Good day, ladies and gentlemen, and welcome to the ON Semiconductor Second Quarter 2017 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 follow at that time. As a reminder, this conference call may be recorded. I would now like to introduce your host for today's conference, Mr.
Parag Agwala, Vice President of Corporate Development and Investor Relations. Sir, you may begin.
Thank you, Daniel. Good morning, and thank you for joining ON Semiconductor Corporation's Q2 2017 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.aonsemi.com. A replay of this web broadcast, along with our earnings release for the Q2 of 2017, will be available on our website approximately 1 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 and channels 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 intending to identify forward looking statements.
We wish to caution that such statements are subject to risks and uncertainties that could cause the 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 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 2017. 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. For all synergy related discussion on this call, we have used FaceTime's 2015 results as a base for all comparisons.
During the Q3, we will attend Citi Technology Conference in New York on September 7 and Deutsche Bank Conference in Las Vegas on September 12. Now let me turn it over to Bernard Guzman, who will provide an overview of the Q2 2017 results. Bernard?
Thank you, Parag, and thank you everyone for joining us today. We once again delivered solid financial results, which exceeded our guidance and Street consensus for all key metrics. Our Q2 results clearly demonstrate the consistent and strong execution on the operational front and strength of our broad range of product portfolio for automotive, industrial and communications end markets. Strong operating leverage and free cash flow generation in the Q2 clearly demonstrate the strength of our operating model. Visibility into our business continues to remain strong as we benefit from our design wins in automotive, industrial and communications end markets.
Diversity in our customer base, product portfolio and end markets have insulated us from the volatility caused by weaknesses in certain end markets and geographies. With our largest end customer contributing less than 5% of our revenue and a product portfolio weighted towards end markets with fastest growing semiconductor content, which generally have lower customer and product related risk. At the same time, we are well positioned to benefit from secular and macro trends in the semiconductor industry. We continue to make strong progress in the integration of Fairchild and remain on track to deliver the targeted synergies. At the same time, we have taken steps to optimize our product portfolio to drive margin expansion for the company.
During the Q2, we exited the mobile image sensor market as the margin profile for that business was not compatible with our target financial model. Furthermore, we monetize the value of highly differentiated mobile imaging technology through our intellectual property licensing agreement with a third party. We have excluded the gain of approximately $24,000,000 related to this transaction from our 2nd quarter non GAAP results. We delivered robust free cash flow performance during the Q2. As we indicated earlier, we intend to use this free cash flow to de risk our balance sheet.
For 2017, we now expect free cash flow in the range of $1,000,000 to $650,000,000 higher than our earlier expectation of approximately $550,000,000 to 600,000,000 dollars As a comparison, we generated free cash flow of approximately $371,000,000 in 2016. Now let me provide you details on our Q2 results. Total revenue for the Q2 of 2017 was approximately $1,338,000,000 an increase of approximately 52% year over year and a decrease of 7% as compared to GAAP revenue in the Q1. Recall that our first quarter GAAP revenue included a one time benefit of approximately $155,000,000 due to the change in revenue recognition to sell in method from sell through method. 2nd quarter revenue increased by approximately 4% as compared to non GAAP revenue in the Q1.
GAAP net income for the 2nd quarter was $0.22 per diluted share. GAAP income before income tax for the Q2 was approximately $143,200,000 as compared to $115,000,000 in the first quarter. Non GAAP income before income tax for the 2nd quarter was approximately 171,100,000 dollars Net cash paid for taxes in the 2nd quarter was approximately 17,100,000 and diluted shares outstanding were approximately 4.20 $1,000,000 Non GAAP income before income tax for the Q1 was approximately 133,200,000 dollars Net cash paid for taxes in the Q1 was approximately 18,400,000 and diluted shares outstanding were approximately 426,000,000. GAAP gross margin for the 2nd quarter was 36.8% as compared to 35% for the Q1. Non GAAP gross margin for the 2nd quarter was 36.9%, an impressive increase of approximately 150 basis points over the 35.4 percent in the Q1.
Better than expected non GAAP gross margin in the 2nd quarter was driven by strong operational execution and higher than expected revenues. On the operational front, enterprise wide manufacturing cost reduction cost reductions and supply chain synergies from Fairchild were the major contributors to the gross margin expansion. With tailwinds from additional manufacturing synergies from Fairchild, mix improvement and portfolio optimization, we remain on track to achieve our target non GAAP gross margin of 40% by 2020. GAAP operating margin for the Q2 of 2017 was approximately 11.5% as compared to approximately 12.8% in the prior quarter. Our non GAAP operating margin for the 2nd quarter was 14.7%, an increase of approximately 150 basis points over 13.2% in the Q1.
On a revenue increase of approximately 4%, our non GAAP operating profit increased by approximately 16%. This strong operating performance demonstrates the operating leverage and strength of our operating model. GAAP operating expenses for the 2nd quarter were approximately $337,900,000 as compared to approximately $319,900,000 for the Q1 of 2017. Non GAAP operating expenses for the 2nd quarter were approximately $296,800,000 dollars as compared to approximately expenses for the Q2 were at the higher end of our guidance, primarily due to the accrual for higher variable compensation resulting from significantly better results. We expect our OpEx intensity to decline in the Q3 of 2017.
We had strong free cash flow performance in the 2nd quarter. We define free cash flow as cash flow from operations less capital expenditures. 2nd quarter free cash flow was approximately $264,200,000 as compared to approximately $155,000,000 in the first quarter. Operating cash flow for the 2nd quarter was approximately $333,200,000 2nd quarter free cash flow and operating cash flow included approximately $24,000,000 from a licensing arrangement related to the mobile image sensor business. Capital expenditures during the Q2 were approximately $69,000,000 Capital intensity based on non GAAP revenue during the 1st 6 months of the year was approximately 4.6%, significantly below our target model of 6% to 7%.
We expect that capital expenditure in the second half will increase as capital intensity for 2017 is expected to be in the range of 6% to 7%. As I indicated earlier, we expect free cash flow for 2017 to be in the range of $600,000,000 to 650,000,000 dollars higher than our previous expectation of approximately $550,000,000 to $600,000,000 We exited the Q2 of 2017 with cash, cash equivalents and short term investments of approximately $872,000,000 as compared to approximately $729,000,000 in the Q1. We used approximately $137,000,000 in the Q2 of 2017 for the repayment of debt. At the end of the Q2 of 2017, days of inventory on hand adjusted for fair market value step up were 108 days, down 3 days as compared to inventory days at the end of the first quarter. 2nd quarter distribution inventory in days was approximately flat as compared to the first quarter.
Q1. Q2 was slightly up sequentially. Now let me provide you an update on the performance of our business units, starting with the Power Solutions Group or PSG. Revenues for PSG was approximately 671,000,000 dollars Revenue for Analog Solutions Group for the Q2 of 2017 was approximately $468,000,000 and revenue for the Image Sensor Group was approximately $198,000,000 Now, I would like to turn the call over to Keith Jackson for additional comments on the business environment. Keith?
Thanks, Bernard. Once again, I
am very pleased with our results. Our 2nd quarter results clearly demonstrate the strong momentum of our power, analog and sensor portfolio for automotive, industrial and communications end markets. At the same time, our robust free cash flow generation, strong margin performance and solid operating leverage demonstrate the strength of our operating model. While we have benefited from a favorable industry and a macroeconomic environment, automotive, industrial and communications end markets and solid automotive, industrial and communications end markets and solid execution on the operational front to realize synergies and cost savings. Our results over the last many quarters demonstrate progress that we have made in transforming ON into a highly diversified and broad based supplier of power and log in sensor solutions for automotive, industrial and communications end markets.
As Bernard indicated earlier, this highly diversified base of customers, products and end markets has insulated us from demand volatility from certain end markets and geographies. Customers are realizing the depth and breadth of our power, analog and sensor portfolio, and they are increasingly relying on us for key enabling technologies that are disrupting existing business models. We are engaging at very early stage with key players in artificial intelligence for automotive, machine vision and robotics applications. Also, we continue to extend our leadership in the ADAS markets for automotive and are investing in sensor fusion solutions for ADAS. We believe that our exposure to secular growth drivers and emerging applications will enable us to continue to outgrow the semiconductor industry.
We continue to make strong progress in the integration of Fairchild. Integration of Fairchild's IT systems is expected to be complete in the Q4 of 2017. Also, we are on track to begin realizing manufacturing synergies from Fairchild towards the end of this year as we start in sourcing of Fairchild's back end operations. We expect to exit 2017 with annual synergies run rate of $180,000,000 Our target of annual synergies run rate of $245,000,000 by the end of 2019 remains unchanged. Performance at Fairchild continues to be strong, with continued strength in bookings momentum.
We are realizing revenue synergies from Fairchild as our strategy of leveraging our sales reach and customer relationships to accelerate Fairchild's revenue is yielding strong results. We again had record bookings quarter for Fairchild in the Q2. During the Q2, bookings for Fairchild were at the highest levels for the last 3 years. Let me now comment on the business trends in the Q2. During the Q2, demand trends and bookings were strong across most end markets and geographies.
Also, supply and demand dynamics remained favorable in the 2nd quarter as we didn't see any evidence of inventory build in distribution channel or of anomalous booking patterns. Commentary from customers in our booking trends point to sustained improvement in demand environment for most end markets. Customers continue to remain concerned about potential supply tightness as demand continues to grow at a steady pace. Now I'll provide details of the progress in our various end markets for the Q2 of 2017. Revenue for the automotive market in the Q2 was approximately $410,000,000 and represented approximately 31% of our revenue in the 2nd quarter.
2nd quarter automotive revenue grew by approximately 30% year over year and was marginally up quarter over quarter on a non GAAP basis. Our momentum in the automotive market remains intact with leadership in fast growing applications such as ADAS and LED lighting and exposure to highly diversified customer base across the globe. For the Q2, we again posted strong growth in our CMOS image sensor business for viewing ADAS applications. We continue to gain market share in automotive image sensors and our design win pipeline for our CMOS image sensors for automotive applications continues to grow at a rapid pace. As I indicated earlier, we are working with market leaders for development of artificial intelligence based ADAS systems.
Our power franchise for automotive continues to strengthen and we're working with leading ecosystem partners on power management solutions for processors and other related applications in automotive. Other drivers for automotive in the Q2 included LED lighting, in vehicle networking, mixed signal ASICs and protection devices. Despite temporary softness in automotive demand in certain geographies, global demand for automotive semiconductors has shown no signs of slowdown. With a broad product portfolio and exposure to the fastest growing segments of the automotive market, we are among the best positioned companies to capitalize on increasing semiconductor content in automobiles. Revenue in the Q3 for automotive end market is expected to be approximately flat quarter over quarter as opposed to normal seasonality of sequential decline in the Q3.
The industrial end market, which includes military, aerospace and medical, contributed revenue of approximately $351,000,000 in the 2nd quarter. The industrial end market represented approximately 26% of our revenue in the 2nd quarter. 2nd quarter industrial revenue grew by approximately 59% year over year and approximately 8% quarter over quarter as compared to non GAAP industrial revenue in the 1st quarter. Strength in the industrial end market was broad based across products and geographies. With the acquisition of Fairchild, our footprint for power management solutions for industrial applications has expanded in a significant manner.
We are seeing a steep acceleration in demand for our power modules for industrial applications. Key drivers of demand for industrial end markets include industrial power supplies, building automation, lighting, industrial automation and alternative energy. We also saw strong growth in our medical business driven by implantable devices and hearing health. We continue to see strong growth in machine vision applications with our Python line of CMOS image sensors. As I indicated earlier, we are engaging at the very early stage with key players in artificial intelligence for machine vision and robotics applications.
Revenue in the Q3 for the industrial end market is expected to be down quarter over quarter due to normal seasonality. The communications end market, which includes both networking and wireless, contributed revenue of approximately $252,000,000 in the 2nd quarter. The communications end market represented approximately 19% of our revenue in the 2nd quarter. 2nd quarter communications revenue grew by approximately 62% year over year and approximately 6% quarter over quarter. Our presence with market leaders in the smartphone market continues to strengthen and our content in major smartphone platforms continues to grow with each generation.
We recently achieved major successes with our power management devices and intelligent charging solutions for smartphones. Revenue in the Q3 for the communications end market is expected to be up quarter over quarter due to normal seasonality. Computing end market contributed revenue of approximately $131,000,000 in the 2nd quarter. The computing end market represented approximately 10% of our revenue in the 2nd quarter. 2nd quarter computing revenue grew by approximately 50% year over year and approximately 3% quarter over quarter.
We remain on track for the ramp of our server related revenue in the second half of this year. Recall that with products from Fairchild, we have won designs for powered stage for cloud computing and server applications with addressable content of more than $30 Revenue in the Q3 for computing end market is expected to be up quarter over quarter due to normal seasonality. The consumer end market contributed revenue of approximately $194,000,000 in the 2nd quarter. Consumer end market represented approximately 15% of our revenue in the Q2. 2nd quarter consumer revenue grew by approximately 96% year over year approximately 7% quarter over quarter.
Strength in white goods was a key driver of consumer related revenue in the second quarter. Revenue in the Q3 for the consumer end market is expected to be up quarter over quarter due to normal seasonality. In summary, our execution remains strong and we continue to deliver solid results. We have shown impressive expansion in our margins and our free cash flow generation is accelerating at a rapid pace. Fairchild integration is progressing on schedule and performance of Fairchild thus far has exceeded our expectations.
While we have benefited from a favorable industry and macroeconomic environment, a significant part of our outperformance has been driven by company specific factors such as accelerating traction in automotive, industrial and communications end markets and solid execution on the operational front to realize synergies and cost savings. With a strong pipeline of design wins, coupled with favorable macroeconomic environment and healthy supply demand dynamics in the semiconductor industry, visibility into business remains strong. 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 whole on semiconductor revenues will be approximately $1340,000,000 to $1390,000,000 in the Q3 of 2017. The exit from the mobile image sensor business is slightly impacting the sequential revenue growth in the 3rd quarter.
Backlog levels for the Q3 of 2017 represent approximately 80% to 85% of our anticipated 3rd quarter revenue. For the Q3 of 2017, we expect GAAP gross margin in the range of 36% to 38% and non GAAP gross margin in the range of approximately 36.2% to 38.2%. Factory utilization in the 3rd quarter is likely to be up sequentially. We expect total GAAP operating expenses of approximately $315,000,000 to $336,000,000 Our GAAP operating expenses include the amortization of intangibles, restructuring, asset impairment and other charges, which are expected to be approximately $30,000,000 to $37,000,000 We expect total non GAAP operating expenses of approximately $285,000,000 to $299,000,000 We anticipate 3rd quarter GAAP net income net other income and expenses, including interest expense, will be approximately $35,000,000 to $38,000,000 which include non cash interest expense of approximately $8,000,000 to $9,000,000 We anticipate our non GAAP net other income and expenses, including interest expense, will be approximately $27,900,000 Cash paid for income taxes in the Q3 of 2017 is expected to be approximately $13,000,000 to $17,000,000 We expect total capital expenditures of approximately $105,000,000 to $125,000,000 in the Q3 of 2017. As I indicated earlier, capital intensity in the second half of twenty seventeen will be higher to compensate for the low level of capital intensity in the first half of the year.
Our target of 6% to 7% annual capital intensity remains unchanged. We also expect share based compensation of approximately $16,000,000 to $18,000,000 in the Q3 of 2017, 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 diluted share count for the Q3 of 2017 is expected to be approximately 427,000,000 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.
With that, I would like to start the Q and A session. Thank you. And Danielle, please open up the line for questions.
You. And our first question comes from the line of Ross Seymore from Deutsche Bank. Your line is
open. Thanks guys for letting me ask a question. The first question is on margins in general. You guys had solid upside in the gross margin, but the OpEx was a little bit higher in the Q2 than expected. Can you just, Bernard, walk us through the puts and takes on the gross margin upside?
And then the OpEx side, the variable aspect of it, I think everybody understands if revenues are stronger, the OpEx can be higher. But just walk us through what drove it so high and why you have Thank you, Ross. So on the gross margin front,
Thank you, Ross. So on the gross margin front, the puts and takes are the same we have articulated in our Analyst Day, mainly revenue fall through, cost reductions, mix and synergies. Those are the major ones. On the OpEx front, as we stated in our prepared remarks, pretty much all of the increase in the sequential increase is due to variable comp. As we go further up, there is always a limit to that.
So we expect that will not continue. Also, we guided our stock based comp to be slightly lower, which is just based on normal calculation of our share. So it's mainly stock based comp and variable compensation for which we know we have limits based on our bonus plan.
Great. Thanks for that. And I guess as my follow-up, Keith, one for you. Furthermore,
we also expect to still continue generating more synergies coming from Fairchild that will help us also moderate and reduce the intensity of our OpEx for the second half of the year.
Keith, one for you quickly. You in your script went through reasons talking about lead times and bookings and no abnormal behavior. Just talk a little bit more about what you're seeing there. I get a lot of investor questions about a peak in the cycle and what does it mean for on, etcetera. So if you can go into maybe quantifying where those lead times are and what you've seen in cycles past and retrospect at peaks and how we might be different currently from those former peaks?
I think there's a couple of things that put us in a good situation. One is there's been a good discipline on capacity expansion in the industry the last couple of years. And what we've seen here is a relatively low amount of increase quarterly, but it's been a steady increase for the last several quarters. So without capacity being added, you end up with fuller factories, a little more supply tightness and a little better positioning on pricing As opposed to something that has ramped quickly in response to some new market demands, it's really just been slow and steady with the controlled discipline on new capacity.
Thank you.
Thank you. And our next question comes from the line of Vivek Arya from Bank of America. Your line is open.
Thanks for taking my Good job on the results. Just to follow on that capacity utilization, if you could help quantify what utilization is right now? Then importantly, I think CapEx was sub 5% in the first half, but you are expecting a ramp in the second half to get back to your 6% to 7% outlook, what's driving that?
So the utilization rates are high 80s right now and will remain there in the next quarter. From a CapEx perspective, it's really just the cycle times on getting new capital, things that have been ordered for some time. The lead time's extended out on those and they just appear to be landing in the Q3 versus the Q2.
Got it. And as my follow-up, good to see the strong free cash flow generation. I think in your prepared remarks, you mentioned the commitment to delevering the balance sheet. At your Analyst Day, you had set out a target to getting to 2x leverage by the end of next year. Given the strong free cash flow, do you think it's time to rethink that target and perhaps pull it in somewhat?
Thank you.
Based on what we're seeing right now, the possibilities of pulling in are very real and we will it is our priority number 1 to delever the balance sheet.
Okay. Thank you.
Thank you. And our next question comes from the line of Chris Daniel from Citigroup. Your line is open.
Hey, thanks guys. For the gross margin upside, should we assume that this is the new baseline for the synergies going forward? And then maybe talk about the gross margins going forward, the other drivers?
In general terms, yes, it is the new Mark. Obviously, the revenue we have increased revenue growth as compared to what we had in our target model and that's basically helping us. But yes, it is the new base to which we can count on our synergies and we still expect about a 50% fall through on incremental revenue and then the incremental savings coming from the different plans we have already articulated in the past.
Great. And then my follow-up on lead times. Can you just give us a kind of a bogey of where they are? Do you expect them to go down this quarter? Or when do you think that you could bring them back to normal?
So they are in the over the mid teens and we expect them to be relatively flat even though we're bringing on significant new capacity in the Q3.
Great. Thanks.
Thank you. And our next question comes from the line of Mark Delaney from Goldman Sachs. Your line is open.
Yes. Good morning. Thanks very much for taking the questions. First question is another one on gross margin. Gross margin has got it up next quarter even though I think the end market mix gets a little bit more challenging with the industrial market down.
I'm wondering how much of that is some of the Fairchild COGS synergies starting to come through. I think you guys have planned for a little over $100,000,000 in total of Fairchild COGS synergies, which would, I think, get you another couple of 100 basis points to gross margin. Are you seeing some of that already in the September quarter? Or is most of that still on the come?
That's mostly still to come. We expect most of the Fairchild related manufacturing synergies to come towards the end of the year and in 2018. There were some supply chain related synergies in the Q2 and we expect that, that will continue. So it is more others than Fairchild synergies that will help in the Q3. Remember, we also said we exited the mobile sensor business, which has margins that were not we didn't like.
So that should also help. And in general terms, the way we are guiding, we're guiding for a 50% follow through on the incremental revenues.
That's helpful, Bernard. And a follow-up question about seasonality in the Q4. Obviously, you have a Fairchild. And so maybe you can help us think about what combined seasonality is for December quarter and the move to sell in versus sell through in terms of the revenue recognition through distribution. How is that also playing into the seasonality this year?
Thank you.
Yes, I don't think the sell in to sell through is affecting in any meaningful way. We are we have the controls in place to make sure we don't grow inventories in a abnormal way. Seasonality for the Q4 has typically been down. Fairchild historically has been down more than on legacy and on legacy is in the 2% range. So it's probably in that 2% to 4% range is what we are expecting that to be.
Thank you. And our next question comes from the line of Ravindra Gill from Needham and Company. Your line is open.
Yes. Thank you and congrats on solid results. A question on the automotive business. It seems that you're well positioned on kind of 2 fronts. 1, the proliferation of ADAS systems with respect to your CMOS sensor portfolio and your radar portfolio, but also the trend towards electric vehicles on your power management portfolio.
So I wanted to get your sense on how you're looking at total content for both sensors and power management modules and how you're kind of positioned to specifically expand the sensor portfolio to incorporate or to support more higher levels of ADAS systems?
Yes. On the car content, there is quite a bit of difference between the electric vehicles and non electric vehicles. It's as much as $300 per automobile increase for electrification. So that's very, very significant. On the image sensing or ADAS side, we're seeing like a 25% CAGR growth rate on that as cars adopt more cameras for more safety features.
And so we see that as being sustainable for at least 3 or 4 years at that kind of CAGR.
Okay, great. And last question for me in terms of the industrial side, on the machine vision. Can you talk a little bit about the trends towards machine vision and factory automation and how that's driving your business going forward?
It's a big part of the outgrowth in the industrial market over years past. Basically, the advent of affordable sensors plus artificial intelligence being added to automation in the industrial side gives a real boost. We're also seeing from a power perspective in industrial automation, the new technologies we have provide significant increases in energy efficiency. And so there's a replacement cycle that goes on with that.
And you had mentioned that you're working on artificial intelligence partnership for development. Could you maybe elaborate further on that? Thank you.
Yes. I can't give any specifics on it. Just to say there are some partners that we are working very closely with to use both our power and sensor solutions in artificial intelligence environments.
Thank you.
Thank you. And our next question comes from the line of Craig Ellis from B. Riley. Your line is open.
Thanks for taking the questions and congratulations on
the execution guys. Keith, I wanted
to follow-up on activity in the compute areas, specifically server power. That's a nice win that's starting for the team. Can you just talk about how server power could evolve over the next few years after getting in on this initial beachhead? What should investors expect from a share and content standpoint as subsequent server generations rollout?
Yes. So we've stated with our current PowerStage participation, it's about $30 per server. We expect and that is not with significant market share. We do expect that the power will be increasing in new server platforms and so you'll get more dollar content, perhaps another $15 over the next couple of years. And then from a market share perspective, we would be participating in that power stage market plus the control market would add more money to that.
So you should see similar kinds of performance as we had in the desktop notebook ramps from a share perspective and a dollar content perspective.
That's helpful. And then a broader question with regard to pricing and activity there. Another company that is also based in the Phoenix area last week indicated that they're seeing firming pricing in their portfolio on the MCU side. So I don't think that's a meaningful or a material part of the ON portfolio, but it brings up one of the trends that we're increasingly seeing in the semiconductor sector. Are you seeing any signs of firming pricing in your product groups?
If so, where? And if not, do you think they could emerge either later this year or next year? Thank you.
No, we see the pricing environment firming across the board. As you would suspect with little extended lead times and continued growth in the marketplace, the supply demand dynamics have become more favorable for us.
And do you see an environment where pricing would actually be flat quarter on quarter? Or are we just looking at more moderate declines, say, in the 0.5 percentage point area?
I think we're at the flattness stage. All right. Thank you. Good luck.
Thank you. And our next question comes from the line of Tristan Gerra from Baird. Your line is open.
Hi, good morning. Given some softness in the U. S. Auto market, what's your expectation for non GAAP growth in automotive revenue this year?
So auto revenue 2017 versus 16 for the company should be up above around 30% year on year.
And excluding Fairchild?
About more 10% if you exclude Fairchild.
Okay, great. And then is your Q3 revenue guidance based on the expectation that channel inventories remain flat in Q3 given some concern in the supply chain that there could be some tightness? And if your outlook is for flat inventory levels, when do you think there is an opportunity for the channel to start replenishing inventories a bit?
So we do expect it to be roughly flat. Think we hit it in our guidance quarter on quarter, not much change. And from a replenishment perspective, actually, we think we're managing it quite well. So we're not looking for any replenishment cycle, just really managing on a sell through basis even though we're not a sell in.
Great. Thank you.
Thank you. And our next question comes from the line of Chris Caso from Raymond James. Your line is open.
Yes, thank you. Good morning. Just to ask about like the September guidance in the context of some of the stronger business conditions you're seeing now. I mean, it seems like the guidance is on the lower end of what we'd say to be normal seasonality. Is that a function of conservatism on your part?
Is it perhaps a different definition of seasonality given Fairchild? Just some perspective there, please.
So as a reminder, the exit of the mobile business is indeed affecting the seasonality or the growth, sequential growth by approximately 1%. Also, we can argue our number is not the most aggressive.
Okay. Fair enough. As a follow on to that, and you talked about in your prepared remarks about no evidence of inventory build or anomalous booking on the part of customers. I mean, given your experience, how high the lead times typically get when you typically see that? I guess, perhaps another way of asking it is, what's different right now from prior years where we have seen some those anomalous bookings?
Well, lead times definitely had reached higher levels when we had the last peak. So this is more moderate at this stage. And I think the other piece of it is even though the lead times have gone out, generally speaking, the supply is keeping up with the demand. So there's not a felt tremendous imbalance there.
Great. Thank you.
Thank you. And our next question comes from the line of Vijay Rakesh from Mizuho. Your line is open.
Yes. Hi, thanks guys. Congratulations on your margins finally breaking out
to the
37% level. Just on the automotive side, if you look at the automotive ADAS, can you talk about what are the tailwinds there, especially what is AB penetration in the U. S. Now? And do you see any tailwinds from China in CapEx, especially as you look at 2018?
Yes. So specifically on ADAS, that continues to be a global phenomenon, not just a Europe or U. S. Phenomenon. There are fewer cars with advanced ADAS in China, but just the sheer number that are being built there and the growth, particularly in the SUV arena is contributing nicely to a very quick ramp.
So what we do see is continued global demand. I mentioned earlier, we're expecting something in the mid-20s CAGR there as a result of not just more content in the higher end cars, but in China as well with the lower end.
Got it. And on the use of cash, know you mentioned delevering was a top priority. Is there any update to that 2x net leverage that you had talked about by end of 2018? Does that get pulled in now?
Thanks. It is very likely will be pulled in, yes.
Great. Thanks.
Thank you. And our next question comes from the line of Kevin Cassidy from Stifel. Your line is open.
Thank you. Going back to the pricing question or comments, if you're seeing better pricing than expected and your estimated or your target for 40% gross margin, I guess, when you're targeting 40 percent gross margin, what were your assumptions for price declines year over year? Yes. We usually build well, we don't usually in our specific model there, we used a 6% decline in ASPs to be offset with cost reductions to get to the 40% growth rate. Okay.
So would you say you're tracking ahead of it then with the it seems the last few quarters you've been saying that price pressure is lessening? Price pressure is lessening, we would be doing better than our model if this continues.
Okay, great. Thank you.
Thank you. And our next question comes from the line of Chris Rolland from Susquehanna. Your line is open.
Hey, guys. Really nice execution. Nice to see it all come together. So exiting the mobile image sensor business during the quarter will impact there and the impact for next quarter as well? And then finally, are there other businesses that you guys view that don't meet that gross margin profile?
So the revenue was approximately 1% of our total. And we continually look at opportunities and we articulated that in our Analyst Day that we're counting on about 40 bps coming from exiting business and we'll continue to continually look at divesting from non strategic underperforming businesses.
Great. Thanks, Bernard. And you guys also talked about the integration of Fairchild's back end. What's the timing there and the impact? And then Keith, you mentioned putting more capacity online to alleviate lead times.
Where does that capacity come from? I assume that you were talking about front end there?
No, actually there's more back end than front end. And that also plays the in sourcing piece of the equation. So more of our capital will go towards back end equipment in the second half of this year. And the Fairchild in sourcing piece really doesn't kick in until all of our qualifications are done and that will be late in this
year. I see. Thanks for that.
Thank you. And our next question comes from the line of Harsh Kumar from Stephens. Your line is open.
Yes. Hey, guys. Congratulations on solid execution. Keith or Barnard, I was curious about your views on the auto market. Generally speaking, you're guiding better than normal, but you mentioned there were parts of it that are temporarily soft.
I was curious if these are end geographies or end markets that are softer than normal. And I was also curious about your views on content growth versus this whole trend of negative SAAR that all the investors are
talking about. And I have
a follow-up. Yes. The
We, in We, in our look, think there's a 6% or more CAGR on content growth with no SAAR growth and that's what we've used in our models.
Understood. And then do you think with the trends you're seeing and the benefits from execution and all the other things you guys are doing on cost side that 40% gross margins are achievable before 2020 at this point in time? And then, you mentioned that we're on the flat side of the pricing curve in the marketplace. And you also mentioned subsequent to another answer that you're building in less than 6% decline. I was curious if you're building in flat by any chance in your model at this point?
We really haven't changed our model. We're experiencing better performance, but we haven't changed that model. What I will say is we are, because of that, certainly ahead of our curve toward the 40%. And certainly, that is a possibility that it could be brought in
Thank you. And our next question comes from the line of Shawn Harrison from Longbow Research. Your line is open.
Good morning and congrats on the results. Two questions, if I may. Just the mobile devices business, is there any different dynamic in the seasonality this year potentially because adaptive charging dynamics and a broader adoption that would maybe mitigate some of the pressure Fairchild used to see at the end of the year? And then second, on the $180,000,000 of synergies targeted for this year, what are we at today through the 1st 6 months?
On the mobile business, we are actually seeing a favorable condition for the Q3. We're expecting the China based handsets to increase over the Q2 as well as preparation for new launches from the non China based areas. So seasonality actually normally should have been even for Fairchild up in the Q3 when they launch those new models and it will continue being so this year. And
on the Fairchild synergies, we are ahead of plan. We have yet to complete the back end integration, the ERP final steps scheduled to happen in the Q4, which we will see some incremental back office savings. And then most of the rest will be coming from the COGS manufacturing line in 2018.
Keith, just as a follow-up on that seasonality, I meant more 4th quarter typically Fairchild It could be down for
that business. Didn't know if you would maybe
Yes. Q4 tends to soften this year. Again, based on specific phone launches, there may not be as much softening. Perfect. Thank you.
Thank you.
And our next question comes from the line of Harlan Sur from JPMorgan. Your line is open.
Good morning, guys, and solid job on the quarterly execution. Within the Industrial segment, you guys have talked about military, aerospace related program traction. Given the focus on defense related spending, what are you guys seeing either a design win pipeline or sort of near to mid term revenue contribution? And can you just remind us the margins for Defense and Aerospace, are they higher than corporate gross margins?
Thanks.
Yes. The margins are higher, and we have seen a strengthening in that business overall and design win pipeline is as active as it's ever
been. Great. Thank you.
Thank you. And our next question comes from the line of Craig Hettenbach from Morgan Stanley. Your line is open.
Hi. This is Danayak calling in for Craig. I just had a follow-up on the mobile side of things. You guys touched upon the content growth opportunity you're seeing in mobile. Can you just elaborate on what are the key applications driving that content growth?
The move to fast charging, move to USB Type C, probably the largest dollar content contributors.
Got it. And just to follow-up on that, on the move up to USB Type C, can you talk about the competitive profile there And how are you differentiating in that market? And finally, like what end market, like what product segments within USB Type C are you seeing the most traction?
So really, it's about efficiency and bandwidth when you're talking about the USB marketplace, and so you do differentiate basically on device performance. We participate in end to end. So we have the whole solution and that gets adopted by various customers in various ways.
Thank you.
Thank you. And our next question comes from the line of John Fitzer from Credit Suisse. Your line is open.
Yes, good afternoon guys. Thanks for letting me ask the questions. Congratulations on the solid results. Bernard, my question just has to do with the full year free cash flow guidance. Even if I adjust for the one time licensing gain in the first half and sort of higher CapEx in the second half, it looks like on an organic basis, you're kind of guiding to flat half on half free cash flow despite revenue growth and better profitability in the second half.
Are there other big one time issues? And I know the free cash flow can have some timing issues that hit in the back half of the year? Or do I just chalk this up to you being kind of conservative?
Probably a little bit more of the second of the tariff. Matter. We do have to pay the bonuses that we accrued for in the first half. So we have a little bit of working capital leakage in the second half. But other than that, it's and as you mentioned, also CapEx is definitely going to pick up substantially.
But other than that, nothing more, no other one times.
Perfect. And then guys, you sort of gave the revenue impact from getting out of the mobile image sensing business. What was the margin impact? How do I think about the margin for that business? And I know this was asked earlier, but Keith can you help size kind of other revenue pruning you might do and kind of the timing of that or how we should think about that versus your long term sort of gross margin and op margin model?
So the second part of your question there, Bernard indicated earlier, we had about 40 bps in our model of improvement due to getting out of such businesses. There are 3 or 4 of them actively being discussed right now and the timing frankly will be whatever we can do from a closing perspective. So we're quite active in that area, but really can't do a prediction based on the timing the customers take.
And on the margin contribution for the mobile image sensor, it was very, very low.
Perfect. Thanks, guys.
Thank you. And this concludes today's Q and A session. I would now like to turn the call back over to Parag Agrawal for closing remarks.
Thank you, everyone, for joining the call today. We look forward to seeing you at various conferences. Goodbye.
Ladies and gentlemen, thank you for participating in today's conference. This does conclude the program and you may all disconnect. Everyone have a great day.