Microsemi's (MSCC) Jim Peterson on Q1 2016 Results - Earnings Call Transcript

| About: Microsemi Corporation (MSCC)

Microsemi Corporation (NASDAQ:MSCC)

Q1 2016 Earnings Conference Call

January 28, 2016 4:45 PM ET

Executives

Terri Donnelly – Executive Assistant-Microsemi Corp.

John Hohener – Executive Vice President, Chief Financial Officer, Secretary and Treasurer

Jim Peterson – Chairman and Chief Executive Officer

Paul Pickle – President and Chief Operating Officer

Steve Litchfield – Executive Vice President and Chief Strategy Officer

Analysts

Harsh Kumar – Stephens

Tore Svanberg – Stifel

Quinn Bolton – Needham & Company

Steven Smigie – Raymond James

Doug Freedman – Sterne Agee

Mitch Steves – RBC Capital Markets

David Wong – Wells Fargo

Ambrish Srivastava – BMO

Will Stein – SunTrust

Suji Desilva – Topeka

Operator

Ladies and gentlemen, thank you for standing by. Welcome to Microsemi's First Fiscal Quarter Earnings Call. All lines have been placed on mute to prevent any background noise. After the speakers' remarks, there will be a question-and-answer session. [Operator Instructions]

I would now like to turn the conference over to Terri Donnelly, Call Coordinator. Please go ahead.

Terri Donnelly

Good afternoon and welcome to Microsemi's earnings conference call for the first quarter of fiscal year 2015. I am Terri Donnelly, coordinator of this call.

In a few moments, you will hear from and have an opportunity to ask questions of: Jim Peterson, our Chairman of the Board and Chief Executive Officer; of Paul Pickle, our President and Chief Operating Officer; of John Hohener, our Executive Vice President and Chief Financial Officer; and of Steve Litchfield, our Executive Vice President and Chief Strategy Officer.

A recording of this conference call will be available on the Microsemi website under the Investors section. Our website is located at www.microsemi.com.

Microsemi issues guidance in the form of a limited business outlook on our expectations for the next quarter. This business outlook reflects our current expectations and is continually subject to reassessment due to our changing market conditions and other factors. Therefore, it must be considered only as management's present opinion. Actual results may be materially different. However, management undertakes no obligation to update these or any forward-looking statements, whether as a result of new information, future events, or otherwise. If an update to our business outlook is provided, the information will be in the form of a news release.

We wish to caution you that all of our statements, except the company's past financial results, are just our current opinions, predictions, and expectations. Actual future events or results may differ materially. For a review of the risk factors, please refer to Microsemi's report, on Form 10-K, for the fiscal year ended September 27, 2015, which was filed with the SEC on November 12, 2015

With that said, I'm going to turn the call over to John to discuss our financial results, and then Jim will address our end markets and overall business strategy. Here's John Hohener.

John Hohener

Thank you, Terri. In the first quarter we reported record net sales of $329.2 million, up 8.5% from the $303.6 million we reported a year ago and above the high end of our guidance for the first quarter. GAAP gross margin for the first quarter was 57.1% up 390 basis points from the 53.2% reported in the fourth quarter of 2015 and up 170 basis points from the 55.4% in the first quarter of 2015.

GAAP operating margin for the first quarter was 11.1%, up 130 basis points from the 9.8% reported in both the fourth and first quarters of 2015. GAAP operating income for the first quarter of 2016 was $36.6 million, up 13.5% from the $32.3 million reported in the fourth quarter of 2015 and up 23.2% from the $29.7 million reported in the first quarter of 2015.

Included in GAAP operating results for the first quarter of 2016 were non-cash charges of $25.4 million in amortization of intangibles and $14 million in stock-based compensation. We estimate that stock-based compensation expense for the second quarter of 2016 will be $25.8 million with the increase primarily a result of assuming PMC equity awards.

For the first quarter we also recorded restructuring and acquisition cost of $7.8 million related primarily to the financing of the PMC transaction. Non- GAAP gross margin was 57.1% first quarter 2016 up 60 basis points from 56.5% reported in the fourth quarter of 2015 and up 90 basis points from the 56.2% reported in the first quarter of 2015. This improvement reflects our continued path to recognizing 60% gross margin on our core business in the second half of calendar 2016 due to product mix operational efficiency and consolidations. With the addition of PMC we now expect gross margin in the second quarter of 2016 of between 60% to 62%.

During our first quarter, non-GAAP selling, general, and administrative expense was 49.2 million or 14.9% of net sales. Research and development expense was $54.9 million or 16.7% from net sales. As we had forecast our OpEx increased compared to the fourth quarter in support of a strategic product development. With the acquisition of PMC, we forecast our overall operating expense to be between $156 million and $162 million in the next quarter. Non-GAAP operating income for the first quarter was $83.8 million or 25.5% of sales, up 13% from the prior year first quarter. For the first quarter, we recorded $8.1 million in non-GAAP interest and other expense compared to $8 million in the prior quarter.

We ended the quarter with our credit facility principal balance at $981.8 million and improved our leverage ratio 2.77 to 1. With the acquisition of PMC, our new credit facility increased initially to $2.925 billion. Subsequent to the close we have repaid $100 million in principal and today the balance is $2.825 billion. Our overall blended interest rate is 5.33%. We’re currently guiding our interest expense in Q2 to be approximately $33 million, the increase principal of which is for a period of 11 weeks.

As such a full quarter of interest expense would have been $37.5 million. As we previously communicated post acquisition was synergies, our leverage ratio will be 4.5 times that we expect to see this below three times in 18 months. We are laser focused on lowering this by growing EBITDA aggressively paying down debt and also through selective divestitures. Our non-GAAP effective tax rate was 8.5% in the first quarter and we expect the rate for Q2 to remain approximately the same.

Non-GAAP net income for the first quarter was $69.3 million or $0.72 per diluted share compared to $70.3 million or $0.73 per diluted in the fourth quarter and compared to $61.9 million or $0.65 per diluted share in prior year first quarter. Our diluted share count for the quarter was $96.5 million. Slightly less than 20% of the PMC purchase was completed with newly issued shares. As such we forecasted our share count will increase to approximately 112 million fully diluted shares next quarter increasing to approximately $116 million when majoring a full quarter in our fiscal Q3.

Capital spending was $10.5 million in the first quarter compared to $9.1 million in the prior quarter. With the addition of PMC, we expect to see an increase in CapEx next quarter to $15 million. Our new annualized target including PMC is $60 million. Accounts receivable decreased to $176.2 million compared to $186.9 million at the end of the prior quarter, with improving DSO from 53 to 50 days. Inventories were $231.4 million compared to $227.2 million at the end of the prior quarter. And once again, we delivered record operating cash flow $82.9 million and record free cash flow of $72.4 million both of which included cash payments for restructuring and transaction cost of $5.5 million. This quarter, we also paid a breakup fee of $88.5 million related to the PMC acquisition.

This is listed in other assets on our balance sheet. It will be recorded as acquisition consideration in the second quarter. After this payment, we still ended the quarter with a strong cash balance of $199.7 million. Depreciation and amortization expense was flat at $34.7 million. With the addition of PMC, we expect depreciation and amortization expense in the second quarter of 2016 to be approximately $60 million. Our best estimates of the end market percentage breakout of net sales for the first quarter was approximately aerospace 14%, communications 40%, defense and security 26% and industrial 20%.

Our best estimate of net sales by our focus product areas for this first quarter was approximately FPGAs and SoCs 23%, mixed-signal RF 34%, timing 17% and discretes 26%. We ended the quarter with record backlog driven by record bookings resulting in a book-to-bill ratio greater than one to one. For a business outlook, as a reminder, our results today for the first quarter of 2016 ended January 3 and do not include any contribution from the PMC acquisition, which closed on January 15.

Commensurate with the acquisition of PMC in the second quarter, we have implemented several changes related to PMC’s distribution network and we’ll transition their business from a sell through to a seller methodology for channel shipments. This transition as well as the abbreviated quarter where they are part of Microsemi, means that we will not realize the full run rate contribution of this business. We expect revenue to be between $435 million and $455 million in our fiscal second quarter. We expect non-GAAP diluted earnings per share between $0.62 and $0.68.

This is impacted by the increased share count from a transaction, a partial revenue quarter with full expenses along with added interest expense. We will see meaningful improvement from this in Q3. A couple of additional notes regarding PMC, first, we closed on the acquisition ahead of plan. Secondly, the $100 million of synergies are on track and we remain comfortable that we will see 75% of annualized synergies coming out of the business by the end of the June quarter, which is the first full quarter of owning the business. This results in continued confidence in achieving greater in $0.40 of accretion.

With that, I’ll turn the call over to Jim.

Jim Peterson

Okay. Thanks, John. And let me start off with some key takeaways for today. Our first quarter picked up right where the fourth quarter left off. As reporting record revenues operating and free cash flows in September quarter. I’m pleased to report that we set new records for Microsemi’s core business in each of these categories again in the December quarter. Our unique end market diversity continued deliver steady results, even in a rocky or macro environment elsewhere.

Our fiscal first quarter aerospace, communication and defense were up nicely year-over-year and we expect continued relative strength. Our book-to-bill strengthened to above one to one in the December quarter. Total backlog a record levels and we entered the March quarter with a higher starting backlog versus the prior quarter.

On the product front, our FPGAs continue to take market share growing 8% sequentially and 8% year-over-year. We expect to continue taking market share and driving growth and these are most profitable product category. We are committed driving shareholder value through continued execution growing product revenues, realizing improved efficiency in the business, increasing cash flows, acquiring strategic assets and divesting non-strategic assets, de-levering and ultimately returning capital to our shareholders.

With that, let’s get to the end market commentary. Communications, our largest end market accounted for 40% of revenue and was up 18% year-over-year and 3% sequentially, totaling approximately $131 million. Communication infrastructure, broadband gateway, an enterprise networking all exceeded revenue targets, importantly infrastructure continued its recovery. Growing for the second consecutive quarter, we are optimistic about the remainder of 2016 to be continued strength in bookings. We expect some March quarter seasonality in our broadband gateway markets with the revenue growth resuming in the remaining of the year.

Defense and what has typically been a down seasonal quarter grew 2% sequentially and 3% year-over-year to account for 26% of revenues. We’re about $87 million. We’re excited about our prospects in 2016 expected continued strength in our results as budgets moved back to growth mode and we drive increasing dollar content into defense applications. Aerospace, after a strong 2015, our aerospace markets took a breather and the December quarter declining 11% sequentially to about $48 million.

At 40% of our revenues, aerospace is up 19% year-over-year and we’re optimistic about the future. In 2016, we see continued strength from the commercial air end markets as customers ramp production of the next generation airframes against strong multi-year backlogs and as our content within grows. We also continue to expect a recovery year satellite in 2016.

Industrial was flat sequentially and down 7% year-over-year for the December quarter, totaling $64 million and 20% of total revenues. Medical remain steady contributor, but the year-over-year results still reflect a slowdown in oil exploration applications.

Looking at recent bookings and backlog, we forecast modest growth for the remainder of 2016. Move on to the product breakouts. Mixed-signal RF accounted for approximately 34% of revenues in the quarter, up 2% sequentially and 29% year-over-year, totaling about $13 million. Ethernet, PoE, voice circuits and ultra low power radios are notable performance relative to expectations.

FPGAs and SoCs represented 23% of mix in the December quarter, up 8% sequentially and 8% year-over-year. Design win activities are on the rise. As our industry exclusive [indiscernible] and low capabilities are helping us capture and increasing number designs at major North American communications equipment suppliers.

In 2016, we expect to continue capturing mainstream market share with our fourth generation IGLOO2 and SmartFusion2 devices. Expand our space opportunities with our new RTG4 solutions introduce later in this year. Our fifth generation FPGA and SoC solutions which promise more density while still offering, unsurpassed security, reliability and power consumption performance.

Timing products were 17% of total revenue, up 6% sequentially and 2% year-over-year in the December quarter, totaling $56 million. Silicon timing device and communication infrastructure continue to strengthen in December, up for the second consecutive quarter, while system level timing and sync systems were also up. Discrete products 20% of total revenues down 7% year-over-year and totaling approximately $84 million. The down year-over-year results largely reflect weakness and downhole drilling applications for our discrete solutions, as well as some seasonally, and more traditional industrial power applications.

We see a return of growth in the second half of the year, driven primarily by aerospace and defense opportunities as well as some emerging designs in solar and electrical, vehicle applications. Delivering an impressive first quarter is the only start, to what we expect to be a great year for Microsemi. Our team continues to achieve significant milestones with record revenue in GAAP operating income, as well as a record operating and free cash flows. As we look to integrate our recently completed acquisition of PMC Sierra, we will continue to focus on long-term growth and cash flow to deliver the enhanced profitability necessary to yield strong shareholder returns.

With that, I would like to thank you for your interest and support and we will now take questions from our analysts regarding our earnings release only. In the interest of time, please limit yourself to one well thought out question, and if necessary, a brief follow-up. Susan, I turn it over to you.

Question-and-Answer Session

Operator

Certainly. [Operator Instructions] Your first question comes from the line of Harsh Kumar with Stephens.

Harsh Kumar

Yes, hey guys, thank you. Just wanted to ask about the accounting. It’s a little bit confusing from some investors that I have talked to. So PMC, I think, the Street was looking for a call at $125 million to $130 million, I see that you are recognizing something like $110 million, may be John could you take us to like how the accounting works when you buy somebody? What’s going on? Where do the rest of the revenues go? When can you recognize it?

Jim Peterson

Okay, [indiscernible] I’ll turn it over to John.

John Hohener

Certainly.

Jim Peterson

I think the dollar, I realize it was somewhere between $110 million, $120 million realized, but that was full quarter. But let’s also talk a bit about the models that were out there, just leave the Street models for PMC they were about $560 million. Now let’s be honest. The takedown at the PMC, I think they actually had a poor history of execution versus their forecast. So if you go through the numbers right, I think if you take 2016 and dial somewhere between $530 million to $540 million, all right, I think that is a good starting point. John

John Hohener

And Harish, specifically how it relates to, I think you are talking about converting down from a sell-through to a sell-in model. What happens in that regard is any shipments that went into the channel on their watch, that are still on the channel prior to going to end customers, when we acquire them, in essence, nobody can acknowledge that revenue. Now, the positive on that side is that we obviously acquired their receivable, and therefore we acquired their cash flow, but that revenue is – it is lot and does impact our initial quarter out of this suite.

Harsh Kumar

Okay. And then as a follow-up if I can ask you, just to be clear, you are having to eat the expenses correct. You got to eat the expenses, you can’t get some of the revenue and one how long can we expect this will last before you rationalize to like a proper quarter.

John Hohener

Well, certainly. We’re going to have that the distributor revenue probably goes out in the March quarter and some in the June quarter, but then it will be all out.

Jim Peterson

This is very similar to the cash, right. As an acquiring company, if you try to take a run to this sell through and sell-in, it will wash out just like John said.

Harsh Kumar

I got you. Thanks. And then last thing how you guys had a plan for cleaning up expenses particularly OpEx, curious now that you’ve got it. We’ve seen anything different has the process started, how it’s going and how fast can the expenses be taken out, the first $75 million trend and that’s it for me.

John Hohener

Yes, just more on track. As we told the truth first full quarter, right, which is the June quarter. We take it out $75 million, right. Then on top of that we have additional $25 million, so we said $100 million in the first year, COG is being in the back end of it.

Harsh Kumar

Thanks, guys.

Jim Peterson

Again, it is very similar to the cash. And I’ll just comment on the cash. We have seen the full impact of that as it relates to OpEx, but we do still see some upside on the COGS from for test. And we’ve indicated that would be between ninth and the twelfth month as well related to them.

Harsh Kumar

Thank you, sir. Thank you, guys.

John Hohener

You bet.

Operator

Your next question comes from the line of Tore Svanberg, Stifel

Tore Svanberg

Yes, thank you. You mentioned $75 million cost savings in the first full quarter, which will be the June quarter. Is all of that coming out of OpEx or is some of that coming out of COGS as well.

John Hohener

Look, I think the majority will the SG&A and R&D, right. We always find that in the front end you’ll see the COGS. The beauty of it is we have 100% overlap. So the existing supply chain, so about 15% of that action comes out of the COGS more towards the backend.

Tore Svanberg

Okay, very good. And as my follow-up Jim, could you talk a little bit about some of the growth engines you have here in the first half of the year, you talked about record backlog, record bookings, may be by end market, which ones should we expect to be up versus down for the foreseeable future.

Jim Peterson

Yes, as you know 81 stocked rank, but really well, all right. You will be solid growth 2016. We have good strength in the gateway to communication, the Ethernet, the switching, the buys, that said not all cylinders and we do welcome the new platforms including the OTM, that we got from our most recent acquisition. Defense, and it’s seasonally down last quarter, we’ve got that up 2%, so sequentially 3%. So again, bucking those seasonal trends that used to – kind of detract from – as we kicked off in a year. Defense, we know spending is going to be up, and we’re driving dollar content to the defense space. Aerospace up 90% year-over-year, we’ve all seen Boeing, we see a little breather. But that for us is the interesting one because mix change. Boeing is going through a mixed change.

But I think from the aerospace story, the thing you should keep your eye keen on, is our dollar content. We have probably the strongest backlog we’ve had ever. And then of course, satellite business, which we’ve all been waiting for, I’m waiting for, which is, if I got to the highest margin business, that seems to be soon. Right, that’s something I can label that business. And then industrial, I know it’s down 7% year-over-year, I’m not saying capitulation, but I think the group is kind of bottomed, and I will even give that a forecast for, let’s just got modest growth for the balance of the year.

Tore Svanberg

Great, thank you for that color.

Jim Peterson

Okay.

Operator

Your next question comes from the line of Quinn Bolton of Needham & Company.

Quinn Bolton

All right, Jim and John just I was wondering if you might be able to comment obviously the core business, sounds like you’re in good shape yet record bookings, and I know the quarter has record backlog. Can you give us some sense what the core business excluding PMC might have look like in the March quarter. And sort of if you’re willing to do that how much dilution might be resulted just having that tough period of PMC and a full quarter of interest expense. And then, I got a second question for John.

Jim Peterson

Sure, on the organic growth for Microsemi core business for this year, [indiscernible] and carved out on about 6% or 8%. Realized last year we grew at very close to 7% organic. John, do you want to touch?

John Hohener

Yes, I think with the record backlog and with the mix that we’ve already talked about. We were certainly on our plans to achieve our 60% gross margin by the end of the calendar year, which we talked about, which means we would have some meaningful increases in gross margin moving forward. We had mix we have a found closure that’s almost there that we’ve talked about before. And of course we increased revenues and as Jim just alluded to increased satellite shipments. So I think that strong signals for our core business.

Jim Peterson

Yes, let’s just be clear, we acquire an asset, it doesn’t mean we stop focusing on what we call Microsemi proper core business. So, the push has not stopped.

Quinn Bolton

Right, all of those comments would lead me to believe that core business in the March quarter, probably would have done at least $0.72. Is that a fair assessment?

Jim Peterson

John, what was the guidance [indiscernible] comfortable talking there.

John Hohener

Certainly, we would have been at or grown from Q2.

Quinn Bolton

Thanks. And then just a follow-up question, you guys talked about really working down the leverage ratio over the next 18 months. Wondering if you might be prepared to kind of talk to us about what level of debt repayments you might be able to take on especially once you get out to the June quarter you get that $75 million of annualized expense. I mean you’re going to be looking at $50 million, $75 million, $1 million a quarter. Do you have certain repayment schedules that might limit how much you could repay in any given quarter?

John Hohener

Yes, Jim.

Jim Peterson

First and foremost, realize the target. If you’d a measured which I know you do when your friends do for living, its 18 months three times better. Yes, John.

John Hohener

Yes. And to your point we are going to generate very strong cash flow. I would say that the $75 million number couple of quarters out is going to be easily a run rate number we are going to use. In fact, we are talking about exiting 2016. This is free cash flow now to use to pay down debt exceeding $450 million. Jim.

Jim Peterson

He might point the real thing – out here, is watch this free cash flow. You're going to love it.

Quinn Bolton

Great, thanks guys.

Operator

Your next question comes from the line of Steven Smigie, Raymond James.

Steven Smigie

Great, thanks guys. I just hoping you could give a little color, if you have any sense what seasonality might look like going forward for the client company?

Jim Peterson

Sure. You know what? Let me just – Paul you want to proceed?

Paul Pickle

Yes, so typically – if you look that – if you think Microsemi Corp has Q1 seasonality. We didn’t have that last year. This year, obviously, Q1 was very strong for us as well. But we've been we typically see that in that December quarter timeframe. And then if we fold on the PMC business, their typical seasonality is March quarter. So you should see a change that had a little bit of – a little bit lower growth upfront with strengthening in the back half of the year. That’s what you should see going forward.

Steven Smigie

Okay, great, thanks. And just a follow-up on the gross margin question. As we think about the company maybe a year out, you got and sadly comeback and executing on some – and you’re bringing at the NCN. Where do you think gross margin could be getting to if you had a year to work on it?

Paul Pickle

Yes, I’m going to take as a third question. I’m going to stick to it right now [indiscernible] early target. You guys you entered this quarter, you know what the additions going to be. And with the satellite business coming back which is it’ll second half, the strength of our next generation products, the strength of our FPJ business growing 8%, then 8% year-over-year all to higher margin business. The mix is going to be in our favor, but you chopped down 60-30 and I'm going to guide you quarterly going forward.

Steven Smigie

Okay great. Thank you.

Operator

Your next question comes from the line of Doug Freedman with Sterne Agee.

Doug Freedman

Great, thanks guys for taking my questions. Just looking at the OpEx, can you clarify for me? I just want to make sure I got this correct. The deal close, I think you had about 10 weeks this quarter. So when I go into the June quarter, how much more do I need to add? Or are you going to be able to hold that given the synergies that you are targeting?

Jim Peterson

It’s going to go up radically as it relates to the PMC portion. I don’t have those numbers in front of me. But our goal is, as the revenue increases we are going to – continue to see a reduction of operating income as a percentage of revenue, see an increase in operating income as a percentage of revenue.

Doug Freedman

Okay. I guess, then as my follow-up, how should we think about you segmenting the PMC related revenues into which business segment will you drop them?

John Hohener

[indiscernible] you about the company, are you going to really put those revenues.

Jim Peterson

Well, as far as the end markets go, I mean you’ll actually see a different and market breakout from us next quarter. So storage, we have broken this out before early on in the process, we said storage would be about be about 20% of the business on a go-forward basis. We will tweak that a little bit in the April conference call.

Doug Freedman

All right, thanks guys.

Jim Peterson

Thank you.

Operator

Your next question comes from the line of Mitch Steves, RBC Capital Markets.

Mitch Steves

Hey, thanks for taking my question guys. So assuming that we believe your OpEx reduction story, which I do. One of the main questions we’re getting is, essentially on the PMC side is, what percent of the storage business is actually exposed to hyper scale versus that traditional players?

Jim Peterson

Hyper scale is ever growing, Litch, you want it to break out?

Steve Litchfield

Yes, well, I mean, there is a majority of the business today is really on the enterprise storage side. I mean, hyper scale for us is really just emerging. It is a small dollar amount. Quite frankly, it’s part of the headwinds that we’ve talked about a number of times, and a number of people, yes, I mean, to your point a lot of investors have these concerns about the growth over the last three years. And so as we look forward, we’re starting to see hyper scale really finally getting some real traction that has some material dollars and attached to them.

What’s exciting to Microsemi is that the relationship’s that the company has established, and really that came about based on the technologies, that the company’s is developed and so we really believe that we’ve got a leading position in this area. And so our hyper scale business will definitely be a meaningful part of the business going forward. Not just part, and the previous PMC business, quite frankly, it will be a meaningful part of Microsemi.

John Hohener

Yes, I think we saw at Microsemi, you get a realistic hyper scale numbers from this point going forward. Yes, hyper scale, quite frankly the cloud for everybody is new, perhaps someone sort of got ahead of the time. But we’ve done at the ideal time going forward.

Mitch Steves

Got it, thanks and then one more. Since you guys mentioned that we should be watching the free cash flow pretty aggressively here, and that’s going to be one of the main portion of obviously paying down the debt. Should we expect that to essentially increase quarter-over-quarter every quarter going forward or increase on a year-over-year basis in terms of the speed at which you are generating free cash flow?

Jim Peterson

Yes, I’m going to go for quarter-over-quarter and I’m going to drive it hard, John.

John Hohener

Yes, and I think the key point there is as we do paydown more we generate more, bottom line and therefore by definition we’ll have more cash in order to continue paying down.

Mitch Steves

Got it thank you so much.

John Hohener

Okay thank you.

Operator

Your next question comes from the line of David Wong of Wells Fargo.

David Wong

Thanks very much, I just wanted to be sure I understand your free cash flow comment. So if we take into to term cash restructuring and other cash charges are you saying that two quarters out that’s the September quarter, a huge quarter as your net cash balance. So cash minus debt starts improving at $75 million a quarter?

Jim Peterson

John.

John Hohener

Certainly, we can generate $75 million a quarter, unless we get past the run way here of all charges associated with the acquisition, yes.

David Wong

And the run way is the next two quarters margin on June or the run way is long where there will be cash charges that you like to work with?

Jim Peterson

It’s Jim, but the majority of it quite frankly it’s going to be March. I mean it’s the cost of the acquisition itself the borrowing the cost associated with the borrowing the severance that we pay all of those things most of them come out by the March timeframe.

John Hohener

Yes, pretty traditional M&A you [indiscernible].

David Wong

Okay and I wanted to clarify your answer to the earlier question. So your guidance assumes that Microsemi core business revenues excluding the MC will be up sequentially in the March quarter.

Jim Peterson

Slightly, the only thing we still feel is down tech might be the some seasonality in communications…

Paul Pickle

Litch you’ve got a number there?

Steve Litchfield

Well the revenue was [indiscernible] so there could be $110 million to $120 million contribution from PMC in the market of course.

Jim Peterson

So the balance would be us.

David Wong

Great. Thanks very much.

Jim Peterson

Yes, thank you.

Operator

Your next question comes from the line of Ambrish Srivastava of BMO.

Ambrish Srivastava

That was BMO, but that’s fine. My first question is, and I apologize if I missed it, what is the longer-term question. What is the free cash generating ability that we should be thinking about because that seems to me like a big additional plus when you do PMC acquisition? And then my follow-up may be you talked about FPGA share gains it’s a little bit longer term now what you have a bigger – you’ve had a bigger footprint in the data center market. It’s just offering enough opportunities to you, where we’re seeing a lot of obviously FPGA with end-servers. But with PMC, does that open up new opportunities for you in that end-market at FPGA. Thank you.

Jim Peterson

Let me answer – let me speak the FPGA and then I will turn it over the free cash flow to John because it was good news. We’re having tremendous amount of design wins going forward with FPGA. And the PMC acquisition does open up some opportunities. It gives us opportunity to – in the end customers and in the labs and the system architectures to introduce our FPGA technologies going forward. But realize, we have best-in-class power, we have best-in-class security reliability in the FPGA market space. So we are actually taking market share and enjoy the heck out of it. John, you want to go take that cash flow question?

John Hohener

Yes. What I said earlier and I articulate is – one we exit the year, we’re going to be on a run-rate basis, on annual run-rate basis – free cash flow of greater than $450 million. I also want to take a second and just correct an answer that I said earlier, I don’t want to leave the impression that our operating expenses are going up in the third quarter. We will have more weeks as it relates to PMC, but with the synergies that we’ve been talking about, we actually see our operating expenses coming down.

Jim Peterson

Thanks, John.

Ambrish Srivastava

So, sorry, John, we should expect to address the paydown of the 9% debt rate?

John Hohener

Say one more time please?

Ambrish Srivastava

We should see an exhausted pay down of the highest interest debt because…

John Hohener

Yes, certainly that would be our target.

Ambrish Srivastava

Okay, great. Thank you, gentlemen.

Operator

Your next question comes from the line of Will Stein, SunTrust.

Will Stein

Thanks for taking my question. Understanding that you’ve told us about the $100 million cost savings target and that’s longer-term and $75 million in the first full quarter. Can you give us an idea as to what you’re expecting or what the guidance implies for the cost savings in the current March quarter?

Jim Peterson

John?

John Hohener

We’re going to have a significant amount of cost savings in the March quarter. But we’re not guiding that, we’re guiding the first full quarter of $75 million.

Jim Peterson

But I think the lion’s share is going to be March, yes.

Will Stein

Great. And then, one more if I can. You also noted that we should take a look at – we should consider possible divestitures as a source of cash. Can you help us sort of frame that for those who have covered you very long time. I assume this would relate to a part of PMC-S that might be relatively less attractive to you and assuming so should we think of this as a – quite a small piece of that business or could there be something bigger within that that you consider moving away from?

Jim Peterson

Yes, we acquired a lot of business over the year, I think may be 15 or 18 acquisitions. And there are some businesses within that are big businesses. But there’s certainly not core technologies that I’ll acquire or invest in today. So, we’ll look at those. Then the second part of your question about PMC, I’ll leave that to Litchfield, but I don’t think that’s going to be of anything significant.

Steve Litchfield

Yes, I mean – right now, I mean, we’ve been talking about divestitures since kind of our Analyst Day almost about 10 months ago now.

Jim Peterson

Right.

Steve Litchfield

And so we’re continuing to assess that obviously with a couple of large acquisitions in the past 12 months, really presses us to look hard at existing technologies and capabilities that we have that are maybe not exactly aligned either from a financial standpoint or from a technology standpoint going forward and that’s really what we’re looking at right now.

Jim Peterson

And then also the follow-on has been answered and someone can ask a question. What would you do with that cash? And John, what will we do with that cash?

John Hohener

Well, you know, we have a saying around here. We have three uses of cash de-levering, paying down debt, and addressing the leverage.

Unidentified Analyst

Thank you.

Jim Peterson

You bet.

Operator

Your next question comes from the line of Suji Desilva, Topeka.

Suji Desilva

Thanks, guys. On the inventory, I slightly clear on this – the revenue recognition shipped at PMC. How many quarters does it takes the supply chain to – clean up that inventory, I think you’ve already said, but I just want to get that again.

Jim Peterson

Yes, we’re estimating, it goes over two quarters.

Suji Desilva

So by September, it will be…

Jim Peterson

No, no, it’s not good – by June.

Suji Desilva

By June, okay, got it. Great. And my other question is defense in this quarter was above seasonal, is that trend you guys think can continue above seasonal performance for defense through the reminder of the year – calendar year?

Jim Peterson

You know check out, right. We all know the budget has increased, right. And the spending goes in a lot of ways, right. I mean defense spending is focusing on healthcare, right, retirement, sizing, base reductions, [indiscernible] and missiles and the like. So as the general budget increases that’s far military sales and defense businesses increase so shall we, but it is a good sign that we buck the seasonality trend of 2% sequential growth.

Suji Desilva

Great, thanks guys.

Operator

[Operator Instructions] You do have a follow-up question that is coming from the line of Tore Svanberg at Stifel.

Tore Svanberg

Yes, thank you. Two quick follow-ups. First of all, it looks like you’ll get through your 60% target obviously in the June quarter, but given the OpEx reduction – there’s a chance of get to 30% operating margin by June or is that more second half?

Jim Peterson

John?

John Hohener

Yes, I certainly, we should be able to get in the 30% relatively quickly, let me – my model just to make sure that – yes, we can – yes, Q4 is certainly. Yes, just now, Q4.

Unidentified Analyst

Okay, okay. The other question is on your FPGA business none of the Intel-Altera deal close. Has the strategy changed there at all?

John Hohener

My strategy has always been same from you know this. We believe we have superior product because I believe the design win momentum prove that and with Pickle, little bit little quiet, so let’s just Pickle jump on this one.

Paul Pickle

I think, we have the opportunity our strategy shift just a little bit sustain and mid-range core market. The introduction of our Gen 5 products this next year is going to give us a little significant advantages can retain all of our differentiators, but open up a couple of spaces. And I think, what was interesting with PMC acquisition, Jim instead to it before, but we saw some alignment between some other products and our FPGA sits in reality, the FPGA, so the application. So we don’t have do this projects. We can put those bond somewhere else and still capture is started.

John Hohener

Thank you, Paul.

Unidentified Analyst

Sounds good. Thank you.

Operator

Your next question comes from the line of Will Stein of SunTrust.

Will Stein

Thanks for letting me in the call. I had a question earlier about potential repayment of the new 9 and 8 coupon bond. It was my understanding that might have meaningful premium, a sort of make hold provision that would make that a relatively on attractive repurchase. So I want make sure I heard that correctly and if perhaps the real pay down would be on the term loan.

Jim Peterson

Certainly, at this point in time there is a premium as it relates to that, we certainly want to assess that in terms of does it still makes sense to pay that down in order to reduce the future payments at 9 and 8 or we would then move to the term loan be which probably be the next course of action to your point.

John Hohener

Yes. On 5.33 at realize that the nine plus stuff that’s a great target for guy like me.

Will Stein

Great, thank you.

Operator

At this time, there are no further questions. I would now like to turn the conference back over to Mr. Peterson for any closing remarks.

Jim Peterson

Thanks for joining today and have a great day.

Operator

Thank you for participating in today’s conference. You may now disconnect.

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