Good day, ladies and gentlemen. Welcome to the Semiconductor third quarter 2016 earnings conference call. At this time, all participants are in a listen-only mode. Later we will conduct a question and answer session. Instructions will follow at that time. If anyone should require assistance during the conference, please press star then zero on your touch-tone telephone. As a reminder, this conference is being recorded. I would like to introduce your host for today's conference, Parag Agarwal, Vice President, Corporate Development and Investor Relations. Sir, you may begin.
Thank you, Terrence. Good morning. Thank you for joining ON Semiconductor Corporation third quarter 2016 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 will be available on our website approximately one hour following this live broadcast and will continue to be available for approximately 30 days following this conference call, along with our earnings release for the third quarter of 2016. The script for today's call and the 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 includes 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 Form 10-Ks, Form 10-Qs, and other filings with the Securities and Exchange Commission.
Additional factors are described in our earnings release for the third quarter of 2016. Our estimates may change. The company assumes no obligation to update forward-looking statements to reflect actual results, changed assumptions, or other factors, except as required by law. We will be holding our 2017 Analyst Day on March 10th in Scottsdale, Arizona. We will be sending out invitations and additional details of the event in the coming days. During the fourth quarter, we will be attending the Credit Suisse Technology, Media & Telecom Conference on November 30th. Now, let me turn over to Bernard Gutmann, who will provide an overview of third quarter 2016 results. Bernard?
Thank you, Parag, and thank you everyone for joining us today. Let me start by updating you on recent directives from the Securities and Exchange Commission on disclosure of non-GAAP financial measures. Due to new and revised compliance and disclosure interpretations on the use of non-GAAP financial metrics by U.S.-listed companies from the U.S. Securities and Exchange Commission, we are revising our practices with respect to guidance and use of non-GAAP measures. Please see the earnings release for additional information. Now, let me provide you details on our third quarter 2016 results. ON Semiconductor today announced that total revenue for the third quarter of 2016 was approximately $951 million, an increase of approximately 8% as compared to the second quarter of 2016. Third quarter revenue included the contribution of approximately $53 million from our acquisition of Fairchild Semiconductor, which closed on September 19th, 2016.
The incremental contribution from Fairchild was partially offset by approximately $5 million of revenue we didn't see this quarter as a result of the divestiture of our Ignition IGBT, TVS Diodes, and Thyristor product lines. GAAP net income for the third quarter was $0.02 per diluted share. GAAP income before income tax for the third quarter was approximately $87.3 million. Non-GAAP income before income tax for the third quarter was approximately $107.3 million. Net cash paid for taxes in the third quarter was approximately $6.5 million, and diluted shares outstanding were approximately 420 million. GAAP gross margin for the third quarter was 34.6%, and non-GAAP gross margin for the third quarter was 35.9%. GAAP and non-GAAP gross margin for the second quarter of 2016 was 35.1%. GAAP operating margin for the third quarter of 2016 was approximately 4.9%, as compared to approximately 8.6% in the prior quarter.
Our non-GAAP operating margin for the third quarter was 12.9%, as compared to 12.3% in the prior quarter. GAAP operating expenses for the third quarter were approximately $282 million, as compared to approximately $233 million for the second quarter of 2016. Non-GAAP operating expenses for the third quarter were approximately $218 million, as compared to approximately $200 million in the second quarter. The sequential increase in operating expenses was driven by the inclusion of Fairchild in our third quarter results, annual merit increases, which became effective in the third quarter of every year, costs related to Fairchild integration, and increases in legal and tax consulting fees. We had stronger operating cash flow performance in the third quarter. I am very excited about the cash flow potential of ON Semiconductor, and with the addition of Fairchild, we should see meaningfully improved cash flow performance in 2017.
Operating cash flow for the third quarter was approximately $133 million as compared to approximately $104 million in the second quarter. Operating cash flow for the third quarter was negatively impacted by approximately $26 million related to the modification of our Term Loan B financing. During the third quarter, we spent approximately $36 million of cash for the purchase of capital equipment, and we obtained approximately $104 million from the divestiture of our Ignition IGBT, TVS Diodes, and Thyristor product lines. We exited the third quarter of 2016 with cash equivalents, and short-term investments of approximately $880 million, as compared to approximately $588 million in the second quarter. At the end of the third quarter of 2016, days of inventory on hand, adjusted for 11 days of revenue contribution from Fairchild and the fair market value step-up, were 113 days.
ON Semiconductor days of inventory in the second quarter were 120 days. In the third quarter of 2016, distribution inventory days increased marginally as compared to the second quarter, primarily due to the inclusion of Fairchild. For the third quarter of 2016, our lead times were up quarter-over-quarter. Our global factory utilization for the third quarter was slightly up sequentially. Let me provide you an update on the performance of our business units. Starting with the Power Solutions Group, or PSG, revenue for PSG was approximately $408 million. Revenue for our Analog Solutions Group for the third quarter of 2016 was approximately $363 million. Revenue for the Image Sensor Group was approximately $180 million. I would like to turn the call over to Keith Jackson for additional comments on the business environment. Keith?
Thanks, Bernard. I will start with update on progress we have made thus far on integration of Fairchild, I will provide commentary on current business trends and on various end markets. We are pleased with our acquisition of Fairchild and also with the progress we have made thus far in the integration process. We are tracking significantly ahead of where our announced synergy targets. Recall that at the close of transaction, we announced that we were targeting to achieve annual synergy run rate of $75 million six months after the close of the transaction. We already have exceeded our six months post-close target, and we plan to implement further actions in the current quarter to realize additional synergies. We expect to start to see the impact of these measures on our operating costs in the early next year.
Let me provide additional detail on the action we've taken to realize synergies in various functional areas. On the R&D front, we have identified redundant or uneconomical programs and are in the process of eliminating many of these programs. A sizable portion of R&D program rationalization will likely be achieved in the current quarter. As we previously mentioned, although ON Semiconductor and Fairchild had very complementary product portfolios, both companies were investing to grow in similar areas. In sales and marketing, we took actions on the first day after close of the transaction to effectively integrate the sales team. Redundancies in account management were eliminated, and customer accounts were allocated immediately after close of the transaction. Based on inputs from our customers, we retained the best talent between the sales forces of the two companies.
With the addition of Fairchild's portfolio, ON Semiconductor has significantly improved its presence in the distribution channel. We intend to leverage our expanded presence to drive higher sales through the distribution channel. In general and administrative, we are rationalizing corporate functions such as finance, IT, legal, and human resources. As we integrate the systems of the two companies, we should see meaningful savings on the G&A front. The departure of Fairchild management team has contributed to savings on the G&A front. On the operations front, planning is well underway, and we are beginning to execute on synergies. Our initial assessment indicates that Fairchild's facilities are in good condition, and we intend to increase loading at most of these facilities through insourcing and production transfers to drive higher margins. Fairchild's operations planning systems are very similar to ours, and we expect a seamless integration of operations of the two companies.
Our initial assessment fully validates our financial and strategic rationale behind the acquisition. The acquisition is highly complementary, and overlap and redundancies in products and customers of the two companies are lower than previously expected. Fairchild has a very strong product portfolio, and with our scale and execution rigor, we are confident that we can generate significant value from Fairchild's portfolio. As we have indicated earlier, Fairchild's expertise in mid and high voltage power management is highly complementary to our strength in low voltage power management. Customer reception to the transaction has been very positive. Customers realize the combined strength of the two companies, and they are willing to engage with us in an even more meaningful manner than before. We've seen increased interest from automotive, industrial, and communication customers in our combined portfolio.
Fairchild has also added a list of marquee customers in the network and industrial end markets, and we are pleased to be working with these customers. As we had indicated earlier, the combination of ON Semiconductor and Fairchild creates a new leader in discrete power management market. Given our scale, execution history, and relationships, customers now have a very credible alternative to traditional market players for discrete power management solutions. Customers across end markets and geographies intensify their engagement with us for mid to high voltage power management solutions. We will provide further updates on the financial and strategic impact of the acquisition at our Analyst Day on March 10th, 2017. Let me now comment on the business trends in the third quarter. During the third quarter, demand trends were stable, and the bookings were generally steady across most end markets and geographies.
End market trends were generally in line with expectations. Recent commentary from customers points to a steady demand environment. Despite a stable macro environment and generally benign demand environment, we continue to manage our business in a prudent manner. We continue to execute on our strategy of focusing on automotive, industrial, and communications end markets. With the acquisition of Fairchild, we are well positioned to increase our presence in these markets in a meaningful manner. We expect that our investment should start showing concrete results in 2017 and beyond. Now I'll provide details of the progress in our various end markets. With inclusion of Fairchild's results for part of the third quarter, the normal quarter-over-quarter comparison that we have historically provided is not quite as meaningful. Therefore, I'll limit my remarks to qualitative summary and limited quantitative data.
The automotive end market contributed revenue of approximately $319 million and represented approximately 33% of our revenue in the third quarter. Third-quarter automotive revenue was negatively impacted by a divestiture of Ignition IGBT business, TVS Diodes, and Thyristor product lines. Our automotive design funnel remains robust as semiconductor growth in light vehicles continues to outpace production. We continue to see strong demand for image sensors for ADAS applications. We have secured wins on marquee platforms, and we are well positioned to drive strong growth in our automotive image sensors. Other applications driving growth in automotive include advanced front lighting, park assist, and DC to DC conversion. With the addition of Fairchild, we are now very well positioned to benefit from the fast-growing EV, HEV market.
The industrial end market, which includes military, aerospace, and medical, contributed revenue of approximately $212 million and represented approximately 22% of our revenue in the third quarter. Key drivers on growth in the industrial markets remain intact. In the medical market, we continue to maintain our leadership in the hearing health market, and we are preparing to launch new products in the fourth quarter. In machine vision market, we are seeing strong demand for our CMOS and CCD image sensors. The communications end market, which includes both networking and wireless, contributed revenue of approximately $192 million and represented approximately 20% of our revenue in the third quarter. Our momentum in the smartphone market remains strong, and our presence with global OEMs and China-based OEMs continues to grow. We continue to increase our content on marquee platforms by virtue of our innovative power management solutions.
Fairchild further improves our position with key global and China-based OEMs with its wall-to-battery solutions, converters, audio switches, power switches, and other analog switches. The computing end market contributed revenue of approximately $116 million and represented approximately 12% of our revenue in the third quarter. We noticed a slowdown in the computing market due to an inventory adjustment. The consumer end market contributed revenue of approximately $113 million and represented approximately 12% of our revenue in the third quarter. We noticed a greater than seasonal strength in consumer business, primarily due to gaming consoles and white goods. 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 $1.19 billion-$1.24 billion in the fourth quarter of 2016. Backlog levels for the fourth quarter of 2016 represent approximately 80%-85% of our anticipated fourth quarter revenues. Our guidance for the fourth quarter is in line with normal seasonality, with our organic business down approximately 2% at midpoint and Fairchild down approximately 7% at midpoint. We expect inventory distributors to be flat quarter-over-quarter on a dollar basis. We expect total capital expenditures of approximately $40 million-$50 million in the fourth quarter of 2016. For the fourth quarter of 2016, we expect GAAP gross margin in the range of 27.4%-29.5% and non-GAAP gross margin in the range of approximately 33.6%-35.6%.
Factory utilization in the fourth quarter is likely to be down sequentially. We expect total GAAP operating expenses of approximately $327 million-$359 million. Our GAAP operating expenses include the amortization of intangibles, restructuring, asset impairments, and other charges, which are expected to be approximately $54 million-$72 million. We expect total non-GAAP operating expenses of approximately $273 million-$287 million. We anticipate GAAP net other income and expense, including interest expense, will be approximately $40 million-$43 million for the fourth quarter of 2016, which includes non-cash interest expense of approximately $6 million-$7 million. We anticipate our non-GAAP net other income and expense, including interest expense, will be approximately $34 million-$36 million. Cash paid for income taxes is expected to be approximately $7 million-$11 million.
We also expect share-based compensation of approximately $13 million-$15 million in the fourth quarter of 2016, of which approximately $2 million is expected to be in cost of goods sold. 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 fourth quarter of 2016 is expected to be approximately 424 million shares based on the current stock price. Further details on share counts and earnings per share calculations are provided regularly in our quarterly and annual reports on Form 10-Q and Form 10-K. With that, I would like to start the Q&A session. Thank you, Terrence, please open the line for questions.
Thank you. Ladies and gentlemen, at this time, if you have a question, please press star then the number 1 key on your touchtone telephone. If your question has been answered or you wish to move yourself in the queue, please press the pound key. Again, if you would like to ask a question, press star, then one. Our first question comes from Ross Seymore from Deutsche Bank. Your line is open.
Hi, guys. Thanks for letting me ask a question. I guess the first one, heading into the fourth quarter, then potentially into the first quarter, can you just talk a little bit about the demand patterns you're seeing by subsegments? I realize sequential math is a little screwed up by the full fourth quarter of Fairchild, but just trying to get into what normal seasonality will be for the full company for the first quarter, then what the pluses and minuses are that get you to your revenue guide for the fourth quarter itself.
Okay. Well, it's a good time to address some of the differences between the Fairchild patterns and ON. ON normally would be down 2%-3% in the fourth quarter, then down another couple of percent in Q1. Fairchild had a very different pattern. They were down like 7% or 8% in the fourth quarter, then up 1% or 2% in the first quarter. The net of that is a little more smoothing of the transitions on a quarterly basis. Primary drivers were really the mix of business that the two companies had. What you see is a pronounced impact on the Fairchild side from the communications or handset market, which had the stronger patterns.
Right now, we're seeing things a little better than seasonality going into the fourth quarter and with the backlog patterns going into the first quarter for both companies, which basically says computing's down a bit, the handsets down a bit, automotive down a bit, and basically across all the markets, they're going to be down a little bit from Q3. There's really no strengthening in Q4 over Q3 market-wise. Q1 should see a strengthening in industrial and automotive, and the other markets should be approximately flat.
Great. I guess as my follow-up, one for Bernard, can you just walk us through your expectations sequentially and then kind of going into next year on the synergy side, and specifically on the OpEx line? How should it trend from that $280 million mark that you are guiding to in the fourth quarter?
As we mentioned in the written remarks, we are ahead of schedule on the savings and ergo our midpoint of our guidance is $280 million. In general terms, we expect those numbers to be flat to down. We expect the first quarter to still show some improvement over that. As you go into the back half of the year, we should expect still some small reductions, it will be partially offset with our normal merit increases. In general terms, we expect our OpEx to move towards the 22% of revenue towards the end of the year.
Great. Thank you.
Our next question comes from Chris Danely from Citigroup. Your line is open.
Hey, thanks, guys. Just a clarification on end markets. I think you said in the comments and prepared remarks that there was a slowdown from the PC market. Was that the reason that you came up a little short with the Q3 revenue? Maybe talk about how the slowdown in the PC market is impacting Q4, then any impact from the Galaxy Note7 problems as well.
Primary difference in Q3 was not computing. It was actually the divestiture of the business we mentioned for the ignition IGBTs and the thyristor businesses. That difference basically made up the entire gap. On the computing side, our comments were we did start to see some inventory corrections through the computing side. I believe we see them a little earlier than others, but I think you're going to see that in Q4. In general, there was not a big change Q3 over Q2 or Q4 over Q3 for our market, basically due to the increased Skylake content.
Okay, great. Then for my follow-up, can you just maybe talk about where you're finding these additional synergies? Is it more on the COGS or the OpEx side?
It's both. On the OpEx side, we're identifying continued opportunities as we understand the investment profiles in more detail, and just getting rid of redundancies there. That's opened up some new doors for us. On the COGS side, we now have enough data to do the analysis on insourcing, and that should provide some earlier than expected opportunities in 2017.
Great. Thanks, guys.
Our next question comes from Chris Caso from CLSA. Your line is open.
Yes. Thank you. Good morning. I guess as a first question, if you could clarify what the Fairchild revenue was for the full quarter. In addition Fairchild had a sell-in revenue recognition policy. Do you guys continue that as part of ON Semiconductor? What are the implications of that?
Yes, thanks, Chris. Fairchild's stub period, which is the one we had under our control, was $53 million. We don't have full visibility of what occurred before. It wasn't under our ownership, and there was no public forum for that. In general terms, I believe it was pretty much in line with what their management was expecting and was not a surprise in general terms, but we don't have a precise number. Indeed, Fairchild recognizes revenue on a sell-in basis. We will continue recognizing revenue on a sell-in basis for the Fairchild piece. We are exploring the possibility of early adopting the sell-in conversion, which, as you know, all companies will have to migrate to sell-in as of January 1, 2018 as the latest. We're exploring whether we do an early adoption of that at the beginning of 2017.
It's still not completely defined, but that's the current thought process. Pretty much after January 1, 2017, we should all be converting to a sell-in methodology.
Okay, thank you. As a follow-up, perhaps you could talk about the handset business a bit. Obviously, a lot of moving parts there with some new product ramps going. How is that going versus your expectations, and what can we assume as we go into Q1?
Yeah, that's a little bit of why seasonality is a little better than normal. We've actually seen some pickups in our design platforms, both with the global providers and in China. We think there should be some good opportunities for strength in Q1. I think that certainly is gonna remain so at least through the early Chinese New Year this year.
Great. Thank you.
Our next question comes from Vijay Rakesh from Mizuho. Your line is open.
Hi, guys. Thanks. Just briefly on the gross margin side, I know long term, you guys have maintained that 40% outlook. Is that a 2018 target? What top line do you see you need to get to that 40% longer-term gross margin? Thanks.
We will be giving details on that at the next Analyst Day, but the fundamental tends to get to that 40% remain intact, and we actually believe that the Fairchild acquisition enhances our ability to get there. In general terms, as we have said before, it consists mainly of fall through on incremental revenue, of self-help on manufacturing and consolidation, and mix improvements, and potentially divestitures. Those are the four legs that will really allow us to get to that 40%. We have in the past talked about a 5% growth in revenue that has fallen short in 2015 and 2016, but we do expect that there will be some low to middle single-digit growth in the markets that will allow us to get there.
Got it. On the auto side, you mentioned ADAS being a nice tailwind here. Can you talk about what % of your autos is now ADAS and how that is growing and how you see your mix of auto revenues in 2017? Thanks.
Yeah. I don't have precise numbers of ADAS because it's defined slightly different by each of the makers and whether it's Class 1 through Class 5. I don't really have access to precise data to give you there. What I can tell you is we're gonna be up double digits in automotive in 2016, the opportunity is there in 2017 as well, really on the backs of more adoption of more safety features.
Thanks.
Our next question comes from Rajvindra Gill from Needham & Company. Your line is open.
Yeah, thanks for taking my question. Just housekeeping. On the Q4 guidance, the Fairchild business implies something like $335 million revenue to get to the midpoint. If I look at the organic business being down about 2%, it implies that it's up about 5% year-over-year. I just want to make sure that those numbers are accurate.
In general terms, they are indeed in the ballpark. As we said in the prepared remarks, we expect ON legacy to be down about 2%, which is seasonal, and Fairchild to be down about 7%, which is also seasonally slightly better.
Okay, thank you. In terms of the gross margin drivers next year, you talked a little bit about that in your prepared remarks, but I was wondering if you could maybe elaborate on the Fairchild business, how that will contribute to a higher gross margin, either through fab consolidation or back-end test assembly consolidation. I was wondering if you could describe where you see some of the gross margin levers as you fold Fairchild in.
Yeah, there won't be any consolidation savings in 2017. It takes us more than a year to actually realize those. What we're looking at next year is additional insourcing into the combined factory network basically less outside manufacturing. This will get us better factory utilization and, frankly, some much lower costs in some of ON's factories by moving them from the low 80s up further from there. A lot of factory loading, mostly insourcing, would be a primary driver. Then secondarily, continued mix shift, which has been enhanced with the acquisition.
Last question from me, I'll hop back in the queue. In the press earnings release, you have a restatement of the end markets going back to March of 2014. There are some slight changes there in terms of the actual end markets, then you're kind of consolidating on the business unit split to those three categories. Wondering what was the reason for that and what was the changes that you see that occurred throughout the different products in end markets?
Typically, we do look at that end market every quarter, we fine-tune our end market information. That's pretty much a regular process that we go through, just fine-tuning the information.
The product groups we specifically are organized the way we did because we felt it would accelerate our synergies by aligning similar businesses across the company. Basically that whole restructuring, I think, has really helped us get ahead of the synergy game.
Our next question comes from Craig Ellis from B. Riley. Your line is open.
Thanks for taking the question. Team, I wanted to follow up on the ahead of schedule synergies progress and just explore the longer-term implications. The prior calendar 2017 through 2019 targets were $160 million, $200 million, and $225 million. If you're tracking ahead both on OpEx and COGS now, should we expect there to be upside to those targets? If so, can you provide either quantitative or qualitative color on that?
I'll chime in. Bernard can give more details. The answer is yes. We do expect upsides. We're not ready to give specific numbers at this point. There's no question we will both accelerate, meaning bring them in in time, and actually have identified more total numbers that we'll be able to deliver.
The follow-up, Keith, is on the end markets, and it's not so much about the near-term dynamics, but for the last couple of years, ON's had a focus on auto, industrial, and communications as its core end markets where it strived to drive above industry average growth. Now that you've got an inside look at the Fairchild portfolio, what do those products do to your relative growth rates in your core end markets?
I think two areas were pretty exciting. One was industrial. In the motor control, in the higher voltage power control areas, they actually were very well established, and so we're pretty excited there. Actually, I'll give you three areas. In handsets, the charging wall to battery products were very well designed into next generation platforms. Lastly, the opportunity for EV and HEV vehicles with their silicon carbide products is well-positioned as well. Those three areas, one in each of the three markets, we think provides us a much stronger position.
Thank you. If I could sneak one in for Keith. For Bernard. Bernard, is the $45 million midpoint CapEx number a decent proxy for what we should expect next year?
We still are targeting 6%-7% of revenue. It is a little bit lumpy. Sometimes it's higher, sometimes it's lower. In general terms, 6%-7% is still our model. We don't expect to deviate from it.
Thanks, guys.
Our next question comes from Tristan Gerra from Baird. Your line is open.
Hi, good morning. A quick question on the insourcing. I think a while back, 10 years ago, you were touting how outsourcing enabled you to reduce the cyclicality in the business by using the outside fabs as a buffer whenever things were slowing down. Could you remind us now what's the percentage of outsourcing, what it's going to be once you make those changes? Is it fair to assume that you have a view of the business being less cyclical that allows you to do this relative to your stance from years ago?
Our model was to have approximately 20% of our business outsourced to help deal with cyclicality. It turns out the Fairchild business on the back ends, for example, was over 50%, significantly in excess of our target. We look at ON's cost structure specifically again in the back end, it's substantially better than any of the outsource opportunities. Really, Tristan, it's just truing us back up to that 80/20 model with 80% inside will get us most of the gains that we're after.
Great. If I heard the number well, your Image Sensor Group revenue implies a little bit of a year-over-year decline in the quarter. Could you talk about the trends in that business? Are we still on track in terms of the accretion for the year and also the type of growth drivers that you see going forward?
We had very substantial double-digit growth in the automotive sector, which is the focus in that business. The slight declines year-over-year were all coming out of handsets in the consumer side which, again, we mentioned at the time of purchase, we wanted to de-emphasize those because they were quite low margin. Really everything remains on track as we look at it another year along.
Great. Thank you.
Our next question comes from Vivek Arya from Bank of America. Your line is open.
Thanks for taking my question. I wanted to just revisit this synergy question. When I look at ON and Fairchild separately in Q2, the combined OpEx, if my math is right, was about $285 million. For Q4, you're guiding to $280 million. First part is that the right baseline for looking at where you are in terms of synergy success? The other part of that is, what is the right way to look at absolute OpEx for 2017, even if it's in a somewhat qualitative way?
The Q2 is probably Q3 is probably a better base. If you look at the midpoint of our guidance for the ON legacy, it was at $205 million. In that sense, if you take Q2 actuals for Fairchild, which I think was around $85 million, you're looking at a starting point of about $290 million. The way to look at it for next year is we intend to gradually come down to achieve about a 22% of revenue level. It will be trending down from the existing approximately 23%.
Got it. Thanks. As my follow-up, Keith, one thing as I look at the power discrete sector tends to trade at a lower valuation, and one reason could be the lower gross margins versus the rest of the semis. I think you mentioned that there are opportunities for some potential divestitures. Are there things that you can do beyond just top-line growth that can help you accelerate the improvement and gross margins so you can get to your 40% target? Thank you.
Yeah, I think there's two things pretty strong in our favor there. One, we do think with our manufacturing network and the specific market focus we've got, that business just naturally can be in the high 30, so 38%, 39%, which is really not 40, but it's very supportive directionally from where it was run by the two companies separately. On top of that, there are divestiture opportunities. I can't give any details on those, obviously, but there are some lower-margin parts of that business we will be looking to spin out.
Okay. Thank you.
Our next question comes from Steve McGeach from Raymond James. Your line is open.
Great. Thanks a lot, guys. Congrats on all the good work on the synergies. The first question was on some of the R&D. You'd said you got some of the success there was in figuring out stuff that maybe you weren't going to focus on anymore. I was just hoping you might share sort of what products maybe you'll be de-emphasizing. If it's not appropriate for a public call, I understand, but any color there on what does not work for you guys anymore?
The majority of those synergies are redundant programs where we were both going after highly attractive new markets. I'd say that accounts for most of it. The balance is in some, I don't want to call them skunk works, but just some exploratory work that was going after some markets that we had not anticipated that do not look very attractive and some technologies that we don't think make any sense. It's really just odds and ends, but it added up to some reasonable numbers.
Okay, great. Thanks. Then Bernard, I was wondering if you've looked at this yet. In the event that you do shift ON over to the sell-in models, as everybody sort of has to do, I guess, at some point here, how should we think that that would impact results? Is there sort of a one-quarter shift over, pulls forward, and then we're kind of on track going forward? Or how do you anticipate that might look like, if you've had a chance to look at it yet?
Yes, we have had a chance to look at it. There should be no impact to the P&L. The guidance or the rules for this basically eliminates all of the sell-through deferred margin through equity without flowing through the P&L. Pretty much the only thing that will happen is on the financials is that the balance sheet will stop showing a deferred margin side, and it will be all rolled into equity. From the P&L point of view, there will be no impact.
Okay, great. Thanks very much.
Our next question comes from Shawn Harrison from Longbow Research. Your line is open.
Hi, good morning. I wanted to just delve into maybe debt reduction and how you're looking at that through the end of the year. I know the Series Bs were out there, but maybe if you could talk about does this guidance include any additional debt reduction associated with Fairchild, how you think about that during 2017 and maybe a minimum cash balance that you'd like to maintain?
As we said when we announced the deal on September 19th, reducing our leverage is going to be one of our priorities. We do have debt that becomes due at the end of the year, and we do have a good amount of cash on the balance sheet that allows us to have the flexibility of basically reducing that debt. We will be focusing as we increase our Free Cash Flow generation, we'll be focusing on using that cash to delever up until we get to a level of about two times net over the next couple of years.
Okay. As a follow-up, if I may, the $75 million run rate achieved, was that all OpEx related or did any of that fall into COGS? Second, I know that the accretion target was $0.20 for 2017, I believe. What is the new accretion target for 2017?
The majority of the initial savings are coming from OpEx. There is some savings on purchasing leverage on COGS. The $0.20 for right now remains intact, and we'll provide more details in our analyst day. Right now, we are definitely on track to that $0.20 accretion for 2017.
Thank you very much.
Our next question comes from Christopher Rolland from Susquehanna International Group. Your line is open.
Hey, guys. Thanks for the question. In your written commentary, you guys highlighted bringing capacity potentially in-house to Fairchild to help increase utilizations there. What current facilities do you guys plan to bring in there, or what products do you guys plan to bring in? Also, do you guys plan to equip the half of Fairchild's Korean facilities that were currently empty?
Okay. Kind of two fronts. One, on the assembly test side, across the board, we're looking at increasing utilization in those locations, and we will be focusing capital expenditures to expand the factories for increased leverage on bringing things inside. From a wafer fab perspective, really, we're looking at doing much more, including expanding Korea on the high voltage and medium voltage areas. The discrete factories of Fairchild should be seeing significantly more loadings from design wins that are ramping now on the ON side.
I see. Okay. Thank you. I think you guys addressed the revenue associated with your IGBT business. I guess it's less than $25 million a year, but the purchase price was more than $100 million, call it four to five times sales. That's significantly above two times sales where you guys trade at. I'm making an assumption that that business was significantly more profitable than the rest of your business. If that is true, we know it's 2% of revenue, but what kind of percent of profits are we talking about here? Is it 4%? Is it 5% of profitability? How should we think about that divestiture?
Chris, let me clarify something. The Ignition IGBT was $25 million, but we also sold some TVS and Thyristor product lines in conjunction with that same sale that was more on the mandated side by the FTC. The total revenue for that was definitely more than twice what you quoted for that business. We won't give details on the profitability, but I would say it's not above corporate average.
Got it. Okay. Thank you for that clarification.
Our next question comes from Kevin Cassidy from Stifel. Your line is open.
Thanks. This time of year, you typically renegotiate contract prices with your customers. Can you say how this year's negotiations went, and maybe give us an idea of what kind of price declines we'd expect in 2017?
Yeah, they are going well, we're quite pleased. Our expectations for next year are actually a little better than they were this year, they should still average in that 1%, give or take, range per quarter.
Per quarter.
Yeah.
What percentage of your revenue would be under contract?
It's a little less than 40% is under contract, of that, a little more than half of that total contract number is annual.
Okay, great. Thank you.
Our next question comes from Harlan Sur from J.P. Morgan. Your line is open.
Morning. Thanks for taking my question. Historically, in a disciplined supply-demand environment, the team has trended between kind of nine to 10.5 weeks on distribution inventories. Can you just give us an update on where inventories are currently sitting, and maybe just some qualitative views on customer discipline on the inventory front?
We're running approximately the same 10 weeks we've been running. It went up a little bit with Fairchild, but not much. Relatively good discipline on the acquired piece, and I think very good discipline on the traditional ON side.
Great. Thanks for that. Bernard, how should we think about the cash tax rate for 2017?
We are basically going to be growing towards that 10% of pre-tax income as we go throughout the year.
Okay. Thank you.
Our next question comes from Mark Delaney from Goldman Sachs. Your line is open.
Yes, good morning, and thanks very much for taking the questions. Two questions for me. First is on the fourth quarter, if you could help us with the gross margins between the two businesses, what would we have normally expected for traditional ON, and then how is Fairchild impacting the gross margins in the December quarter?
We are merging the two companies very quickly together, so we're not splitting the gross margin. In general terms, I think our normal 50% fall through on incremental or decremental revenue is the short-term view of things. That's pretty much what affects, supplemented by additional synergies coming on the Fairchild side.
That's helpful. For a follow-up question, if you could talk a little bit more on your market share opportunities, with NXP divesting a standard products group to Chinese holders, there was talk about some opportunities for ON to pick up shares, especially in auto and industrial. Could you give us either a quantitative or qualitative assessment about how successful you've been on that front?
Yeah. Quantitatively, gonna be difficult right now. It's still early. Qualitatively, those two markets are very sensitive to supply and supply disruptions. I think we're looking like a very good alternative to some of the changes that are out there.
Thank you.
Our next question comes from Craig Hettenbach from Morgan Stanley. Your line is open.
Hi, good morning. This is actually Diana calling from Craig. Thanks for taking my questions. You mentioned about reducing the debt, focusing on using the cash, getting 2 times lever. I'm wondering how should we think about the interest expense run rate going to 2017 and 2018?
The interest rate on our repriced Term Loan B is now LIBOR plus 325 as compared to LIBOR plus 450. If you look at the blended average of all of our debt that we have, it's approximately a little bit higher than 3%.
Okay, got it. Thank you. Just a follow-up on the inventory. When you look at the adjusted inventory days is around 113 for the quarter and 120 for ON Semi. That's kind of within your 110 and 120 targets. Would Fairchild kind of influence that target? What kind of inventory level you guys want to hold going forward? Thank you.
We believe that the 110-120 is a comfortable place to be at, and we'll continue with the targeting to be within that range.
At this time, I am showing no further questions. I would like to turn the call back to Parag Agarwal for closing remarks.
Thank you everyone for joining the call today. We look forward to seeing you at various conference during the quarter. Thank you.
Ladies and gentlemen, thank you for your participation in today's conference. This concludes the program. You may now disconnect. Everyone have a great day.