. Can you talk about the magnitude of the CapEx there, and then how much of that raw wafer capacity that you do have internally, and how does that change with that new capacity that you put in place?
It's approximately a $60 million investment this year and should take our internal capabilities up about 15%.
What's the cost savings that you get from doing that?
It should be in the order of 15%-25%, depending on the type of wafers.
Okay. Just as a follow-up on capacity in general. Can you talk in general terms, perhaps look out over the last year or so, how much additional capacity you've put in place? I know that's a tough question because there's differences between front-end and back-end capacity. I guess the nature of the question is how capacity has been expanding as related to how demand has been increasing.
Yeah. I could only give you estimates. That would be calculations I don't have in front of me, but certainly we have been adding capacity for the double-digit growth we've been getting. With the exception of the raw wafer capacity, it is all additive to a revenue perspective.
All right. Thank you.
Our next question comes from Rajvindra Gill, Needham & Company. Your line is now open.
Yes, thank you. Congrats on solid results. Just to follow up again on the wafers. You talked about that you're one of the few companies that actually have internal manufacturing for raw wafers. Can you talk a little bit about how that can give you a competitive advantage going forward, both from a cost-saving perspective, but also from a product delivery? I view that as a kind of unique advantage that you have in the marketplace.
Yeah. In addition to pricing going up fairly significantly for external wafers, we also have capacity limitations. It's a very tight market, and I think that's well known. We get to protect our top-line growth, as well as improve our gross margins. It is not our intent to produce all of our wafers internally, but it is in specialty areas where we think there might be constraints from the industry, we're making those investments, to make sure we're not constrained in our growth and do have a price advantage. As I mentioned earlier, it's anywhere from 15%-25%, depending on the type of wafer.
Very good. Bernard, the CapEx intensity is increasing. We've been in a kind of a supply constraint environment for several quarters, actually starting at the beginning of last year. I'm just wondering, is the entire industry, have they underestimated the level of demand that's coming from auto industrial now that we've had many quarters where we've seen increasing dollar content for auto industrial machine vision applications? I'm just trying to get a sense of, it seems like the demand environment is coming in much stronger than expected, and this has been happening for several quarters, and the industry is trying to catch up as fast as they can. Just wondering if you could elaborate a little bit on that as well. Thank you.
No, I think we agree with your statement, with your assessment. Definitely the demand environment for us has been very strong for those end markets, for automotive and industrial, and as such, we are trying to make sure we have the capacity to serve those needs. We believe we're also gaining share. As a result, we are definitely increasing our CapEx investments and make sure that we are in a position to serve those demands.
Do you see CapEx investments increasing across the industry?
Slightly.
Okay. Thank you.
Our next question comes from Shawn Harrison with Longbow Research. Your line is now open.
Hi. Good morning. If I may follow up just on the CapEx outside of the raw wafers. With the Fujitsu investment announced last year and now the increase in CapEx outside of the raw wafers, is there a way to highlight what dollar of CapEx going in would represent in terms of revenue opportunity for you, coming out on the other side in terms of just the return on that investment?
I would say our 7% model we put in place was for something in the low to mid-single-digit growth rates. As we go to the eight or nine, we're now looking for something in the high single-digit range.
Okay. Thank you. As a follow-up, with $800+ million of free cash forecast for calendar 2018, that implies give or take around $700 million for the rest of the year. Could you split between buyback versus debt reduction? Is it a 50/50 split? Just some type of range that we should think about for the next three quarters of the year.
We haven't given the details on that. We will continue delevering in a meaningful way, and at the same time, have some share buybacks to have a full picture.
Is there a minimum level of leverage that you would not like to go below, Bernard?
At this moment, not really. Obviously, we don't really want to get to zero, and for that, we need still a lot of money to pay down our debt. We're also trying to risk manage the rising interest rate environment we're currently under.
Perfect. My congrats on the results and guidance.
Our next question comes from Craig Ellis with B. Riley. Your line is now open.
Thanks for taking the question. I'll echo the congrats. Keith, I wanted to follow up on a couple of comments that were made in the prepared script. On a couple instances, the company addressed the long-term demand environment and stated it was very positive, and also indicated that customers are interested in long-term supply agreements, which I don't recall hearing in at least the recent past. The question is: One, if you were to engage in more long-term supply agreements, what would that do for manufacturing efficiencies, given the visibility you would have? Two, what would the implications be for pricing?
Generally, it stabilizes our manufacturing environment, which is more efficient for us, so we can plan more level rather than peaks and valleys. Generally, again, speaking, we would only do this for margin products that enhance our situation. The two together, we see as a very positive move for the company.
How quickly can you move on those deals and how material could they be as a % of revenue?
We're moving on them actively all the time, and they would never be more than 50% of our capacity in any market.
Okay. Thank you. Then the follow-up is for Bernard. Bernard, nice to see the midpoint of gross margin guidance at 38%, a real milestone for the company. The question is: as you look at where the business is from a portfolio optimization standpoint with your carve-outs and bridge inventory build, which you had been saying last year was not possible due to the demand environment, where are we on those two items as we look out over the next year or two? Thank you.
Well, we'll continually look at opportunities for portfolio enhancing and small divestitures that are not strategic and, at the same time, help us from a gross margin point of view. Don't expect anything big, but we continue looking at doing some work in that area. We continue being in the same situation with the inventory bridge build. As we talked about earlier, we see demands, long-term demands, being pretty strong. At this moment we are not able to build bridge inventories, but we are getting the fall-through on the incremental revenues, and that's showing up in the gross margin improvement that we have seen historically and will continue seeing, and it's shown through our upcoming guidance of 38%.
Thank you.
Our next question comes from Harsh Kumar with Piper Jaffray. Your line is now open.
First of all, congratulations. Very good results and guidance. Keith, I had a question. Every time previously we've talked to you and you guys have publicly spoken, you've said you were more tied to macro. Now it seems like greater than 55%, almost 58% of your revenues are coming from automotive and industrial. Should we think of you as maybe not so tied to macro and maybe more kind of tied to these end markets?
Clearly we can't distance ourselves from the macro environment. We are a broad-based supplier. Even within those two markets, there's still an economic tie. The difference is just the dollar content and how rapidly it's rising, particularly in industrial for us. That certainly is providing a boost to the overall macro demand.
Fair enough. Keith, I wanted to understand the long-term commitments you're talking about. Would this be that a customer would commit a certain amount of dollars, fixed dollars that they have to buy per year? Again, would that not lower your seasonality to some degree?
It is for amounts that extend beyond a year, it would maybe moderate it slightly, not necessarily. We do take into account the customer's patterns into those contracts.
Thanks, guys.
Our next question comes from Tristan Gerra with Baird. Your line is now open.
Hi, good morning. Given the outlook to continue the strength in demand and tightness, what will be your initial Q3 visibility? Could you talk about any other manufacturing bottlenecks that you see outside of wafers, including potential back-end tightness?
On the visibility, obviously, we don't guide out. Our normal seasonality for the third quarter is approximately 4% up.
Yeah, just a little color on that. We would see the handset market coming back in the second half, which is not present in Q2. That is what provides some of the impetus as well as the consumer side also increasing in the third quarter.
Okay. Could you remind us of your exposure to China's ZTE specifically?
It is not a significant exposure.
It is included right now in our guidance for the second quarter.
Great. Thank you.
Thank you. Our next question comes from Kevin Cassidy with Stifel. Your line is now open.
Thanks for taking my question. Reference to the long-term supply agreement again. The industry's had these in the past. Is there any changes to the way these can be enforced? Is these agreements different than in the past?
Well, I'm not familiar with all of the industry practices. In our case, they are very much tied to dollar amounts, it is not just a number of units. Again, we think it leads to a very healthy thing for both companies.
Okay, thanks. On the computing segment, with servers now becoming a bigger portion, can you tell us how much that changed, we say, even year-over-year in the first quarter? How much is server-related versus desktop and notebook related?
In the first quarter results, actually, I don't have that.
It's mostly driven by servers. Big part is coming from servers.
Mostly the change was from servers.
Yes.
Okay. I guess the answer is the delta is pretty much all servers.
Okay. All the upside is servers. Okay, great. Thank you.
Our next question comes from Harlan Sur with J.P. Morgan. Your line is now open.
Morning. Nice job on the solid execution by the team. Bernard, can you give us some parameters for OpEx as a percent of revenues kind of second half. The other way that the team has always articulated OpEx targets is that you'll be growing OpEx at about half the rate of revenues. Is that another way that we can think about it for 2018?
As you go forward, as a general measurement, that's correct. We did spend as a percent of incremental revenues a little bit more in the first quarter as we are investing more R&D into automotive and industrial applications. As a long-term view, yes, it is still a correct way to look at it, and we expect, as I said in the prepared remarks, to continue showing improvements towards the 21% as we go throughout the year.
Great. Thanks for that. Then Keith, first half of this year, cloud spending is strong. You talked about new compute workloads, which is clearly also a driver. You've got early upgrade cycle, and we're also seeing some healthy enterprise spending as well. We saw strong sequential and year-over-year growth in compute in Q1, guiding for strong growth in Q2. Seems like cloud spending will be strong throughout all of this year. Is that kind of how you guys see it, continued strength throughout 2018?
Yes, we do believe that'll be the case.
Great. Thank you.
Yeah, it's all the trends in AI, as well as just the general continuation of the server strategies.
Great. Thank you.
Our next question comes from Christopher Rolland with Susquehanna. Your line is now open.
Great. Congrats on the nice results, guys. My first question, on the raw wafers, are they only silicon, or are you guys doing specialty like silicon carbide? Are you insourcing that as well? Perhaps talk a bit more about that ramp that you guys see coming in the second half for silicon carbide.
The investments include both the pure silicon and specialty wafers, it's the mix that supports our growth.
Great. I don't know if you have any details on silicon carbide, perhaps what % of sales that could be a few years down the road.
We are expecting tremendous growth. Today, it's a very low percentage. I would imagine it would show up, even with high growth, as being something that's in the 4% or 5% range in three years.
Great. Lastly, just lead times. Where are you guys now?
Lead times are in the middle teens, and they increased slightly over last quarter. As we mentioned in previous occasions, we saw a lead time expansion in the first half of last year, and since then they have been relatively constant with a slight uptick in the second quarter.
Great. Thanks so much, guys. Bye.
Our next question comes from Craig Hettenbach with Morgan Stanley. Your line is now open.
Yes, thank you. Just wanted to follow up on the long-term supply agreements and just any other context you can provide, particularly as it relates to prior periods of tightness and what the parallel is to that versus what might be different this go around.
I think the environment is a little different. In the past, I would say these were kind of panic reactions to extremely tight markets, so they don't happen very often. In this case, our customers are looking out and expecting very strong growth on the power side, and also not seeing the attendant capacity increases coming from the marketplace and are looking for more long-term agreements to mitigate both of those things.
Great. Just as a follow-up on the industrial market and the double-digit growth again there, can you talk about just what you're seeing from a demand perspective and then also just a sell-through perspective through the distribution channel?
Those are-- I don't know if you relate it to the industrial piece for the sell-through, but the sell-through on the distribution side is looking much stronger than it did in the first quarter. We're seeing some acceleration in growth as we've entered 2018. The industrial side, again, it's very broad-based growth. Almost all of it is driven by the need for higher energy efficiency in each of the applications, which gives much more dollar content for us.
Got it. Thank you.
Our next question comes from Mark Delaney with Goldman Sachs. Your line is now open.
Yes. Good morning. Thanks for taking the questions. I have two questions. The first is about free cash flow, and I think the company maintained its view for about $800 million of free cash flow this year. That's despite what you talked about in terms of the higher CapEx requirements, which I think is maybe an $80 million-$90 million incremental headwind to free cash flow. Can you just be a bit more explicit about what would be driving the implied higher view of operating cash flow this year? Is that flow-through from net income, or is there other factors like working capital or cash taxes, things like that are helping the free cash flow view?
It is primarily from net income with potentially some help from a little bit on cash taxes. The primary impact is better growth and fall through on the bottom on the net income side.
That's helpful. A follow-up question is about the view of the communication segment for all of 2018. I think, if I'm not mistaken, Keith, last quarter, you said you thought the segment would not decline this year. Given what seems like a slower start to the year, is that still the view for the full year? I ask to help us gauge the potential magnitude of the pickup in the second half of the year in the comm segment.
Yeah, I do expect the second half of the year demand will offset the weakness here at the beginning of the year. We do expect to see some of the 5G-type spending toward the end of the year. The net of that should be kind of flattish.
Got it. Thanks so much.
As a reminder, if you would like to ask a question, please press star, then one on your touchtone telephone. Our next question comes from John Pitzer with Credit Suisse. Your line is now open.
Yeah, guys, thanks for sneaking me in. Congratulations on the strong results. Keith, I just want to go back to the long-term supply agreements. I think you said in an answer to an earlier question that you'd never have more than half of your capacity in any product area on long-term supply agreement. I'm just kind of curious if you can quantify the agreements you have in place today, either as a % of capacity or revenue over the lifetime. Are you getting any sort of prepayments? Because oftentimes you'll see that in long-term supply agreements to help offset some of the CapEx needs that you have. Just to reiterate an earlier question, these agreements tend to be pretty easy to keep in place when things are tight, a little bit harder to kind of enforce when the industry goes into a less tight supply situation.
I guess what's your insurance that in a different business environment, you'll get the pricing and the volume commitments that you've asked for?
Our experience has actually been quite good. With the customers we engage, they are respectful of the supply agreements. They have not yielded disappointments in the past. We see continued compliance going forward. As far as percentages, it really is mostly in the power areas. These are customers that, irrespective of market, are seeing growth in those businesses. Back to my earlier comments on being more secular, we see the demand increasing even with the economy ebbing and flowing.
Keith, as a follow-up, you guys have kind of been pruning your portfolio of lower-margin businesses, and despite that, you've been able to put up some good growth rates year-over-year for multiple quarters now. I'm just kind of curious, where are you in that process? I guess as we think about the target model, as you get a cost advantage by making more of your own wafers, as you continue to prune the portfolio, why wouldn't there be an upside to the target margins over time?
Certainly, we are expecting to bring in the date for achievement of the target models. At the Analyst Day next year, we hope to unveil to you how much higher we can go after that.
Just as far as pruning low-margin business, are you basically through with that? Or is there more revenue you'd be willing to give up to drive higher margins?
No, there's still some more to come this year, then we should be done.
Perfect. Thanks, guys.
We do have a follow-up question from Craig Ellis with B. Riley. Your line is now open.
Thanks for taking the follow-up questions. I just wanted to touch on one of the things we've been looking for on gross margins. Bernard, in the past, you've said that in the second half of this year, we could expect back-end synergies from your Fairchild acquisition. Can you just help us understand when would we expect those to hit? And over what period should they be benefiting gross margins at the margin?
I expect it to start kicking in the second half, as you mentioned, of 2018 and a gradual improvement throughout the second half of 2018 and also 2019.
Just with regards to. Oh, go ahead.
Go ahead.
With regards to CapEx and its linearity with the guidance at 8%-9% this year and next, should we expect fairly linear CapEx through the year, or is there any reason it would be either front-end loaded or back-end loaded in either year? Thank you.
It's more there is lumpiness depending on the delivery of equipment and installation thereof. In general terms, we're trying to make it as linear as possible, but there might be ups and downs based on those factors.
Thanks, guys.
Our next question comes from Vijay Rakesh with Mizuho. Your line is now open.
Yeah. Hi, guys. Just wondering, on the inventory side, can you give us a color on how much of it is PC handsets and how much of it is auto industrial?
Our inventory profile generally tracks the percentage of our business. There's not a dramatic change. In Q1, there might have been slightly more handset inventory than normal. Everything else should have been right in line.
Got it. Just wondering how much of your wafers are now insourced. Also on the EV side, you guys mentioned second half ramps. Are you supplying mostly to U.S. customers or to Chinese OEMs? If you can give some color on that. Thanks.
Okay. On the insourcing part, it's less than 50% today of the raw wafers. On the shipments in silicon carbide, it will be more China-based.
Great. Thanks a lot.
That concludes our question and answer session. I would now like to turn the call back over to Parag Agarwal for any further remarks.
Thank you everyone for joining the call today, and please feel free to reach out to us with any follow-up questions. Goodbye.
Ladies and gentlemen, thank you for participating in today's conference. This does conclude today's program. You may all disconnect. Everyone, have a great day.