Good day, ladies and gentlemen, and 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 and instructions will follow at that time. As a reminder, this conference is being recorded. I would like to introduce your host for today's conference, Biraj Agarwal, VP of Corporate Development and Investor Relations.
Sir, you may begin.
Thank you, Terrence. Good morning and thank you for joining ON Semiconductor Corporation Q3 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 atwww.awnsemi.com. A replay will be available on our website approximately 1 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 Q3 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 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 Form 10ks, Form 10 Qs and other filings with the Securities and Exchange Commission. Additional factors are described in our earnings release for the Q3 of 2016. Our estimates may change and 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 10 in Scottsdale, Arizona and we will be sending out invitations and additional details of the events in coming days.
During the Q4, we will be attending the Credit Suisse Technology Media Telecom Conference on November 30. Now, let me turn over to Bernard Gutman, who will provide an overview of Q3 2016 results. Bernard? Thank you, Bharat, 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 Q3 2016 results. ON Semiconductor today announced that total revenue for the Q3 of 2016 was approximately 951,000,000 dollars an increase of approximately 8% as compared to the Q2 of 2016. 3rd quarter revenue included the contribution of approximately $53,000,000 from our acquisition of Fairchild Semiconductor, which closed on September 19, 2016. The incremental contribution from Fairchild was partially offset by approximately $5,000,000 of revenue we didn't see this quarter as a result the divestiture of our Ignition IGBT, TVS diodes and thyristor product lines.
GAAP net income for the 3rd quarter was $0.02 per diluted share. GAAP income before income tax for the 3rd quarter was approximately 87,300,000 dollars Non GAAP income before income tax for the Q3 was approximately $107,300,000 Net cash paid for taxes in the 3rd quarter was approximately $6,500,000 and diluted shares outstanding were approximately 420,000,000 GAAP gross margin for the Q3 was 34.6 percent and non GAAP gross margin for the 3rd quarter was 35.9%. GAAP and non GAAP gross margin for the Q2 of 2016 was 35.1%. GAAP operating margin for the Q3 of 2016 was approximately 4.9% as compared as compared to approximately 8.6% in the prior quarter. Our non GAAP operating margin for the 3rd quarter was 12.9% as compared to 12.3% in the prior quarter.
GAAP operating expenses for the Q3 were approximately $282,000,000 dollars as compared to approximately 233,000,000 for the Q2 of 2016. Non GAAP operating expenses for the 3rd quarter were approximately $218,000,000 as compared to approximately $200,000,000 in the 2nd quarter. The sequential increase in operating expenses was driven by the inclusion of Fairchild in our Q3 results, annual merit increases, which became effective in the Q3 of every year, costs related to Fairchild integration and increase in legal and tax consulting fees. We had stronger operating cash flow performance in the 3rd quarter. I'm 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 Q3 was approximately $133,000,000 as compared to approximately $104,000,000 in the 2nd quarter. Operating cash flow for the 3rd quarter was negatively impacted by approximately $26,000,000 related to the modification of our Term Loan B financing. During the Q3, we spent approximately $36,000,000 of cash for the purchase of capital equipment, and we obtained approximately $104,000,000 from the divestiture of our Ignition IGBT, TVS diodes and thyristor product lines. We exited the Q3 of 2016 with cash, cash equivalents and short term investments of approximately 880,000,000 dollars as compared to approximately $588,000,000 in the 2nd quarter. At the end of the Q3 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 Q2 were 120 days. In the Q3 of 2016, distribution inventory days increased marginally as compared to the Q2, primarily due to the inclusion of Fairchild. For the Q3 of 2016, our lead times were up quarter over quarter. Our global factory utilization for the Q3 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, Revenue for PSG was approximately $408,000,000 Revenue for our analogs product group for the Q3 of 2016 was approximately $363,000,000 Revenue for the image sensor group was approximately 180,000,000 dollars Now, 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 and then 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. As of now, 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 $75,000,000 6 months after the close of the transaction. We already have exceeded our 6 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 now provide additional detail on the action we've taken to realize synergies in various functional areas. On the R and D front, we have identified redundant or uneconomical programs and are in a process of eliminating many of these programs. A sizable portion of R and 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 1st day after close of the transaction to effectively integrate the sales team. Redundancies and account management were eliminated and customer accounts were allocated immediately after close of the transaction. Based on inputs from our customers, we retain the best talent between the sales forces of the 2 companies. With 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 2 companies, we should see meaningful savings on the G and A front. The departure of Fairchild management team has contributed to savings on the G and 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 in sourcing and production transfers to drive higher margins.
Bearchow's operations planning systems are very similar to ours and we expect a seamless integration of operations of the 2 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 2 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 2 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. Beartoothold 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, customer now have a very credible alternative to traditional market players for discrete power management solutions. Customers across end markets and geographies intensified 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 10, 2017. Let me now comment on the business trends
in the
Q3. During the Q3, 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. And with the acquisition of Fairchild, we are well positioned to increase our presence in these markets in a meaningful manner. We expect that our investments 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 3rd 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 $319,000,000 and represented approximately 33% of our revenue in the Q3. 3rd quarter automotive revenue was negatively impacted by a divestiture of ignition iDVT 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 addition to Fairchild, we are now very well positioned to benefit from the fast growing EVHEV market. The industrial end market, which includes military, aerospace and medical contributed revenue of approximately $212,000,000 and represented approximately 22% of our revenue in the Q3. 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 Q4.
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 $192,000,000 and represented approximately 20% of our revenue in the 3rd 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. Beartchild 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 $116,000,000 and represented approximately 12% of our revenue in the 3rd quarter. We noticed a slowdown in the community market due to an inventory adjustment. Consumer end market contributed revenue of approximately $113,000,000 and represented approximately 12 percent of our revenue in the Q3. We noticed a greater than seasonal strength in consumer business, primarily due to gaming consoles and white goods. 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 $1,190,000,000 to $1,240,000,000 in the Q4 of 2016. Backlog levels for the Q4 of 20 16 represent approximately 80% to 85% of our anticipated 4th quarter revenues. Our guidance for the 4th 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 $40,000,000 to $50,000,000 in the Q4 of 2016. For the Q4 of 2016, we expect GAAP gross margin in the range of 27.4% to 29.5% and non GAAP gross margin in the range of approximately 33.6% to 35.6%. Factory utilization in the 4th quarter is likely to be down sequentially. We expect total GAAP operating expenses of approximately $327,000,000 to 359,000,000 dollars Our GAAP operating expenses include the amortization of intangibles, restructuring, asset impairments and other charges, which are expected to be approximately $54,000,000 to $72,000,000 We expect total non GAAP operating expenses of approximately $273,000,000 to $287,000,000 We anticipate GAAP net other income and expense, including interest expense, will be approximately $40,000,000 to $43,000,000 for the Q4 of 2016, which includes non cash interest expense of approximately $6,000,000 to $7,000,000 We anticipate our non GAAP net other income and expense, including interest expense, will be approximately $34,000,000 to $36,000,000 Cash paid for income taxes is expected to be approximately $7,000,000 to $11,000,000 We also expect share based compensation of approximately $13,000,000 to $15,000,000 in the Q4 of 2016, 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 Q4 of 2016 is expected to be approximately 424,000,000 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 Terrence, please open the line for questions.
Thank And 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 Q4 and then potentially into Q1, can you just talk a little bit about the demand patterns you're seeing by sub segments? And I realize sequential math is a little screwed up by the full Q4 of Fairchild. But just trying to get into what normal seasonality will be for the full company for the Q1 and then what the pluses and minuses are that gets you to your revenue guide for the Q4 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% to 3% in the 4th quarter and then down another couple of percent in Q1. Fairchild had a very different pattern. They were down like 7% or 8% in the 4th quarter and then up 1% or 2% in the Q1. So 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 2 companies had. And what you see is a pronounced impact on the Fairchild side from the communications or handset market, which had the stronger patterns. So right now, we're seeing things a little better than seasonality going into the Q4 and with the backlog patterns going into the Q1 for both companies, which basically says computing is 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. And 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 $2.80 mark that you are guiding to in the 4th quarter?
So as we mentioned in the written remarks, we are ahead of schedule on the savings and ergo our mid the flat to down. We expect the Q1 to still show some improvement over that. And then as you go into the back half of the year, we should expect still some small reductions, but it will be partially offset with our normal merit increases. But in general terms, we expect our revenues our OpEx to move towards the 22% of revenue towards the end of the year.
Great. Thank you.
Our next question comes from Chris Danley from Citigroup. Your line is open.
Hey, thanks guys. Just a clarification on end markets. So I think you said in the comments in prepared remarks that there was a slowdown from the PC end market. Was that the reason that you came a bullish short with Q3 revenue? Maybe talk about how the slowdown in the PC market is impacting Q4?
And then any impact from the Note 7 problems as well?
So primary difference in Q3 was not computing, it was actually the divestiture of the business we mentioned for the Ignition IGPTs and the Thyristor businesses. So that difference is it was basically made up the entire gap. On the computing side, our comments where 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. But 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. And 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. And on the COGS side, we now have enough data to do the analysis on in sourcing and that should provide some earlier than expected opportunities in 2017.
Great. Thanks, guys.
And 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 and what are the implications of that?
Yes. Thanks, Chris. So Fairchild's tough period, which is the one we had under our control was $53,000,000 We don't have full visibility of what occurred before. It wasn't under our ownership and there 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 is recognizes revenue on a sell in basis. We will continue recognizing revenue on a sell in basis for the Fairchild piece. And we are exploring the possibility of adopting the early adopting the sell in conversion, which as you know, all companies will have to migrate to sell in as of Oneoneeighteen as the latest. So we are 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.
So pretty much after 1onetwenty 17, we should all be merging to a sell in methodology.
Okay. Thank you. And 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?
Yes, 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. And so we think there should be some good opportunities for strength in Q1. And I think that certainly is going to remain so at least through the early Chinese New Year this year.
Great. Thank you.
And 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? And what top line do you see to get to that do you need to get to that 40% longer term gross margin?
Thanks.
So 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. And 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 4 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 '16. 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. And on the auto side, you mentioned ADAS being a nice tailwind here. Can you talk about what percent 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. And so I don't really have access to precise data to give you there. What I can tell you is we're going to be up double digits in automotive in 2016 and the opportunity is there in 2017 as well, really on the backs of more adoption of more safety features.
Thanks.
And our next question comes from Rajvindra Gill from Needham and Company. Your line is open.
Yes. Thanks for taking
my questions. So just housekeeping. So on the Q4 guidance, the Fairchild business implies something like $335,000,000 revenue to get to the midpoint. And if I look at the organic business being down about 2%, it implies that it's up about 5% year over year. So 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 fair channel to be down about 7%, which is also seasonally slightly better.
Okay. Thank you. And in terms of the gross margin drivers next year, and 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 wonder if you could describe where you see some of the gross margin levers
as you fold Fairchild in?
Yes. 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 in sourcing into the combined factory network. So basically less outside manufacturing.
This will get us better factory utilization and some frankly, so much lower costs in some of ON's factories by moving them from the low 80s up further from there. So a lot of factory loading, mostly in sourcing would be a primary driver. And then secondarily, continued mix shift, which has been enhanced with the acquisition.
And last question for me and then 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. And there are some slight changes there in terms of the actual end markets and then you're kind of consolidating on the business unit split to those 3 categories. Wondering what was the reason for that and what was the changes that you see that occurred throughout the different products? And Ed, Mark?
So typically, we do look at that end market every quarter and there is it typically happens, we fine tune our end market information. So 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 and by aligning similar businesses across the company. And so basically that whole restructuring, I think, has really helped us get ahead of the synergy game.
And 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 $160,000,000 $200,000,000 $225,000,000 If you're tracking ahead both on OpEx and COGS now, should we expect there to be upside to those targets? And if so, can you provide either quantitative or qualitative color on that?
I'll chime in. Bernard can give more details. But the answer is yes, we do expect upsides. We're not ready to give specific numbers at this point. But 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.
And then 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 strive to drive above industry average growth. Now that you've gotten inside look at the Fairchild portfolio, what did those products do to your relative growth rates in your core end markets?
Yes, I
think 2 areas were pretty exciting. 1 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 3 areas.
In handsets, the charging wall to battery products were very well designed into next generation platforms. And then lastly, the opportunity for EV and HEV vehicles with their silicon carbide products is well positioned as well. So those three areas, 1 in each of the 3 markets, we think provides us a much stronger position.
Thank you. And if I could sneak one
in for Keith. Keith is the excuse me, for Bernard. Bernard is the $45,000,000 midpoint CapEx number a decent proxy for what we should expect next year?
We still are targeting 6 to 7% of revenue. It is a little bit lumpy. Sometimes it's higher, sometimes it's lower. But in general terms, 6% to 7% is still our model. We don't expect to deviate from it.
Thanks, guys.
And our next question comes from Tristan Gerra from Baird. Your line is open.
Hi, good morning. A quick question on the in sourcing. 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 fads 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?
And 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?
Yes, 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%. And so significantly in excess of our target. And we look at ON's cost structure specifically again in the back end and it's substantially better than any of the outsource opportunities. So really Tristan, it's just truing us back up to that eightytwenty model with 80% inside, will get us most of the gains that we're after.
Great. And then 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?
Yes, we had very substantial double digit growth in the automotive sector, which is the focus in that business. The slight declines year on year were all coming out of handsets in the consumer side, which again we mentioned at the time of purchase, we wanted to deemphasize those because they were quite low margin. And so really everything remains on track as we look at it another year long.
Great. Thank you.
And 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. So when I look at ON and Fairchild separately in Q2, the combined OpEx, if my math is right, was about $285,000,000 And for Q4, you're guiding to 280,000,000 dollars So first part is, is that the right baseline for looking at where you are in terms of synergy success? And the other part of that is, what is the right way to look at absolute OpEx for 2017, even if in a somewhat qualitative way?
So 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 $205,000,000 So in that sense, and if you take Q2 actuals for Fairchild, which I think was around $85,000,000 you're looking at a starting point of about 2.90 dollars The way to look at it for next year is we intend to gradually come down to achieve about 22% of revenue level. So it will be trending down from the existing approximately 23%.
Got it. Thanks. And 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. And I think you mentioned that there are opportunities for some potential divestitures. So are there things that you can do beyond just top line growth that can help you accelerate the improvement in gross margins so you can get to your 40% targets?
Thank you.
Yes, I think there's 2 things pretty strong in our favor there. 1, we do think with our manufacturing network and the specific market focus we've got, that business just naturally can be in the high 30s, so 38%, 39%, which is really not 40%, but it's very supportive directionally from where it was run by the 2 companies separately. On top of that, there opportunities, and 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.
And our next question comes from Steve Smiggy from Raymond James. Your line is open.
Great. Thanks a lot guys and congrats on all the good work on the synergies. The first question was on some of the R and 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. Was just hoping you might share sort of what products maybe you'll be deemphasizing and if it's not appropriate for 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 are both going after highly attractive new markets. And 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. So it's really just odds and ends, but it added up to some reasonable numbers.
Okay, great. Thanks. And then Bernard, I was wondering if you could if you've looked at this yet in the event that you do shift on over to the sell in models that everybody sort of has to do I guess at some point here. What how should we think that that would impact results? Is there sort of a 1 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 and L. The guidance or the rules for this basically eliminates all of the sell through deferred margin through equity without flowing through the P and L. So 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 and L point of view, there will be no impact.
Okay, great. Thanks very much.
And our next question comes from Sean Harrison from Longbow. 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 the 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? So as we said in when we announced the deal on September 19, 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. And 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 2x net over the next couple of years.
Okay. And then as a follow-up, if I may, the $75,000,000 run rate achieved, was that all OpEx related or did any of that fall into COGS? And second, I know the accretion target was $0.20 for 2017, I believe. What is the new accretion target for 2017?
So 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. But right now, we are definitely on track to that $0.20 accretion for 2017. Thank you
very much.
And our next question comes from Chris Rolland from Susquehanna International Group. Your line is open.
Hey, guys. Thanks for the question. So in your written commentary, you guys highlighted bringing capacity potentially in house to Fairchild to help increase utilizations there. So what current facilities do you guys plan to bring in there? What products do you guys plan to bring in?
And then also, do you guys plan to equip the half of Fairchild's Korean facilities that were currently empty?
Okay. So kind of 2 fronts. 1 on the assembly test side, across the board, we're 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. So the discrete factories of Fairchild should be seeing significantly more loadings from design wins that are ramping now on the on-site.
I see. Okay. And then I think you guys addressed the revenue associated with your IGBT business. I guess it's less than like $25,000,000 a year, but the purchase price was more than $100,000,000 So call it 4 to 5 times sales. That's significantly above 2 times sales where you guys trade at.
So I'm making an assumption that that business was significantly more profitable than the rest of your business. And if that is true, we know it's 2% of revenue, but what kind of percent of profits are we talking about here? Is 4%? Is it 5% of profitability? How should we think about that divestiture?
So let me Chris, let me clarify something. The Ignition IGBT was 25, 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. So the total revenue for that was definitely more than twice what you called it for that business. And we don't we don't give details on the profitability, but I would say it's probably not it's not above corporate average.
Got it. Okay. Thank you for that clarification.
And 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 Sears negotiations went and maybe give us an idea of what kind of price declines we'd expect in 2017?
Yes. They are going well. And so we're quite pleased. Our expectations for next year are actually a little better than they were this year, but they should still average in that 1%, give or take range per quarter.
Per quarter, yes. And what percentage of your revenue would be under contract?
It's a little less than 40% is under contract and of that a little more than half of that total contract number is annual.
Okay, great. Thank you.
And our next question comes from Harlan Sur from JPMorgan. Your line is open.
Good morning. Thanks for taking my question. Historically in a disciplined supply demand environment, the team has trended between kind of 9 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?
So we're running approximately the same 10 weeks we've been running. It went up a little bit with Fairchild, but not much. And so relatively good discipline on the acquired piece and I think very good discipline on the traditional on-site.
Great. Thanks for that. And then Bernard, how should we think about the cash tax rate for 2017?
So we are basically going to be growing towards that 10% of pre tax income as we go throughout the year.
Okay. Thank you.
And 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 Q4, if you could help us with the gross margins between the two businesses, what will we have normally expected for traditional on and then how is Fairchild impacting the gross margins in the December quarter?
So we are merging the 2 companies very quickly together. So we are 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. And then 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 and 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?
Yes, quantitatively going to be difficult right now. It's still early. But qualitatively, those two markets are very sensitive to supply and supply disruptions. And I think we're looking like a very good alternative to some of the changes that are out there.
Thank you. And our
next question comes from Craig Hittendock from Morgan Stanley. Your line is open.
Hi, good morning. This is actually Diana calling from Craig. Thanks for taking my questions. First, you mentioned about reducing the debt, focusing on using the cash, getting 2x lever. Wondering how should we think about the interest expense run rate going to 2017 2018?
So the interest rate on our repriced term loan B is now LIBOR plus 3.25 percent as compared to LIBOR plus 4.50 percent. If you look at the blended average of all of our debt that we have, it's approximately 3 a little bit higher than 3%.
Okay, got it. Thank you. And then 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. So that's kind of like within your 110 and 20 targets.
So would Fairchild kind of influence that targets like what kind of inventory level you guys want to hold going forward? Thank you.
We believe that the 110 to 120 is a comfortable place to be at and we'll continue with the targeting to be within that range.
And at this time, I'm showing no further questions. I would like to turn the call back to Paraj Agrawal 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.