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Freescale Semiconductor, Ltd. (NYSE:FSL)

Q2 2014 Earnings Conference Call

July 24, 2014 5:00 pm ET

Executives

Mitch Haws - VP, Investor Relations

Gregg Lowe - President and CEO

Dan Durn - SVP and CFO

Analysts

Andrew Paik - Credit Suisse

Gabriela Borges - Goldman Sachs

Ross Seymore - Deutsche Bank

William Stein - SunTrust Robinson Humphrey

Stacy Rasgon - Sanford C. Bernstein

Doug Freedman - RBC Capital Markets

Craig Hettenbach - Morgan Stanley

Rajvindra Gill - Needham & Company

Suji De Silva - Topeka Capital Markets

C.J. Muse - ISI Group

Operator

Welcome to Freescale's Second Quarter 2014 Results Conference Call. At this time, all participants are in a listen-only mode. After the presentation, we will conduct a question-and-answer session. (Operator instructions) Today’s conference is being recorded. If you have any objections, you may disconnect at this time. I will now turn the meeting over to Mitch Haws. Sir, you may begin.

Mitch Haws

Thanks, Katie, and welcome to each of you to our second quarter 2014 earnings call. With me today are Gregg Lowe, our President and CEO, and Dan Durn, Freescale's Chief Financial Officer.

Before we begin the prepared remarks today, I would like to remind everyone that today’s discussion does contain forward-looking statements that are based on our current outlook, and as such do include certain risks and uncertainties. Please refer to the cautionary statement in today’s press release and review our 10-K and other SEC filings for more information on the specific risk factors that could cause actual results to differ.

The Company does not assume an obligation to update any of the forward-looking statements made today to reflect subsequent events or circumstances. Finally, during the course of today's discussion, we will reference non-GAAP financial measures and we have posted the appropriate GAAP financial reconciliations to our Web-site at freescale.com.

With that, let me turn the call over to Gregg.

Gregg Lowe

Thanks, Mitch, and good afternoon everyone. Before getting into the details of our call, I wanted to welcome Dan to the team as our new CFO. Dan joined us in early June from GLOBALFOUNDRIES and has already made a big impact on the Company and we're very pleased to have him onboard. I’ll spend a couple of minutes highlighting our Q2 results, after which Dan will provide some additional insight into the financials and our Q3 outlook. Following Dan’s comments, we’ll take your questions.

Now looking at the results, the performance in Q2 demonstrates that we are making consistent progress on our goals of growing revenue to gain share and increasing margins. Looking at the quarter specifically, revenues were $1.19 billion, towards the upper end of our guidance and 6% higher than Q1. This represents a 15% year-on-year growth which indicates that we are on track to gain share again in 2014.

With the year-on-year double-digit growth in all of our businesses in the first half, we're on track to have all five businesses contribute to share gains. Adjusted gross margins were 45.2%, up 40 basis points from Q1, and adjusted earnings per share of Q2 were $0.38.

We're continuing to invest in the business to help maintain the momentum. For example, we completed the acquisition of the Mindspeed processor business from MACOM which helps expand our digital networking portfolio, and while in the early innings, we're seeing some good initial design win momentum with that portfolio.

We're investing in new products and CapEx that position us for growth going forward. So overall, some solid progress but there’s still plenty left for us to accomplish, and our entire team is focused on continued improvements in market share and margin. And with that, let me turn the call over to Dan.

Dan Durn

Good afternoon, and thank you again for joining today's call. As most of you know, this is my first earnings call since joining Freescale as CFO. I'm very pleased to be a part of a great team at Freescale and I'm looking forward to meeting many of you at upcoming conferences and other events.

As Gregg highlighted during his remarks, Q2 represents another quarter of solid execution at Freescale. Revenues grew sequentially and year-over-year and indications are that we continue to gain market share. Gross margins improved again, marking six consecutive quarters of sequential improvement. Operating cash flow improved from Q1, given the higher sales, improving margins and lower interest payments. We continue to manage inventory well as days on hand declined eight days sequentially. And adjusted EPS grew more than four-fold from Q2 last year.

Now looking at the results in more detail, revenues were $1.19 billion, 6% ahead of Q1 and 15% above Q2 last year. Revenue for the five core product groups, excluding IP, cellular and other revenues, grew 8% sequentially and 21% compared to Q2 last year.

Looking at the product group performance, Microcontroller net sales were $246 million, representing sequential growth of 10% and growth of 24% compared to Q2 last year. We continue to see strong growth in our 32-bit MCUs sold to both distributors and OEMs worldwide. In addition, sales of our application processors into the automotive and distribution channel continue to grow.

Digital Networking revenues were $291 million, representing excellent growth of 17% sequentially and 27% year-over-year. Networking sales benefited both sequentially and year-over-year from higher spending on wireless networks, in particular China LTE, and higher sales of products sold into the general embedded and enterprise solution market.

Our multicore revenues grew 32% sequentially and nearly doubled when compared to Q2 last year. Multicore now represents over 40% of digital networking revenue.

Automotive Microcontroller revenues were $308 million, slightly ahead of Q1 and up 13% over last year. The business continues to benefit from strong growth in all regions and in distribution, with both increased semi content per unit and higher unit production levels.

Analog and Sensors sales were $205 million, 4% ahead of Q1 and 9% above Q2 last year. The sequential and year-over-year growth was due primarily to increased semiconductor content in automobiles, driven by fuel efficiency requirements and safety features coupled with an increase in worldwide auto production.

RF sales were $120 million, up 6% from Q1 and 48% ahead of Q2 last year. The increase in RF sales was due to growth in wireless infrastructure investment, particularly in China where demand for LTE was and continues to be strong. As we have discussed in prior calls, the demand related to LTE spending has led to tight supply in RF, which impacted sales on a sequential basis. We expect to make progress in Q3 to address the supply gaps.

Other products, which consist primarily of IP revenue and remaining cellular handset revenue, were $21 million, a decline of 48% from Q1. The primary factor in the decline was lower than expected IP revenue. We expect IP revenue to remain at the low levels we saw this quarter over the next several quarters given the challenges inherent in completing deals in the current environment.

Finally, sales to distribution grew 18% sequentially and were up 25% compared to Q2 last year. During Q2, distribution inventory increased as expected to 8.9 weeks which is slightly below the 9 to 10 week historical average. Our book-to-bill ratio in the second quarter was 1.04 compared to 1.07 in the first quarter.

Now looking at gross margins and operating expenses, adjusted gross margins were 45.2% compared to 44.8% in the first quarter. The 40 basis point sequential improvement resulted from higher revenue, our ongoing operating efficiencies and procurement savings. These improvements are impressive when you consider that the sequential decline in IP referenced earlier negatively impacted gross margin by approximately 140 basis points.

Compared to Q2 last year, adjusted gross margins were up 270 basis points, due primarily to higher utilization and higher sales along with cost reductions from operating efficiency and procurement savings. Excluding IP, adjusted gross margins increased 520 basis points over Q2 last year and 180 basis points over Q1 this year.

Looking back over the past six quarters, we have grown gross margin each successive quarter. During that six quarter period, adjusted gross margins excluding IP have increased 810 basis points. The decline in IP did create a margin headwind, but we are well-positioned to continue delivering margin expansion given our execution on revenue growth, operating efficiencies and procurement savings.

Looking prospectively, we expect IP revenue to remain at lower than historical levels, but with IP in the mid-single digits, the major drag on gross margin from the fluctuation in IP is behind us. Our internal frontend factory utilization was approximately 91% in Q2. This compares to 90% in Q1 and 86% in Q2 last year.

Now, looking at our operating expenses, operating expenses as a percentage of sales were 29.1%, down from 29.8% in Q1 and flat on a percentage of sales basis with Q2 last year. The absolute dollar expense increased both on a sequential and year-over-year basis. The increases in dollar spend were a result of increased incentive compensation, expenses associated with our annual Technology Forum and increases in our spending in R&D as we continue expanding our product pipeline to drive business momentum. Additionally, incentive comp is approaching the target and should flatten out going forward.

Adjusted operating earnings were $208 million or 17.5% of sales compared to $186 million or 16.5% of sales in Q1 and $151 million or 14.5% of sales in Q2 last year. Adjusted net earnings in Q2 were $117 million, exclusive of reorganization charges, share-based compensation and other adjustments included in today's earnings release. This compares to adjusted earnings of $77 million in Q1 and $23 million in Q2 last year.

Adjusted net earnings per share exclusive of the adjustments mentioned earlier were $0.38 compared to adjusted earnings per share $0.27 in Q1 and $0.09 in Q2 last year. The year-on-year EPS growth was impressive and was driven in part by $153 million of sales growth and lower interest expense than the same period last year.

EBITDA in Q2 was $266 million or 22.3% of sales compared to $244 million or 21.7% of sales in Q1 and above the $212 million or 20.4% of sales reported in Q2 last year. Adjusted EBITDA was $999 million on a trailing 12-month basis.

Looking at cash, cash and cash equivalents were $744 million compared to $709 million in Q1. Operating cash flow in Q2 was $118 million. Inventory dollars declined $23 million from Q1 and inventory days were 98 compared to 106 in Q1.

Capital expenditures for the quarter were $56 million, driven primarily by investments in assembly and test capacities associated with our growth in RF and microcontrollers. We expect capital expenditures to increase over the next few quarters as we invest to keep pace with demand, and we expect the spend level to be at the higher end of our long-term model of 5% of sales.

Given our consistent execution on managing cash, we continue to have solid liquidity. Our cash and cash equivalents coupled with our undrawn revolver of approximately $400 million affords us the opportunity to continue to invest in the business, fund our capital expenditures and continue to de-lever.

Now let me take a few minutes to discuss Q3. Based on our current outlook, we expect Q3 revenues to be in the range of $1.19 billion to $1.23 billion. The revenue guidance would imply at a high level that RF revenues will increase strongly due to the continued strength in wireless infrastructure, specifically LTE; Microcontroller revenues will increase given solid demand trends in distribution and industrial; Auto MCU and Analog and Sensor revenues will essentially be flat, ahead of normal seasonality; Digital Networking revenues will decline modestly following the very strong performance over the past few quarters. Finally, we expect gross margins to be up approximately 50 basis points sequentially.

At this point, I will turn the call back to Gregg.

Gregg Lowe

Thanks Dan. In closing, we continue to make progress. All five product groups grew sequentially and year-over-year and we expect another quarter of sales growth heading into Q3. The sales growth that Freescale has generated over the past several quarters is a marked change in momentum.

If you compare the first half of this year to the first half of 2013, Microcontrollers are up 25%, Digital Networking is up 25%, Auto MCU is up 16%, RF is up 40%, and Analog and Sensors is up 10%. Data from Gartner and WSTS suggest the market is growing around 7%, plus or minus a little bit. So we're growing about 2x the market and each of our five product groups are growing faster than the market in the first half of this year.

Looking ahead to Q3, the midpoint of our revenue guidance implies a growth of 14% for the first nine months of this year compared to the same period in 2013. Excluding IP, revenues would be up 18% over that time period which we believe puts us on track for market share gains for a second year in a row.

Gross margins and operating margins are improving, which is contributing to stronger cash flow generation and we continue to strengthen the management team. Dan is the most recent example of that along with Paul Hart, an internal promotion who now runs our RF business.

So in closing, our team remains well aligned and focused and also well aware that there is much more to be done. We appreciate your support and look forward to sharing our future successes with you, and at this point we'll open up the call to any questions you might have.

Question-and-Answer Session

Operator

(Operator Instructions) Our first question comes from John Pitzer from Credit Suisse. You may ask your question.

Andrew Paik - Credit Suisse

His is Andrew Paik on behalf of John. My first question is relative to gross margin. You talked about potentially lower than expected IP revenue this year. I just want to quickly see if you are still targeting to reach high [indiscernible] gross margin [indiscernible], and if not, what are some of the elements that are driving the revised [semi] (ph)?

Dan Durn

Absolutely. I think as we think about our long-term gross margin target, I haven't seen anything in my time here that leads me to believe that this is not the right target for the Company. As we think about the levers available to us, utilization revenue, operational execution and excellence and procurement, we're going to continue to drive at those different levers of value and it will be a consistent string of singles and a broad base set of efforts that are going to continue to drive gross margins north.

As we think about the product pipeline that sits behind each of the businesses and the investments that we have made from an R&D perspective to drive those product pipelines and we take a snapshot of those pipelines today, in the mid to longer term we've got a pipeline of products building that are significantly accretive to both the product portfolios and the gross margin delivery today as well as a product pipeline if we were to look back two years and see the products that were being delivered to the market by the Company.

So in the short run, we're going to continue to drive operational excellence, continue to drive utilization and continue to drive procurement savings. In the mid to long-term, we're going to see significant benefits from the investments we've made to drive business momentum and bring a robust set of products to the market.

Andrew Paik - Credit Suisse

Got it. Thank you very much. And then my second question is relative to Digital Networking. You cited strong sequential growth for RF heading into the third quarter due to the continued build of China 4G network. What is exactly driving the decline, expected decline in Digital Networking in the September quarter?

Gregg Lowe

Andrew, the composition of Digital Networking's revenue is a bit different. Recall that two-thirds of their revenue is completely separate from basestation expansion. So that's enterprise in the general embedded market. Enterprise was decent in Q2, probably not as strong into the third quarter. So that's probably the key driver. Dan referenced earlier, RF expansion into Q3, 90% of their revenue is basestation related. So the strong growth that Dan highlighted for RF into Q3 is a result of the ongoing LTE expansion.

Andrew Paik - Credit Suisse

Got it. And you don't see anything that will cause you to continue to see it decelerate heading into December quarter relative to the 4G in RF business?

Gregg Lowe

From our vantage point, we look at the demand signals, the dialog with our own customers, both of which suggest solid growth through the back half of this year. Frankly, customers there are now talking to us about demand through the first half of 2015. So I'm sure at some point there will be a pause as some of the rollouts are digested, but at this point we don't see any signs of that.

Andrew Paik - Credit Suisse

Got it. Thank you very much. Appreciate it.

Operator

Our next question comes from Jim Covello with Goldman Sachs. You may ask your question.

Gabriela Borges - Goldman Sachs

This is Gabriela Borges on behalf of Jim. I want to ask a little bit about the trends you're seeing in the core microcontroller business, both in distribution and industrial more broadly. Maybe you talk about the inventory levels and the demand trends that you are seeing.

Gregg Lowe

Maybe I can hit just the trends. Last year, 2013, our Microcontroller group was our fastest growing business, it grew at about 18% year-on-year. That was really driven by a significant expansion of the portfolio and a whole bunch of new products coming out and a lot of strong customer reception to that. Our Microcontroller group is our most fragmented business, so there's not one particular segment or one particular customer that drives it, there's a lot of diversification in that customer base.

And what's happening I think right now is a continuation of that. We're continuing to see very, very strong acceptance of the new products that we brought out to the market. It were on top of the 18% growth that we had in 2013 over 2012. We're starting off the year in the first half here growing 25% on top of very, very strong growth.

So, I think the way I would characterize it is, this team has done a fabulous job of creating a number of different products that customers like. It's going into a vast and wide range of products that includes everything from industrial applications to wearables to the Internet of things type market, so lots of different end equipments and end products. But I think it's really just a very simple story of a great product portfolio hitting the market and a strong customer reception to that.

Gabriela Borges - Goldman Sachs

That's great, thank you. And then as a follow-up if I may, I heard the Company has made a lot of progress with refinancing debt and bringing the debt profile down. Maybe you could talk about what the next step on that plan might be and give us an update on how you're thinking about that?

Dan Durn

Absolutely. As we think about usage of cash at the Company, I think there's been three primary vectors for the Company. We want to make sure we're investing to drive growth and momentum in the business not only from a product portfolio standpoint, but two, it also be from a CapEx and production capacity standpoint to fuel that growth. I think the third leg of that stool is delevering from a balance sheet perspective. That has been and will continue to be a strong focus of the Company.

As we take a look at the last 18 months and look at what's been done, the team has done a great job at not only delevering but also lowering the annual interest expense at the Company and that will continue to be a strong focus of the Company going forward and we'll opportunistically look for attractive opportunities to delever over time.

Gabriela Borges - Goldman Sachs

Great, thanks so much.

Operator

Our next question comes from Ross Seymore with Deutsche Bank.

Ross Seymore - Deutsche Bank

A couple of questions. First on the revenue side of things, distribution overall, you talked about that being up 18% sequentially and I think 23%, 25% year-over-year. Can you go into a little of what's driving that, either by product segment, new distributor agreements, I know you're also doing some consolidation, so any other color would be helpful?

Gregg Lowe

Yes, certainly the consolidation has had an impact on that. Recall we went from three global distributors to two and we made that transition in first quarter. So basically in the first quarter we saw a pretty sizable reduction because we took one of the distributors out of the network and those, the remaining two distributors run out, stepping in and picking up that business. So that's what's causing the quarter on quarter change there.

I'm really very pleased with how this transition has gone. We have significantly increased the number of people on the street through our distribution network that are promoting, selling and working with our product line. The two distributors that we have, the two global distributors that we have right now have made significant amounts of investment and we're really pleased with how that transition has gone.

From a product standpoint, probably our most exposed business to the distribution network would be the Microcontroller business just simply because it has the most fragmented customer base, but really excited about the consolidation, how that's going and what that bodes for us in the future.

Ross Seymore - Deutsche Bank

Thanks. And I guess as my follow-up, on the OpEx side of things, Dan, you mentioned that the variable comp was reaching target levels, but if we just thought about OpEx as a whole into the back half of the year, how should we compare that to what you guys printed in the second quarter?

Dan Durn

Absolutely. As we think about OpEx and OpEx going forward, I think we'll take a mindset of maintaining product momentum but looking for opportunities to drive more discipline from an OpEx standpoint so that we see more flow-through to the bottom line from incremental revenue growth and drive value for shareholders.

On a sequential basis, we will hold the spend level in dollars flat and look to drive that down into Q4 incrementally. Over that two quarter period, we're going to be spending a lot of time thinking about what the right OpEx spend ratio is at the Company, we want to be mindful of a lot of hard work over the last six, eight quarters to build a significant amount of momentum at this Company while addressing spend levels and spend ratios in a rigorous and disciplined way to make sure that we got the right kind of operating leverage for the Company.

And while we're putting those plans together, again I want to put a stake in the ground, say at a consistent spend level into Q3 and look to drop it incrementally into Q4. From a ratio standpoint, I'd like to be in the 28 – let's call it a 100 basis point south of where we sit from Q1.

Ross Seymore - Deutsche Bank

So hit that target in Q1 of 2015?

Dan Durn

In a Q4 spend ratio, as you think about Q1 spend ratio 2014 at 29.8%, in Q4 of this year I'd like to be 100 basis points off of that Q1 2014 spend ratio level.

Ross Seymore - Deutsche Bank

Got you. Okay, thanks for the clarification. If I could sneak in one really quick one, accounts receivables popped up a bunch in the second quarter. Can you just discuss what's going on there?

Dan Durn

Yes. As we think about accounts receivables, clearly Q2 AR is higher than normal. Given the profile of revenue in the quarter compared to Q1, it partly reflects the improving supply constraints of our RF business as well as strong demand across the board in a number of our other businesses. As we think about that level on a prospective basis, I think low 40s is a good target for us to think about. I don't think we'll see sequential improvement in this level into Q3 given the traditional seasonal patterns of our business in Q3, but we'll begin to make progress against that target towards the lower level in Q4.

Operator

Our next question comes from William Stein with SunTrust. Mr. Stein, you may ask your question.

William Stein - SunTrust Robinson Humphrey

Amongst some of the changes you've made in the last year, one, you already addressed net distribution, another big one is some significant direct sales force additions in China, and I'm hoping you can update us on the progress of that please?

Gregg Lowe

Yes, I can do that. So, we added 10 new offices in China in 2013 and I don't think we've actually said the number of people but quite a number of people to our sales force, basically to expand our presence into the Tier 2 cities in China. We just had a review on that, it must have been two months back or so. We looked at the revenue and the design win momentum we're seeing in those Tier 2 cities where we've opened up new offices and it's very, very nice set of results. I believe in eight of the 10 cities, our growth in the rest of China. So that's hitting the ground running and I think that we're still in the early phases of it but I think that's working really well.

William Stein - SunTrust Robinson Humphrey

Okay, thanks. And if I can ask one follow-up, I'm hoping you can remind us what the Company view as the normal seasonality would be in the December quarter. Understanding you are not guiding to that now, just anything that you see coming down the pipeline that would cause you to think that it could be very different from that?

Mitch Haws

This is Mitch. Normally in Q4, Automotive is a bit weaker. That's a fairly sizable book of business for us. Networking seasonality is very tough call but if you look at the portion of the business that's automotive related tends to be a bit weaker. We don't have a lot of consumer exposure. To the extent we do have that, it's a bit weaker in Q4. So usually the progression [indiscernible] is down a bit from the third quarter.

Dan Durn

I think that historical patterns would suggest down 2% to flat in Q4. I don't think we see anything today that is a significant departure but we don't have perfect visibility into it and we'll update that a quarter from now.

William Stein - SunTrust Robinson Humphrey

Helpful, thanks, and especially thanks for the gross margin commentary around the IP and how that affect, that was very helpful, thank you.

Operator

Our next question comes from Stacy Rasgon with Sanford Bernstein. You may ask your question.

Stacy Rasgon - Sanford C. Bernstein

I wanted to compare your guidance to your prior peak. You're guiding about $1.2 billion, the last time you had that was in Q2 '11, also $1.2 billion. Back then you had gross margins of 45.6% in that quarter. You guided about 45.7% now, so same gross margins. I guess if I take out the IP issues, you'd be around 47%, so 150 basis points higher. At the same time, your utilizations are up something like 13%. Your cellular business has declined hugely from where it was, and even three gears of operational improvements from then to now. I'm just wondering why given revenue is at the same level and all the improvements that have happened between then and now, why gross margins aren't higher than they are today?

Dan Durn

I think you touched on it when you talked about the cellular business as well as the IP business. There's $150 million of delta between the reference period you talked about in Q2 of 2011 and today. Clearly we have a profile of business that's much stronger and much more diverse. Microcontrollers for instance is a much larger portion of the business, 21% today, versus where it was historically on the back of 25% growth over that period of time. But given the high margins associated with those two businesses that have shown significant falloff, IP and mobility business, the cellular business, it creates a significant headwind, against which we're making a significant number of progress.

In addition to that, I think you can see at a similar OpEx profile, we're investing significantly more from an R&D standpoint at the expense of the more disciplined profile from an SG&A perspective. And you look at the interest profile back then versus today, the interest expense on an annual basis is roughly cut in half, roughly, and it shows about a 33% increase in earnings profile over where we'll be next quarter. Next quarter will be a 33% increase, give or take, versus where we were in Q2 2011.

So, it's something we spend a lot of time thinking about. I think it shows the significant amount of progress and a lot of the tailwind to momentum behind the business, and we're just going to continue to grind it out, continue to stay focused on operational excellence and drive discipline into the business to continue the journey north.

Stacy Rasgon - Sanford C. Bernstein

Let me follow-up on that, I just want to clarify something, so you're telling me that the number one cellular business was significantly higher margins than corporate average investment dilutive as one-way? Second, the utilization is up 12% or 13%, I thought you used to give us kind of like a 3-to-1 ratio. So that by itself should have been something like 300 or 400 basis points of improvement in gross margins, coupled with all the operational improvements, and yet I don't think, we don't seem to be seeing them here. Can you clarify on those two points?

Dan Durn

Utilization is partially up from consolidation of the 6-inch fabs into the three remaining 8-inch fabs, and I think the fall-through ratios that you're referencing are a bit more of a steady-state dynamic as we're working through a restructuring of the manufacturing footprint. So there's a lot of moving pieces here that make it difficult to take a straight-line comparison versus where we were three years ago and where we are today.

Stacy Rasgon - Sanford C. Bernstein

And the cellular piece?

Dan Durn

Cellular piece is a high-margin business, given that the last time bills we made and the work-down of that inventory. It's a significantly higher-margin business versus where we are in a corporate average today.

Gregg Lowe

Recall that you see the revenue that we recorded back in 2011, it's really without much in the way of cost support assumption with it. That was in wind-down mode really starting in 2009 and 2010.

Stacy Rasgon - Sanford C. Bernstein

Got it, okay. Thank you, that's helpful guys.

Operator

Our next question is from Doug Freedman with RBC Capital Markets. You may ask your question.

Doug Freedman - RBC Capital Markets

If I could focus in a little bit on the OpEx and the way in which OpEx has been expanding in line with revenues, is there any plans to get any OpEx leverage, is there a possibility that we could see revenue start to grow faster than your OpEx lines?

Dan Durn

I think I'll just make a couple of comments on this. First, on an absolute dollar spend basis, you're going to see it flat into Q3 and down into Q4 and that's going to drive sequential improvement from a ratio standpoint. I think it's also helpful to understand that as incentive compensation has been layered in over the last four, five quarters as part of the momentum that the team has been building, you haven't seen as much flow-through in leverage while you're going through the fat part of that curve and incentive compensation being layered in. We're now approaching more steady-state run rate targets where you're going to see more of that operational leverage being realized as momentum in the business continues and we continue to grow revenue.

Doug Freedman - RBC Capital Markets

Great. And if I could focus in a little bit on the strength in RF, there's a lot of concerns in the market. Your partners that ship into that market over in the FPA space and analog space continue to talk about sort of a pause in Q4, shortages being caused by the guys like yourself and challenges in supporting the demand. How concerned are you that you're seeing double ordering or an over-forecast out of your customers because you haven't been able to keep pace with their demand?

Mitch Haws

This is Mitch. As I mentioned before, the discussions we have with our customers in that supply chain, our own view of inventory levels, we are constrained a bit in Q2, we'll address that in a big way in Q3, but the demand profile doesn't suggest to us that things are slowing. If you look at the builds not only in China but in other geographies, there will be a point at some point, as I mentioned earlier, when things may pause, but at this point, the mix of customers, the geographies, the technologies that we see in the demand profile suggest that there's decent runway into the first part of 2015.

Doug Freedman - RBC Capital Markets

Great. And my last question really I guess, one Gregg for you, on the automotive front, what percentage of sales now is would you classify as automotive? I know that you breakout the Automotive MCU, but some of the other segments also are automotive-based. And can you talk a little bit about what you see in terms of the value of your automotive content over the next couple of years, and there's a lot of people that are excited about what's going on in auto in terms of semi content, if you could comment on what role Freescale is going to play there would be appreciated?

Gregg Lowe

Approximately 45% of our revenue is automotive related. A vast majority of obviously our automotive microcontroller business like all of that is automotive, a significant portion of our Analog and Sensors business is automotive, and some of the microcontroller products go in there. So about 45% at the Company level, plus or minus a point or two I guess but a pretty sizable percentage of the business.

We're very excited about this business for multiple reasons. One is, the one you just talked about and that is the content. Content had always been sort of increasing inside of automotive but there is sort of a – I think there's a marked difference over the last few years with the advent of infotainment systems, of radar systems, a lot of safety concerns, there's just a lot more content. In fact, we believe the vast majority of the increase in our business this year was due to content versus the number of units. Units were up a couple of percentage points and content was up I think in the teens from a semiconductor standpoint.

So, it's a strong, it's a very large portion of our business, it's an area where we have great historical relationships with customers. In the U.S., somebody who isn't in this business today just because it's a hot thing to be in it, we've been in it now for four decades I guess. So we're seen as kind of a trusted partner there, and we remain very bullish about our opportunity to expand our business in Japan where we're working very hard to grow our market share in light of all the activity that's going on over there.

So, a great place to be, it's a very strong business for us, it obviously has a gestation period that's different from most semiconductor companies. And so I think when folks that aren't significantly exposed to this business, decide to get in. There's several years, maybe half a decade of investment prior to seeing any returns on that. With us already being at 45% of our revenue, it's just a real good position to be in.

Operator

Our next question is from Craig Hettenbach from Morgan Stanley. You may ask your question.

Craig Hettenbach - Morgan Stanley

A question on the gross margin and thanks for the color on the IP impact. As you say that that's kind of filtered through now to the run rate, can you talk about gross margin into next quarter and the next couple quarters, just the puts and takes of the biggest drivers, be it utilization, mix on gross margins?

Dan Durn

Absolutely. As we think about our three legs of the stool, which are gross margin drivers, utilization revenue, given where we sit from the utilization standpoint, I don't think we'll see much tailwind in the gross margin accretion coming from that lever. As we think about operational execution and excellence, I think we'll see a significant portion of that 50 basis point increase coming from that category and it will be followed up and supported by procurement. So as we think about it, probably 40% of the improvement from the procurement bucket and the majority of it coming from operational execution.

Craig Hettenbach - Morgan Stanley

Okay. And then as a follow-up, given the strong selling to distribution, can you talk about kind of sell-through, and then also is there anything to note kind of the trends to the channel in the quarter and then into the beginning of this quarter?

Gregg Lowe

The biggest change is obviously our consolidation of the distribution network. So I think we'll really get a better read on that as we go forward. Inventory is sitting at 8.9 turn or weeks of inventory which is below our historical range of 9 to 10 weeks of inventory. So there doesn't appear to be any kind of issue there.

And again, with this consolidation, we have had a significant increase in the attention we're getting from our two global distribution partners, and we have ongoing reviews with them. In fact, I just had a review with each of our major distributors here in the last month and I think the progress is very, very good. I think this is going to be a real good move for us and I think it' going to end up with a much stronger partnership and significant opportunity for us to grow in the channel.

Craig Hettenbach - Morgan Stanley

Got it. Thanks for the color.

Operator

Our next question comes from Rajvindra Gill from Needham & Company. You may ask your question.

Rajvindra Gill - Needham & Company

Just a point of clarification. You had said that the IP sales were going to drop to mid-single digits. Did I hear that correctly in the third quarter?

Gregg Lowe

That is correct.

Rajvindra Gill - Needham & Company

Okay. So [indiscernible] say $6 million or $7 million a quarter, it would imply for going into third quarter that you are going to see significant growth in RF as you said at least in the 20% plus range, plus at least another 10% to 15% sequential growth in Microcontrollers given the fact that Auto and Analog are going to be flat and DNS is going to be maybe down slightly. So I'm just wondering, if those are kind of the right statistics in terms of the patterns into the third quarter?

Gregg Lowe

Just a point of clarification. We said that IP revenue would be in the mid-single digits and that's roughly flat with where we're at in this quarter. So it's not another sequential down, it's kind of in line with where we're at. But we are – obviously we're going to see very strong growth in our RF business, we're excited about that, that's really the combination of multiple different things, obviously the LTE build-out driving the overall demand, but a great product positioning, product portfolio is better than ever at 45% year-on-year growth through the first half of this year on the back of 17% year-on-year growth in 2013 over 2012. I think that business is really smoking it from a market share standpoint.

Rajvindra Gill - Needham & Company

And if you could elaborate a little bit further on the Digital Networking business, Mitch, you talked about the enterprise sales after several quarters of pretty good growth. It's going to start to decline into the third quarter. Can you talk a little bit about that? I know you had mentioned that 40% of it was related to enterprise or maybe you can talk about the mix of the DNS again in terms of basestation versus wired, wireline and why do you see that part of the business potentially declining especially given some of the mix results I guess in the overall networking space have been fairly mixed and maybe slightly positive?

Dan Durn

If you look at their performance, first half this year over last it's about 25%. Clearly the basestation expansion has been a part of that. It's about a third of the revenue. So the growth that you've seen outside of basestations has been in enterprise, it's been in kind of the general embedded market where we serve a lot of that through distribution.

The second quarter, if you look at the composition, the revenue was hitting on every cylinder frankly. Distribution improved, sales into the general embedded market were up, enterprise is up, you saw decent growth in infrastructure as well. So really it's two-thirds of the business perhaps not having the same type of momentum they had coming into the second quarter.

But then in perspective there, Raj, if you look at year-over-year, it's still up nicely over Q3 last year. I wouldn't expect a decline to be all that meaningful into Q3.

Rajvindra Gill - Needham & Company

Okay, got it. And just last question for me, in terms of the interest expense, you guys have done a fantastic job refinancing and doing equity offerings in order to reduce the interest expense. Should we be looking at kind of this $83 million, $84 million a quarter type of range for interest expense or are you going to be able to say, pay down debt through internal cash flow generation, how should we look at that going forward?

Dan Durn

Let's take each of those questions. First, how to think about modeling interest expense? Think about it in the mid 80s, so I think you're in the right zip code, maybe a little north from an expense standpoint. And then when we think about ability to generate cash and pay down debt, at this level I think there's going to be an opportunity for us to in the back half of the year target some organic cash flow generation to opportunistically target some of that debt.

But from an organic cash flow standpoint, given our current financial profile, I don't think you'll see a substantial step function changes in that profile. Again it's going to be a consistent opportunistic approach as capsule gets generated to prioritize delevering along with other uses of cash and make smart decisions around the financial and balance sheet profile of the Company.

Rajvindra Gill - Needham & Company

Great, thank you very much.

Operator

Our final question comes from Suji De Silva from Topeka. You may ask your question.

Suji De Silva - Topeka Capital Markets

So question on the RF and the basestation. Where are the lead times now versus typical and are you investing enough in CapEx to catch up to the constraint level or staying conservative there?

Gregg Lowe

If you look at lead times across the Company, Suji, it's pretty consistent over the past two or here quarters. As you point out, there are some areas where things are running a bit hot for us and that's most concentrated in RF. So, probably wouldn't want to get into the specifics, it is stretched a bout. The capital that you've seen deploy, the big part of that will be to satisfy the growth in RF. Part of that is for Microcontrollers as well.

So, I would think of it this way, we're going to be within our long-term model of 5% of sales. The sales growth profile here is all different, so obviously the aggregate amount of CapEx is higher, but we feel like we're flowing capital in the right way, it's going to help address some of the supply constraints, to keep us within our long-term model of about 5%.

Suji De Silva - Topeka Capital Markets

Okay great. And then on the guidance for enterprise networking being slightly down in 3Q, where is multicores growth profile, is it still ramping for you, that should continue to grow against sort of the overall enterprise networking business or has it reached the point where it's going to move with the overall business at this point?

Gregg Lowe

That's doing very nicely. Recall last year we grew that multicore business 147%, in 2013 over 2012. Through the first half of this year, it's double where we were last year. So it continues on a very, very substantial, nearly 100% growth rate over last year. And then finally, just to kind of put things in context, multicore is now greater than 40% of our revenue in Digital Networking. So it's not growing from a small number to a bigger but still a small number. This is a substantial business that's really growing very, very rapidly.

Suji De Silva - Topeka Capital Markets

I guess my specific question was, will multicore grow in third quarter against the green of the overall business, [indiscernible] kind of become part of the overall business in terms of flow?

Dan Durn

In terms of the order of magnitude of the [indiscernible], as big as it is getting, it's not going to go with the pace it has. So we expect it to go again in the third quarter.

Operator

We have one final question from C.J. Muse with ISI Group. You may ask your question.

C.J. Muse - ISI Group

I guess first question, Dan, you talked about driving up [indiscernible] in Q4. Can you put some granularity around that? And then could you also talk about trajectory through calendar '15?

Dan Durn

I don't think we want to go out that far from a guidance standpoint. I think the directional guidance, flat and then down modestly into Q4 to drive a different expense ratio is about as far out as we want to go. Again over that next two quarter period, I'm going to spend a lot of time understanding the drivers of the business, the momentum that we've created making sure that as we instil that OpEx discipline into the company that we're not doing anything to compromise the tremendous progress this company has made in driving momentum and a robust set of products into the market that are driving the performance we see in this quarter and the prior handful of quarters.

C.J. Muse - ISI Group

That's helpful. And I guess in terms of buying back debt, the 10.75, August 2020 is clearly something that could be refied much more cheaply, and I guess the question here is, would you take the pain in terms of paying the make whole premium or would you wait for August 15 to do that?

Dan Durn

Like I said before, I think we're going to be opportunistic in terms of how we look at addressing the debt, both from a take-out as well as refinancing, and we'll make smart decisions at the time we're ready to take actions on either the 10.75 or the 8.05, the two high coupon parts of our capital structure.

C.J. Muse - ISI Group

Okay great. And then I guess one last question for Gregg. I'm trying to understand the 25% growth on the disty side year-over-year and I guess part of that question is, clearly days inventory, weeks inventory is healthy but up 25%, is that normalized from including the data from three distys going to two or how should we think about that change and what gives you comfort that that's not an issue?

Gregg Lowe

We are going through a change from three distributors to two. We're seeing that, we saw some of that transition, we saw that transition in Q1 and in Q2. We're sitting right now at 8.9 weeks of inventory in the channel. That's below where we normally run. We normally run between 9 and 10. Distribution is really driven by our Microcontroller business. Our Microcontroller business is in its second year of very, very strong results. So overall, I think we're in pretty good shape there.

Mitch Haws

That concludes today's call. Thank you for your participation and we look forward to seeing you at conferences or other events during the course of the quarter. Thank you.

Operator

Thank you. This concludes today's conference. Participants, you may disconnect at this time.

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