Good day, welcome to the Texas Instruments second quarter 2018 earnings release conference call. Today's conference is being recorded. At this time, I'd like to turn the conference over to Dave Pahl. Please go ahead, sir.
Thank you. Good afternoon, thank you for joining our second quarter 2018 earnings conference call. Rafael Lizardi, TI's Chief Financial Officer, is with me today. For any of you who missed the release, you can find it on our website at ti.com/ir. This call is being broadcast live over the web and can be accessed through our website. A replay will be available through the web. This call will include forward-looking statements that involve both risks and uncertainties that could cause TI's results to differ materially from management's current expectations. We encourage you to review the notice regarding forward-looking statements contained in the earnings release published today, as well as TI's most recent SEC filings for a more complete description. You likely saw last week we announced that Rich Templeton had resumed the roles of President and CEO, along with his current role as Chairman.
Rich has successfully led TI for the past 14 years, under his continuing leadership, we look forward to making TI even stronger and better. I've met with Rich several times over the last couple of weeks, I can tell you he's excited to be back. He'll be attending several conferences in the near future and will be meeting with investors over the next few months. As you might imagine, he's fully engaged and busy doing what he does best, that's executing our strategy, strengthening our competitive advantages, and running our operations with laser focus. Turning to this quarter's results, I'll start with a quick summary. Revenue for the second quarter increased 9% from a year ago, as demand for our products remained strong in the industrial and automotive markets.
In our core businesses, Analog revenue grew 12%, Embedded Processing revenue grew 9% compared to the same quarter a year ago. Operating margins increased in both businesses. Earnings per share were $1.40, including a $0.03 discrete tax benefit, not in our original guidance. With that backdrop, I'll provide some details on our performance, which we believe continues to be representative of the ongoing strength of our business model. In the second quarter, our cash flow from operations was $1.8 billion. We believe that free cash flow growth, especially on a per-share basis, is most important to maximizing shareholder value in the long term. Free cash flow for the trailing 12-month period was $5.7 billion, up 42% from a year ago. Free cash flow margin for the same period was 36.6% of revenue.
We continue to benefit from the quality of our product portfolio that's long-lived and diverse, and the efficiency of our manufacturing strategy, the latter of which includes our growing 300-millimeter Analog output. We believe that free cash flow will be valued only if it's productively invested in the business or returned to owners. For the trailing 12-month period, we returned $5.6 billion of cash to owners through a combination of dividends and stock repurchases. Our commitment to return all of our free cash flow to owners remains unchanged. I'll now provide some details by segment. From a year-ago quarter, Analog revenue grew 12% due to power and signal chain. High volume declined. Embedded Processing revenue increased 9% from a year-ago quarter due to about equal growth in both processors and connected microcontrollers. In our other segment, revenue declined 7% from a year-ago, primarily due to custom ASIC.
I'll provide some insight into this quarter's revenue performance by end market versus a year-ago. Industrial and automotive demand remained strong due to broad-based growth. We continue to be pleased with our investments, which are directed across 14 sectors in industrial and five sectors in automotive, and continue to deliver broad-based and diverse revenue growth. Personal electronics grew low single digits with increases across several sectors and customers. These increases were offset by declines at some customers. Communication equipment declined from a year-ago and declined low to mid single digits sequentially. Lastly, enterprise systems grew. In summary, we continue to focus our strategy on the industrial and automotive markets, where we've been allocating our capital and driving initiatives to strengthen our position. This is based on a belief that industrial and automotive will be the fastest-growing semiconductor markets.
They have increasing semiconductor content, these markets provide diversity and longevity. All of this translates to a high terminal value of our portfolio. Rafael will now review profitability, capital management, and our outlook. Rafael?
Thanks, Dave, good afternoon, everyone. Gross profit in the quarter was $2.62 billion, or 65.2% of revenue. From a year-ago, gross profit increased primarily due to higher revenue. Gross profit margin increased 90 basis points. Operating expenses in the quarter were $825 million, a 2% increase from a year-ago and about as expected. On a trailing 12-month basis, operating expenses were 20.6% of revenue, within our range of expectations. Over the last 12 months, we have invested $1.53 billion in R&D. We are pleased with our disciplined process of allocating capital to R&D that allows us to continue to grow our top line and gain market share. Acquisition charges and non-cash expense were $79 million. Acquisition charges will be about $80 million per quarter through the third quarter of 2019, decline to about $50 million per quarter for two remaining years.
Operating profit was $1.71 billion, or 42.6% of revenue. Operating profit was up 16% from the year-ago quarter. Operating margin for Analog was 47%, up from 44.7% a year ago. For Embedded Processing, it was 35.4%, up from 31.2% a year ago. Our focused investments on the best sustainable growth opportunities with differentiated positions enable both businesses to continue to contribute nicely to free cash flow growth. Net income in the second quarter was $1.41 billion, or $1.40 per share. Let me now comment on our capital management results, starting with our cash generation. Cash flow from operations was $1.83 billion in the quarter. It increased $909 million from the year-ago quarter, primarily due to a lower tax rate, as well as higher revenue, which includes more 300-millimeter Analog revenue. Capital expenditures were $249 million in the quarter.
Free cash flow was $5.73 billion on a trailing 12-month basis, up 42% from a year ago. In the second quarter, we paid $606 million in dividends and repurchased $1.02 billion of our own stock, for a total return of $1.62 billion in the second quarter. We have returned $5.6 billion to owners in the past 12 months, consistent with our strategy to return to owners all of our free cash flow. Over the same period, our dividends represented 41% of free cash flow, underscoring their sustainability. Our balance sheet remains strong, with $5.13 billion of cash and short-term investments at the end of the second quarter. In the quarter, we retired half a billion dollars of debt as it became due and raised $1.5 billion of 30-year debt with a coupon of 4.15%. We currently have total debt of $5.1 billion with a weighted average coupon of 2.77%.
Inventory days were 135, up two days from a year ago and within our expected range. We continue to believe there is strategic value in owning and controlling our inventory. Turning to our outlook for the third quarter, we expect to have revenue in the range of $4.11 billion-$4.45 billion, and earnings per share to be in the range of $1.41-$1.63, which includes an estimated $10 million discrete tax benefit. We continue to expect our ongoing annual operating tax rate to be about 20% in 2018 and 16% starting in 2019. Just as a reminder, the higher tax rate this year is due to non-cash charges. More detail of our expectations for taxes can be found on our website under Financial Summary Data.
In closing, I'll note that the strength of our business model was demonstrated throughout our financial performance over the last few years, from top-line growth and margin expansion to free cash flow generation. We continue to invest in our competitive advantages, which are manufacturing and technology, portfolio breadth, market reach, and diverse and long-lived products. We will continue to strengthen these advantages through disciplined capital allocation and by focusing on the best products, Analog and Embedded Processing, and the best markets, industrial and automotive, which I believe will enable us to continue to improve and deliver free cash flow per share growth for a long time to come. With that, let me turn it back to Dave.
Thanks, Rafael. Operator, you can now open up the lines for questions. In order to provide as many of you as possible the opportunity to ask your question, please limit yourself to a single question. After our response, we'll provide you an opportunity for an additional follow-up. Operator?
Thank you. If you'd like to ask a question, please signal by pressing *1 on your telephone keypad. If you're using a speakerphone, please make sure your mute function is turned off to allow your signal to reach our equipment. Again, that is *1 to ask a question. We'll pause for just a moment to allow everyone an opportunity to signal for questions. We'll take our first question from John Pitzer from Credit Suisse.
Hey, guys. Congratulations on the solid results. Dave, my first question is just on the high-volume Analog segment. I think in your prepared comments, you'd mentioned that it declined year-over-year in the June quarter. I'm kind of curious, to what extent was that by choice as you pruned the portfolio? To what extent do you think that that's just a handset phenomenon as the builds last year for product cycles were more robust than this year? To what extent do you feel that might be a leading indicator for maybe some excess in the quote, unquote, "cycle"?
Yeah. John, thanks for thanks for asking that question. I, you know, I think what we're seeing there is a result of how we've been allocating our resources in R&D. If you remember back in February, in our capital management calls, we went through that. We've got a pretty disciplined process, essentially what we're trying to do is steer more money to long-lived revenue opportunities where we've got some level of differentiation, and we'll have that for some time. I think when you look at the results overall, revenue grew 12% year-over-year. That's inclusive of what happened inside of high volume. Again, I think that that's a result of allocating resources to the best sustainable opportunities. If you drop down into there, in the prepared comments, obviously industrial and automotive continued to do well.
Inside of HVAL, you'd see that industrial and automotive did well as well. It just doesn't make up as much of a percentage of that revenue. Anyway, we're pleased with that outcome and not surprised by it. You have a follow-on, John?
Yeah, I do. That was helpful. Rafael, as my follow-on, I know it's probably better to look at the business trends on a year-over-year basis rather than sequential. On a year-over-year, you showed really good operating margin leverage in the embedded business. Sequentially, it was flat on up revenue, and there's still that gap between embedded op margins and Analog op margins. How do you think about the leverage in the embedded market from here, and will we ever close that gap between embedded and Analog?
Let me step back and take you back to our capital management strategy and some of the things that we say there and how we think about driving value for the owners of the company. To us, it all comes down to growing free cash flow per share. It's not operating margin, it's not gross margin, it's not Analog versus Embedded. It's all about growing free cash flow per share. Both of those business are, and we expect to continue to be contributors to that free cash flow per share. The focus is growing the top line as we continue to invest in what we think are the best markets, industrial, automotive, and in the case of Analog, as we continue to expand our 300-millimeter footprint where we have a structural cost advantage.
Okay. Now we'll go to the next caller, please.
We have Timothy Arcuri from UBS on.
Thank you very much. I had a question on the guidance. The June numbers were a little bit below seasonal. I know that seasonal is hard to really figure out what's actually normal. That was kind of coming off more difficult Q1 comps. If I look at the September quarter guidance, it's a few hundred basis points below seasonal, and it's up like 300 basis points year-over-year, which is the lowest in a couple of years. Is there any element of more difficult comps, or is there in fact some kind of channel inventory headwinds? Thank you.
Yeah, Tim, I'd just say that when we put together our guidance, the two strongest signals that we see are orders that we get from customers, as well as the demand feeds that we get through our consignment programs. I would just say that if there's something specific to call out, as we have in the past, if there was a specific customer or specific end market or something like that was changing, we would let you know about that. As example, lead times remain stable, cancellations remain low, reschedules remain low. We look at inventory in the channels, that remains steady at about four weeks. We really don't see any changes from that standpoint. The other thing, as you pointed out, when you look at a couple of data points, it's hard to describe what is exactly seasonal.
If you look over the last five years, we've had a 9% sequential growth. Three of those five years has been at 6%. If you look over a 10-year period, it's 7%. Certainly our guidance from a seasonal standpoint is certainly within the range of things that we've seen in the past. You have a follow-on?
Thanks. Then I guess just as a quick follow-on. Dave, can you give what orders and book-to-bill were?
I can give that. Let me just find it. Orders, book-to-bill orders were up 10% sequentially. Book-to-bill was 1.06. I'll point out it was 1.06 a year ago and 1.03 last quarter. I always feel the need to comment on book-to-bill with about 60% of our revenue going through consignment programs where we don't get any orders in advance of pull from that demand. Book-to-bill isn't as strong of a signal or at least as clear of a signal as what it used to be in the past. Thank you, Tim, we'll go to the next caller, please.
We'll take our next caller from Ross Seymore from Deutsche Bank.
Hi, Ross.
Thanks for letting me ask a question. Dave, just wanted to ask about from, not necessarily a cyclical point of view, but from a macro point of view, with all the discussions of trade wars, tariffs, et cetera, I know you haven't called out seeing anything, per your answer to the last question, but just how does TI in general think about that dynamic as potentially impacting your business? Are you in fact seeing any impact as of yet?
Yeah, Ross, I'll go ahead and take that. First, let me state, TI is a long-term supporter of free trade and strong IP protection. Those are both important to TI and the broader semiconductor industry. We continue, we feel that way. We have stated that position for a long time, we continue to do that, and advocate that. Specifically on the tariffs that have been announced on integrated circuits, those are still subject to public comment, through the end of July, those are not in place yet. Once they go into effect, or if they go into effect, remember, they will apply to goods that are deemed of Chinese origin that are then imported into the U.S. For TI, only about 13% of our revenue is imported into the U.S.
In other words, 87% of our revenue is exports, not subject to U.S. tariffs. That 13%, only a sliver of that would be deemed as Chinese origin. Bottom line, only about 1% of our revenue would have those tariffs applied to it, that's before we make any potential adjustments, supply chain and other things that we could do to even minimize that impact further. At the end of the day, we don't see a major even, or any direct impact other than some minimal impact. Now, that's not to say that at a macro level, that couldn't have an impact, but that's a very macro comment that goes beyond TI, and beyond the semiconductor industry. That free trade, anything against free trade between the two largest economies in the world, that could eventually have a macro effect that would be detrimental to everybody.
You have a follow-on, Ross?
Yeah, I do. Just switching back to your product segments, seemed like Analog sequentially was pretty much in line with what we've seen for the last few years. Embedded was lower and other was much higher than what we've seen. I know you guys think of things year-over-year, but if we look at it sequentially, are there any reasons behind the Embedded being lower and the other being so much higher?
Yeah. I think if you look at Embedded, it has a higher percentage of comms equipment. It was impacted by that. In other, don't forget that we've got the calculators sit inside of that business, so we've got strong seasonality in second and third quarter. Thank you, Ross, for those questions, and we'll go to the next caller, please.
We have our next question from Ambrish Srivastava from RBC Capital Markets.
Yep. Thanks a lot. I guess two questions from me as well. Maybe first off, could you quantify the revenue impact you had from, not your word mind, but product rationalization or product optimization that you guys went through in the June quarter? Does that revenue headwind, if you may, flow into the September quarter as well to some degree?
Ambrish, can you clarify what you mean by product rationalization?
Yeah. I think, Dave, when you talked about the consumer-centric markets, you talked about how some of the revenue declines there were driven by the fact that you just decided not to participate in some of these markets, a reflection of how your R&D budgets have tracked over time. Is that fair? If so, I guess, how much was that revenue impact driven by?
Well, I think if you look, we shared this back in February on our capital management call. As we looked at allocating resources across end markets and specifically in personal electronics. When you compare our spend there versus five and 10 years ago, it's lower. Now, it's not zero. There's still good opportunities that we find inside of personal electronics and continue to invest. We're just looking for sustainable growth opportunities inside of that space. That's really what we're talking about. Again, I think the first question came in specifically about one of the businesses inside of our Analog segment. I think you have to judge the efficiency of our capital allocation by the total results, and that we're quite pleased with. Does that help to answer your question?
Yep. No, that's helpful. I guess if I could just follow up, you guys have had multiple quarters of gross margin expansion very consistently on a year-over-year basis. As you think about the back half of 2018, could you maybe talk about what are the levers that can enable gross margins to continue to expand from here? Do you feel comfortable that gross margin should expand in the back half?
Yeah, I'll go ahead and take that, Amit. As we have talked about during capital management and in other settings, our focus for value creation for the owners of the company is free cash flow per share. It's not gross margin, it's not operating margin, it's dollars of free cash flow per share. The opportunity for expanding that and continuing to grow that are simple, is the top line, as we continue to invest in the best products and the best markets. The best markets, because that's where the semiconductor content is expanding, and we continue to gain share there. 300-millimeter. We have talked about that for a number of years. As of last year, about $4 billion of our revenue went through 300-millimeter, four out of 10 in the Analog space.
That leaves a lot of room for continued expansion on 300-millimeter and continuing to grow the free cash flow per share.
Okay. Thank you, Amit, and we'll go to the next caller, please.
We'll take our next question from Harlan Sur from JPMorgan.
Well, good afternoon. Solid job on the quarterly execution and strong free cash flow generation. Your focus markets, automotive, you've got five sub-segments. Industrial, you've got 14 sub-segments. Can you guys just give us a sense on the breadth of the year-over-year growth in these markets? Were a majority of these sub-segments up year-over-year? Any color here would be helpful.
Yeah. Sorry, Harlan. When you look at that growth, we're really pleased with it. It's very broad-based. When you look at all of the sectors, out of the 19 combined that we had, 18 of them actually grew. It's very broad-based. I think when you look across just different products, different investments, when we look at our design-ins and our pipeline, those continue to be very broad-based. That gives us confidence in the sustainability of that growth. Of course, doesn't mean that we won't see cyclical headwinds at some point. When you look at it from a five and 10-year standpoint, we feel really good about the progress that we've made. You have a follow-up, Harlan?
Yeah, no, thanks for the insights there. Kind of to follow up on that, maybe from a geographical perspective, right? I think last quarter, all regions, and I know this is ship-to, right? This is ship-to data, but still nevertheless important. Last quarter, I think all regions were up except for Japan. What did you see this quarter?
That is the same story. My friends in Japan, I've talked to them a couple of times. To give a shout-out to them that the revenue is down, but when you look at the we've got some reporting tools that allow us to look through what we call channel-independent reporting. As you mentioned, it's a ship-to. They're continuing to make progress with the customers there. Just a lot of that revenue ends up shipping either somewhere in Asia or it ships in Europe or in the U.S., even though it's designed in there. The actual measurement that we have is the shipping label on the box. Unfortunately, they're still called out on the conference call, which I know that they're not happy about. Thank you, Harlan, we'll go to the next caller, please.
We'll take our next question from Vivek Arya from Bank of America.
Thanks for taking my question, and congratulations on the good execution. For the first one, your CapEx is now, I think it was over 6% in Q2. I think trailing four quarters, it's 5.5%. Depreciation is now below CapEx. Where are all these incremental investments going, and what is the right long-term model we should assume for CapEx and depreciation?
Yeah, let me take that. First, let me step back to remind you what the objective is for CapEx. It's to invest to support new technology development and revenue growth, and specifically to extend our low-cost manufacturing advantage, including 300-millimeter, which maximizes our opportunity to grow free cash flow per share for the long term. The percent of revenue is an interesting metric to have in mind, but the real driver is the long-term growth of free cash flow per share. In periods of sustained strong demand, that CapEx tends to go up, and that's part of what you're seeing. That CapEx is going primarily to support 300-millimeter. There are other things. There's assembly test, there's even other factories where we invest some of that CapEx. Predominantly, it's to continue to expand that footprint of 300-millimeter within RFAB and the existing factories.
Before you go to the next question, I want to go ahead and make a point on our free cash flow growth. In the trailing 12 months, free cash flow grew $1.7 billion, from about $4 billion to $5.7 billion. That was a 42% increase. What drove that? First and foremost, our profit before tax grew about a billion dollars in that comparison. That is higher revenue, more revenue driven by industrial automotive, which again drove the majority of the revenue growth, and more 300-millimeter, which to the question earlier, that continues to help with the expansion of free cash flow. Second, and obviously, tax reform. In the United States, we had tax reform, as we have talked about, that did lower our tax rate in 2018 versus the previous year in a significant way.
Additionally, we had about $200 million of year-to-date of one-time tax-related benefits that are also associated with tax reform. That also played a factor in that comparison.
Okay. Vivek, do you have a follow-up?
Yes. Thanks, Dave. Beyond just the trade issue, I know there's been talk of shortages of passive components. I know you guys don't supply that, but your other peers do. Have you seen your customers behave in a different way? Stock up, stock down on various things that might impact your trajectory just because your customers might be short of other components to help complete their systems?
Yeah, Vivek. I think one thing that we've spent a lot of time trying to do and remain focused on is keeping lead time stable. For the vast majority of our products, they continue to remain stable. That doesn't mean that we don't have hotspots, and of course, we'll work with customers to close those gaps as aggressively as we can. The other important metric that we looked at inside of that is on-time shipping performance. You got to have a stated lead time, and if you're not shipping inside of that, customers tend to get nervous. That has continued to remain at very high levels. We can't see any bottlenecks from customers not being able to get product from other places that shows up in the order book specifically. Could it be there?
It certainly could be, but it's not something that we would have visibility into. I think if we just remain focused on what we can control, which is the lead times and shipping performance, customers can have confidence in getting product from us. Okay, we'll go to the next caller, please.
We'll take our next question from Stacy Rasgon from Bernstein Research.
Hi, guys. Thanks for taking my questions. I first wanted to ask about the nearer term OpEx trajectory. Normally, in Q3, you'd probably be down a little bit sequentially. Is there any drivers or anything that could be going on that would make things into this Q3 different than what we might ordinarily see, given, I guess, some of the historical trends that we've seen leading into this?
Stacy, as you know, we give revenue guidance and EPS guidance, and stop it at that unless there were any unusual trends, and if so, in between the lines, and if so, we would point that out. We're not pointing that out because there's nothing unusual. You should expect just our usual trends within reasonable ranges.
A follow on, Stacy?
I do. Thank you. There's an earlier question on CapEx. We know it's elevated now because you guys are out looking for other assets. At the same time, obviously, as you continue to grow, you're filling up 300-millimeter, and that's a margin benefit. Do you think over time, the benefit from increasing penetration in 300-millimeter more than offsets the depreciation expense on your gross margins?
Well, the way I like to look at this is from a cash standpoint. I think of that investment as a cash investment, cash going out, the first cell on your spreadsheet, and then after that is return. I don't think about it for those purposes from a depreciation standpoint. As we continue to invest on 300, we think those are very good long-term investments that will last for a long time. Anytime we put any of these tools in place and the cash flow through on those investments is pretty high.
Okay. Thank you very much, Stacy. I think we have time for one more caller.
We have one more question from Joseph Moore from Morgan Stanley.
Great. Thank you. I know you said that some of your personal electronics markets were up and some were down. Can you give me a little bit more color on which, and I know smartphones in particular, I think, grew in Q1. Did smartphones continue to grow into Q2? Thanks.
Yeah, Joe. I won't go into that level of detail. We did want to give some color on what was going on inside of personal electronics that we saw multiple sectors growing inside of there. We had some customers that were growing. Also wanted to point out, not all customers were growing. That's what we saw. I think what that illustrates is the power of having a diverse product portfolio and being able to sell to multiple customers. To my point earlier, when we look at the opportunity inside of personal electronics, longer term, we don't see that as a significant growth engine for us. It is a place that we continue to invest, and we really believe the majority of the growth is really going to come from industrial and automotive.
Incrementally, as we've taken up our spend, we've moved it more into those growth areas. Again, we're going to have handsets and PCs and those other things for decades to come. We find good opportunities inside of there and want to continue to invest there. Do you have a follow on, Joe?
Thanks for the color there. In terms of the longer-term question on communications infrastructure, obviously it's been soft for everyone in the last few quarters. How do you think about the 5G opportunity and the comments that you've made just now and repeatedly that the investment areas are industrial and automotive? Do you think there's an opportunity around 5G that you need to invest in? Just help us understand how that'll affect TI.
Sure. Yeah. I think, again, I'd refer back to our capital management presentation as we walk through that thinking remains consistent with that. From a comms equipment standpoint, I would say that our investments have shifted over time. If you look at the 5G standards and the things needed to support the new things, new frequencies being added, things like the massive MIMO antennas that are going in for beamforming and other things like that. That is all complexity that you find in the radio itself. For us, that translates into Analog products to be able to support that. Our spend in Analog is up for supporting that 5G transition. It has been for some time when we look at our spend versus, say, five and 10 years ago.
At the same time, that same change in standards and mix really doesn't impact the digital side. Our spend actually is down on that. Again, I describe our growth primarily coming from industrial and automotive as we look over the next decade. That's where we've tried to increase spending. We will shift spending around to take advantage of things like 5G. I'd just say that, in general, very confident in our position. We're building off of a great position inside of 4G as well. We're very pleased with those investments.
Yeah. That was the last call, correct?
Yeah.
Before we close, I just want to make a point since it wasn't asked, but our result, among other things, demonstrated continued discipline and execution on capital management strategy. We generated on a trailing 12-month basis, $5.7 billion of free cash flow, and we returned $5.6 billion of free cash flow during that timeframe. Virtually all free cash flow generated was returned to the owners of the company. That was both through dividends and buybacks. In the case of dividends, on that comparison, it was 41% of free cash flow. Right between our 40% and 60% guidance, but clearly towards the lower end. That just underscores the sustainability of those dividends.
Okay. Thank you, Rafael, and thank you all for joining us. A replay of this call will be available on our website. Good evening.
That concludes today's conference. We thank you for your participation. You may now disconnect.