Analog Devices (ADI) Vincent T. Roche on Q1 2016 Results - Earnings Call Transcript

| About: Analog Devices (ADI)

Analog Devices, Inc. (NYSE:ADI)

Q1 2016 Earnings Call

February 17, 2016 10:00 am ET

Executives

Ali Husain - Treasurer and Head of Investor Relations

David A. Zinsner - Senior Vice President, Finance and Chief Financial Officer

Vincent T. Roche - President, Chief Executive Officer & Director

Analysts

Ambrish Srivastava - BMO Capital Markets (United States)

Tore Svanberg - Stifel, Nicolaus & Co., Inc.

Stacy Aaron Rasgon - Bernstein Research

Christopher B. Danely - Citigroup Global Markets, Inc. (Broker)

John William Pitzer - Credit Suisse Securities (NYSE:USA) LLC (Broker)

Craig A. Ellis - B. Riley & Co. LLC

Amit Daryanani - RBC Capital Markets LLC

Blayne Curtis - Barclays Capital, Inc.

Vincent Celentano - Raymond James & Associates, Inc.

Harlan Sur - JPMorgan Securities LLC

C.J. Muse - Evercore ISI

Vivek Arya - Bank of America Merrill Lynch

Vinayak Rao - Morgan Stanley & Co. LLC

Ross C. Seymore - Deutsche Bank Securities, Inc.

Ian L. Ing - MKM Partners LLC

Stephen Chin - UBS Securities LLC

Mark Lipacis - Jefferies LLC

Doug Freedman - Sterne Agee CRT

Tristan Gerra - Robert W. Baird & Co., Inc. (Broker)

Deepon Nag - Macquarie Capital (USA), Inc.

Operator

Good morning. My name is Jennifer, and I will be your conference facilitator. At this time, I would like to welcome everyone to Analog Devices First Quarter and Fiscal Year 2016 Earnings Conference Call. All lines have been placed on mute to prevent any background noise. After the opening remarks, there will be a question-and-answer period. Please limit yourself to one question to ensure that management has adequate time to speak to everyone.

I would now like to turn the conference over to your host for today, Mr. Ali Hussein, Treasurer and Director of Investor Relations. Please proceed.

Ali Husain - Treasurer and Head of Investor Relations

All right. Good morning. Thanks, Jennifer, and good morning, everyone. Thanks for joining ADI's first quarter 2016 conference call. You can find our press release, relating financial schedules and our investor toolkit at investor.analog.com. As usual, I'm joined this morning by ADI's CEO, Vincent Roche; ADI's CFO, David Zinsner. The format for today's call will be slightly different. Today's prepared remarks will be relatively short because we want to devote most of the call to Q&A. So, before we start, let's get through some disclosures.

Please note the information we're about to discuss, including our objectives and outlook, includes forward-looking statements. Actual results may differ materially from these forward-looking statements as a result of various factors, including those discussed in our earnings release and our most recent 10-Q. These forward-looking statements reflect our opinion as of the date of this call, and we undertake no obligation to update these forward-looking statements in light of new information or future events.

Our comments today will also include non-GAAP financial measures which we have reconciled to their most directly comparable GAAP financial measures in today's earnings release, which we've posted at investor.analog.com. And so with all that behind us, let's get started.

So as you've likely seen, revenue in the first quarter totaled $769 million, which is about even to the same period in the prior year. Compared to the prior quarter, revenue decreased 21%, but this sequential revenue performance masked what was really a tale of two narratives. While weakness in the consumer portable sector exacerbated what is typical seasonal weakness within the consumer market, our business-to-business or B2B markets of industrial, automotive, and communications infrastructure combined to perform in line with our expectations.

So let me give you a little color on our performance. The industrial market at 45% of revenue decreased 5% sequentially during the seasonally weaker first quarter, which was a good result in a challenging macro environment. Compared to the prior year, the industrial market was stable. The automotive market at 16% of revenue decreased 4% sequentially with all sectors flat to down and in line with the seasonal patterns. As compared to the same period in the prior year, revenue from ADAS or advanced drive assistance systems increased 22%. Powertrain sector revenue grew 8%, and infotainment sector revenue increased 6%.

Turning now to communications infrastructure, revenue in this market increased 4% sequentially, which was well ahead of seasonal patterns. Revenue from both wireless and wireline infrastructure customers increased sequentially, as we believe the trough in the wireless market turns into a nascent recovery. As compared to the prior year, wireless revenues decreased while revenue from wireline customers increased.

In total, ADI's B2B market decreased 3% sequentially. Now in the consumer market, revenues decreased 60% sequentially to $126 million. And this market represented 16% of sales. While prosumer audio/video applications decreased in line with seasonal patterns, revenue from portable consumer applications declined significantly as a result of weaker than forecasted customer demand in this sector, after a prior quarter performance that had far exceeded expectations.

So now, I will turn the call over to Dave for details of our financial performance in 1Q 2016. With the exception of revenue, Dave's comments in our first quarter P&L line items will exclude special items, which in the aggregate totaled $22 million for the quarter. When comparing our first quarter performance to our historical performance, special items are also excluded from prior quarter and year-over-year results. And reconciliations of these non-GAAP measures to their comparable GAAP measures are included on Schedule E in today's release.

So, Dave, over to you.

David A. Zinsner - Senior Vice President, Finance and Chief Financial Officer

Thanks, Ali. The first quarter was a challenging quarter as we executed through weaker economic conditions and significant weakness in the portable consumer electronics sector. Nevertheless, our B2B markets combined to perform in line with our expectations, and we repurchased $132 million of our shares in response to stock price volatility, which helped reduce our share count by approximately 1%. Revenue in the first quarter totaled $769 million, and diluted earnings per share was $0.56.

Gross margin of 62.2% decreased 350 basis points from the prior quarter, primarily on higher inventory reserves and lower utilization rates. Inventory on a dollars basis decreased $7 million sequentially and on a days basis was 128 days on lower sales.

Utilization rates in the first quarter were in the mid-50%s, and we are planning to increase utilization to the high 60%s in the second quarter. Weeks of inventory and distribution were approximately 7.5 weeks, consistent with the prior quarter.

Operating expenses of approximately $265 million declined $27 million, or 9% sequentially and were flat to the prior year as we continued to carefully manage expenses. Operating profit before tax of $214 million or 27.8% of sales decreased from both the prior quarter and the year-ago period. Other expense was approximately $10 million as we raised $1.25 billion in 10-year and 30-year notes. We expect our net interest expense for the remainder of fiscal 2016 to be approximately $15 million per quarter.

Our first quarter tax rate was approximately 13%, which we expect will be our tax rate for the remainder of fiscal 2016. Excluding special items, diluted earnings per share was $0.56, which was a decrease of 11% as compared to the prior year on higher inventory reserves and interest expense.

Nevertheless, our strong financial model continued to generate solid cash flows, which we used to enhance shareholder returns. Excluding a one-time payment relating to the conversion of our Irish pension plan, over the past 12 months, ADI has generated free cash flow of $1 billion, or 30% of sales, and we have returned $800 million to shareholders through dividends and share buybacks.

The first quarter was also a strong working capital quarter, during which free cash flow as a percent of revenue increased to 26%, up from 19% in the prior year, which is an increase of approximately 700 basis points. Capital additions in the first quarter were $23 million, or 3% of revenue, and we are planning for capital additions in 2016 to be in the range of $130 million to $150 million.

In line with our capital allocation strategy, our board of directors approved a $0.02 increase in the quarterly dividend to $0.42 per share, which is payable on March 8, 2016. This dividend represents the 13th dividend increase in the last 12 years. At the current stock price, our dividend yield is approximately 3.2%.

Our board also increased the authorization under our stock repurchase program to $1 billion as we plan to continue to repurchase our stock during periods of stock price volatility. We ended the quarter with a cash and short-term investment balance of $3.8 billion with approximately $1.2 billion available domestically. We had approximately $1.7 billion in debt outstanding, which resulted in a net cash position of $2.1 billion.

Now turning to our outlook for the second quarter, which with the exception of revenue expectations is on a non-GAAP basis and excludes special items that are outlined in today's release. While we are cautious about the macroeconomic environment, current order trends in the industrial, automotive, and communications infrastructure markets suggest combined sequential revenue growth in these B2B markets to be in the mid-to-high single digits in the second quarter.

In consumer, we are expecting another quarter of sequential weakness within the portable sector of this market. In the aggregate, we are planning for revenue in the second quarter to be in the range of minus 2% to plus 4% sequentially. Gross margins are expected to increase to approximately 65.5% in the second quarter on higher utilization, more favorable mix, and lower expected inventory reserves as compared to the first quarter.

We estimate that operating expenses will be up slightly in the second quarter and as a result for operating margins to expand sequentially. Based on these estimates and excluding any special items, diluted earnings per share are planned to be in the range of $0.58 to $0.66, which at the mid-point would represent an 11% sequential increase in EPS.

We are currently operating at the lower end of our financial leverage model range, and we are carefully managing production levels and operating expenses. As business conditions improve, we should drive better operating leverage. Overall, we estimate that we have approximately 800 basis points of operating leverage remaining in our financial model based on our first quarter exit rates.

While near-term market headlines warrant caution, we believe our future prospects remain strong. We have been deepening and broadening our customer engagements while investing in our most critical technology vectors to support a long-term growth. And together with our operating model, these place ADI on a strong platform to achieve up to five dollars in non-GAAP earnings by 2020.

And so now I'll turn the call back over to Ali.

Ali Husain - Treasurer and Head of Investor Relations

Great. Thanks, Dave. All right. So, folks, before we get to Q&A, let's just run through the format. Please limit yourself to one question. If you have a follow-up, please re-queue. And again, we do this in the spirit of fairness, so that all callers get to ask at least one of their questions. We plan to run the call until 11:00, so I think that's plenty of time to get to everyone's questions.

So with that, operator, let's start the Q&A session and folks on the line can ask questions of either Vince, Dave or myself.

Question-and-Answer Session

Operator

Our first question comes from Ambrish Srivastava with BMO Capital Markets.

Ambrish Srivastava - BMO Capital Markets (United States)

Hi. Thank you. Good morning, folks. I had a long-term question on the automotive segment for any of you gents who could answer. Autos has been a great business for you long term, last year didn't grow. Can you just help us – sorry, I'm in a hotel room. Can you please help us understand where the business is positioned in some of the newer areas such as ADAS, self-driving push, safety? So in a sense, what drove the business in the last five years? And what should we be looking at in the future? Thank you.

Vincent T. Roche - President, Chief Executive Officer & Director

Yeah. Well, Ambrish, as you know, our automotive business has three major components to it. One is the infotainment sector, which is largely built around audio and media products. We have a strong powertrain business which in the past number of years has been driven really by our strength in battery monitoring and control. And last but not least, the safety business, which has three major components – passive safety and active safety, which are largely MEMS-based activities, and advanced driver assistance.

Now I can tell you that all those sectors grew over the last several years. The infotainment area has grown in the high single digits. Same thing with the powertrain business. And where we have run into headwinds really is on the MEMS side of the safety business. The advanced driver assistance piece, in fact, has been growing at a rate of about 20% over the last two years or three years.

And in the MEMS area specifically, we have been very careful to exit parts of the business that were commoditizing and focusing our R&D in areas where we can get the kind of returns on performance driven products. So that's where we've suffered the headwind, and it provided a dampening effect over the last year in particular. My sense is based on what I hear from customers, what our business units are predicting is that in the latter half of this year we'll be back into, I think, a pretty solid growth pattern with regard to automotive in general across all those three sectors.

Ali Husain - Treasurer and Head of Investor Relations

Great. Thanks, Ambrish. And let's get to our next caller.

Operator

Our next question comes from Tore Svanberg with Stifel.

Tore Svanberg - Stifel, Nicolaus & Co., Inc.

Yes. Thank you. You talked about order rates in your B&B business being stable in spite of the macro climate. Could you talk a little bit more about sort of the linearity of those bookings? Are they coming sort of in line with seasonal patterns? Or is there any trends for strengthening or weakening as we look forward?

Ali Husain - Treasurer and Head of Investor Relations

Tore, thanks. This is Ali. I'll take this one. I think if you look at the order patterns throughout the quarter, I think they generally trended again ex the consumer business, I'm talking about the B2B business here. They generally trended as we would have expected them to. I'd say November and December were pretty stable. January saw some pretty good strength. I'd say part of that is just the natural cycle there. January tends to be a stronger order flow month than December, just because it has less holidays. Part of it could be – there is – our first and second quarters had the effect of the Lunar New Year. Part of that could be that as well.

But I'd say overall as we now look into February, orders continue to maintain themselves. I'd say when you look at the various businesses, the industrial business is hanging in in February to January rates. The comms business is off a little bit from its January rates. Again, January was a very strong month for the comms business, particularly as you think about some of these wireless infrastructure build-outs in China. There's likely some ordering that happened in the month of January that was likely going to be consumed in February.

So I think overall I'd say it's probably tracking to where we would expect it to be around this time of year. And I think that's certainly implicated in the guidance that we gave for the B2B markets to be in the mid-to-high single digits sequentially in the second quarter.

Operator

Our next question is from Stacy Rasgon with Bernstein Research.

Stacy Aaron Rasgon - Bernstein Research

Hi, guys. Thanks for taking my question. I want to actually follow up on that. So you're guiding the B2B up mid-to-high single digits. You're sort of calling that seasonal. But I think industrial and auto are typically up in the low double digits sequentially in Q2. So is there something else going on, for example, in comm that's offsetting? Or I mean can you give us some feeling for I guess variation across the three B2B businesses above or below that average because it does seem overall you'll get below normal seasonal for industrial and auto?

David A. Zinsner - Senior Vice President, Finance and Chief Financial Officer

Right. Yeah. So we actually went back and looked at kind of the B2B in total and by piece. Communications tends not to have as much seasonal effect, and it's more kind of a cycle effect. But when you look at the industrial and automotive, you're right, Stacy, sometimes it's in the double digits, sometimes it's in the high single digits, kind of depends on the year. I think partly it depends on where Lunar New Year kind of falls, and sometimes Lunar New Year is in the first quarter and sometimes it's in the second quarter. And so I think a little bit of the effect of perhaps us being on the lower end of seasonality in those businesses is the fact that Lunar New Year shows up in the second quarter this time around.

Part of it's just you have to pay attention to what's going on in the macro environment, and I think we're being prudently cautious given some of the perturbations out there, things going on in China, things going on with our customers who sell into the oil and gas space. And so I think there's a little bit of prudence there.

And then partly, I think comms had a pretty good quarter in the first quarter. It's going to probably have kind of a more flattish to up slightly kind of quarter in the second quarter, and that would mute the B2B sequential growth rate as well. But overall, I would say we're kind of pretty pleased with how the B2B business has been operating. It had a better than expected first quarter, and so to have the second quarter be a little bit on the lower end of seasonality is, I think, a pretty good outcome.

Operator

Our next question comes from Chris Danely with Citigroup.

Christopher B. Danely - Citigroup Global Markets, Inc. (Broker)

Hey. Thanks, guys. Just some more color on the consumer end market. How do you expect that to trend this year? Have you seen any change to your forecast recently? And do you think consumer revenue in the second half of calendar 2016 will be above or below what it was in the second half of calendar 2015?

David A. Zinsner - Senior Vice President, Finance and Chief Financial Officer

Tough to call the year-over-year growth rates, Chris. Obviously, we have a good position, I think, in the consumer space, particularly in the portable electronic space. We obviously had a really good second half last year, but as the first half of this year has shown, looks like some of that was not real end demand. And so there might have been a little bit of build of inventory – some inventory build in the second half of last year that we're now feeling the effects of this year. So clearly on a sequential basis, the second half should be quite strong relative to the first half. I'm not sure how things will work out year-over-year, kind of given that inventory build.

Operator

Our next question comes from John Pitzer with Credit Suisse.

John William Pitzer - Credit Suisse Securities (USA) LLC (Broker)

Yeah. Good morning, guys. Thanks for letting me ask the question. I want to go back to the non-consumer or B2B business, and if you look at that revenue over a longer period of time, it sort of peaked out in the October 2014 quarter at about $720 million. And even again sort of your guide for April, you're still going to be $30 million to $40 million below that level. And, Vince, I think in a prior question, you did a good job kind of talking about the puts and takes in autos. I'm assuming industrial military is really a reflection of just kind of a lackluster macro. I guess my question is more on the comm side of the business which is still down the most over that period of time.

Wondering kind of where you think we are in the comm cycle? Do we get back north of $200 million in revenue at some point? Are there structural barriers to get there? And importantly, if you give us an update on how Hittite is performing within that division, that would be helpful because I believe October 2014 was the first full quarter of Hittite revenue.

Vincent T. Roche - President, Chief Executive Officer & Director

Yeah. So I think the situation in the communications infrastructure market is really about – last year was driven by – the downturn was driven largely by what was happening in China with regard to regulatory issues, if you like. What we're seeing – we came off a very, very low bottom at the very early part of 2015. But my sense is now, we're seeing some bookings momentum. My sense is that we'll see a pretty good growth year overall this year in communications infrastructure. There is a lot of innovation still taking place. And we are I believe gaining share across the boards. Our customers are still driving hard in the wireless area, for example, to increase spectral efficiency, reduce power costs, and so on and so forth in the radio systems, and we're right at the heart of that.

The combination of ADI with Hittite makes us, if you like, the supplier of choice when a customer is thinking of that physical layer interface between the air and the bits, if you like. So we're very, very happy with what we're seeing in terms of the revenue contribution from Hittite. In fact, in the past quarter, Hittite was up over the same quarter in the prior year. So I think overall, that's going well in terms of the revenue and profit contribution, in terms of the contribution in improving ADI's capacity to innovate in these radio systems in 4G. And we're also now starting to get involved in producing, if you like, the architectures for 5G.

But my sense is there's still a lot of legs in 4G. And from our perspective, what we're doing is driving technology and product leadership at key customers, and so I think this year, we'll be about what the market does, and the indications are that the market is getting back into a pretty modest buy mode, I think. And as I said, we have some very, very good momentum in terms of design-ins across the globe, which should bode well for 2017 and beyond.

Ali Husain - Treasurer and Head of Investor Relations

Thanks, John.

Operator

Our next question is from Craig Ellis with B. Riley.

Craig A. Ellis - B. Riley & Co. LLC

Thanks for taking the question, guys. I wanted to follow up on the industrial end market. It looks like it's performing seasonally, but from some of the other companies in the sector, we've heard about some weakness in certain geographies like China. So can you address the trends that you're seeing across your major geographies in that key end market? Thank you.

Vincent T. Roche - President, Chief Executive Officer & Director

Well, from the geographic perspective, I would say if you talk about the industrial space specifically, we actually had – the strongest growth we had was in China last quarter, and Europe was the area of slowest growth. So I think it's a case of – the macro – the situation in regard to oil exploration has really impacted the situation in America and to some extent Europe, but from our perspective, China was the area of strongest performance in the first quarter.

Operator

Our next question comes from Amit Daryanani with RBC Capital Markets.

Amit Daryanani - RBC Capital Markets LLC

Thanks a lot. Good morning, guys. I guess I have a question on the gross margin line. I fully understand you guys had a fair bit of deleverage sequentially. I'm wondering if there were any other factors that played in to the margin shortfall that you guys had on a sequential basis. And if you could specifically just maybe quantify the inventory reserves you had to take on the consumer side.

David A. Zinsner - Senior Vice President, Finance and Chief Financial Officer

Yeah. So as you point out, I think we exited the fourth quarter around 66% gross margins. It came down to little over 62%. About half of that was the fact that we lowered utilization in the fab, and obviously when we do that, that has a pretty meaningful effect to the gross margins. And then the other half was inventory reserves. And the inventory reserves were specific to that consumer portable electronics business. We built up inventory to meet what we thought would be backlog in the first quarter and partially second quarter. And as that forecast was taken down by the customer, we were left with more inventory than we needed in the short term, and so we elected to reserve that inventory for that reason.

Operator

Our next question comes from Blayne Curtis with Barclays.

Blayne Curtis - Barclays Capital, Inc.

Hey, guys. Thanks for taking my question. I just want to follow up on that, Dave, when you look at the consumer business, it's obviously down a lot more than others levered to that customer. Can you just talk about within the supply chain? And you mentioned writing off some of your own inventory, but when you look at the supply chain, was there inventory in that supply chain that you're working through? If you could talk about yields within the modules that your product goes into. And is that cleared up as you look at April such that you could see an uptick in July as you saw last year?

David A. Zinsner - Senior Vice President, Finance and Chief Financial Officer

Yeah. I mean, I think that we were a relatively new product, and I think when that happens, I think the whole supply chain probably adds a bit of cushion along the way to make sure that they can all meet the demand. And of course, the end customer doesn't have absolute certainty in terms of what their end demand might look like. So I'm sure they add a little bit of cushion there.

As it turned out, that cushion across the whole supply chain, including the cushion we all had on our own balance sheet, wasn't necessary. And so as a result, you have the effect of an impact to our topline and the need to reserve some of that inventory for a possible disposable. So I think based on what we saw in the first quarter and based on the fact that there was a bit of demand expected in the back half of the second quarter, kind of a resumption to the order flows. We think that this will be behind us by the end of the second quarter, and we'll be back to shipping with consumption.

Operator

Our next question comes from Steve Smigie with Raymond James.

Vincent Celentano - Raymond James & Associates, Inc.

Thanks. This is Vince Celentano on for Steve. I had a question about the defense business. So the DoD recently released their 2017 proposal. They expected R&D to increase by about 4%. How closely does this tie into your own defense business? And what are kind of the factors that determine whether it grows above or below this amount?

David A. Zinsner - Senior Vice President, Finance and Chief Financial Officer

Well, I mean, I think what we have seen is that the defense business has actually been performing quite well. And in fact, I think in the first quarter we were up double digits. So we continue to get maybe a disproportionate amount as it trickles down to us the capital spending that the government allocates to defense. Obviously, I think anything where the government is adding expense or capital expense to the budgets of Defense is going to be a good answer for us. In particular because I think a lot of what they are doing are these military systems that require a lot of semiconductor, a lot of electronic content, and that obviously is beneficial to us. So we've been very pleased with the performance of the defense business.

Obviously, the Hittite acquisition just supercharged it for us and has helped us do even better in that market. We're seeing all kinds of opportunities for our military components into that space. But not only that, we're actually figuring out ways to take things in the rest of our business that maybe were more commercial in nature and addressing that content to the military business to even grow it faster. So the pipeline looks great in that space, and I think we'll do very well over the next few years in that market.

Vincent T. Roche - President, Chief Executive Officer & Director

One of the things that's happening in that area is the mass digitization of a lot of old radio and microwave systems. So there's a huge cycle of upgrades that is in play and that will continue, we believe, for the next several years. So as Dave said, the combination of ADI's mixed-signal technology combined with Hittite's microwave prowess puts us in very, very good stead. And we're certainly seeing that in terms of the business growth in aerospace and defense over the last 12 months or 18 months. And we expect it to be a good contributor to the industrial story over the coming years as well.

Ali Husain - Treasurer and Head of Investor Relations

Next question, operator.

Operator

Our next question comes from Harlan Sur with JPMorgan.

Harlan Sur - JPMorgan Securities LLC

Good morning. Thank you for taking my question. Great job on the OpEx controls over the past few quarters. How should we think about OpEx beyond fiscal Q2?

David A. Zinsner - Senior Vice President, Finance and Chief Financial Officer

Well, as we indicated in the prepared remarks, we do expect it to go up a little bit in the second quarter. The second quarter and third quarter gets the impact of salary increases. And so there is kind of a natural lift, although it's not significant in the second quarter and third quarter, it will happen. After that I think we're going to be very cautious about how we deploy capital and operating expenses until we're really clear on what the macro environment looks like. And so as we came into this year, Vince really set the edict that we basically are going to kind of keep the pie the same and we'll divide the pie differently based on the markets and product areas that we think have the best opportunity for a return. And I think that's kind of going to be the mindset for us for the foreseeable feature, unless things kind of change dramatically on the macro side.

Harlan Sur - JPMorgan Securities LLC

Thank you.

Operator

Our next question comes from C.J. Muse with Evercore ISI.

C.J. Muse - Evercore ISI

Yeah. Good morning. Thank you for taking my question. I guess a follow-up question on the inventory reserve and gross margins. Did you take reserve for your inventory or for inventory at ODMs? Part B, I guess, is that inventory now obsolete or could that be a tailwind to gross margin in the back half of the year? And then lastly, in terms of getting back to prior peak gross margin last year of 66.5%, what kind of step up in utilization do we need to see? Thank you.

David A. Zinsner - Senior Vice President, Finance and Chief Financial Officer

Okay. So a three-part question. Good. Yeah. So first of all, on the inventory side, that inventory is not necessarily obsolete. So it's possible it could be used in the future. What was the other part of that specific question on the reserves? I forgot that.

C.J. Muse - Evercore ISI

Were you taking reserve for your own inventory...

David A. Zinsner - Senior Vice President, Finance and Chief Financial Officer

Yeah.

C.J. Muse - Evercore ISI

...or inventory at key ODMs?

David A. Zinsner - Senior Vice President, Finance and Chief Financial Officer

Yeah. No, once it ships out, it's not our inventory anymore. So we don't take reserves on that. This inventory was on our balance sheet. It was in our supply chain. So that's the inventory reserved. It is possible, like you said, if demand were to change in the back half of the year, it's possible that inventory does get sold. I wouldn't rule that out.

In terms of the gross margins getting back north of 66%, I think we actually have a great shot at that. Certainly in the first quarter we were artificially low because of where utilizations were and because of these inventory reserves. We don't expect the inventory reserve situation to repeat itself in the second quarter, but even the utilization if not up to prior peaks we're thinking it's going to be in the low – the high 60s%, rather. And in fact, we've been in the high 70s% in prior periods, and that's at least 100 basis point improvement to the gross margins. So I think we have a good path towards getting our gross margins back north of 66% and actually probably in relatively short order.

C.J. Muse - Evercore ISI

Very helpful. Thank you.

Operator

Our next question comes from Vivek Arya with Bank of America Merrill Lynch.

Vivek Arya - Bank of America Merrill Lynch

I'm wondering if you could give us a sense for how large was your largest customer. And broadly, can you talk about diversification in your consumer business? It's obvious the results and the stock has been extremely volatile. And from our perspective, it's very hard to see whether you can or even want to maintain that socket. You might have it this year, but we don't know what the situation will be next year. So, could you just give us some color on how we should think about modeling that volatility in your results? Thank you.

David A. Zinsner - Senior Vice President, Finance and Chief Financial Officer

Yeah. So in the first quarter – I don't have the number right in front of me, but I think I'm fairly certain it was below 10%, our largest customer, and then it's a long tail after that. So we're pretty diversified from a customer perspective. I think it's a valid question as to do we want this business or not. Sometimes we think about that ourselves based on the Street reactions. But I would tell you this has been one of the single most successful products we've ever developed in terms of its return on investment.

It was a relatively small amount of R&D investment, we were able to utilize technology that was highly proprietary that really cut – was at the cutting edge of technology, and we were able to redeploy it and kind of customize it to a given customer that really made a difference in their application. And that's kind of our philosophy in consumer. And it has always been our philosophy in consumer. And so we're going to continue to do that. There will probably be several different things we will do in the consumer space that will have characteristics like this that require – that leverage our existing technology and drive great returns. And quite honestly, I think that the long-term shareholders of ADI want us to do that. They want us to drive good return on investment.

There may be some volatility that happens from quarter-to-quarter, but over the long run, I think we'll be very happy. One of the things I think we sighted was that excluding this pension fund changeover that we had in the fourth quarter, we will have generated $1 billion in the last 12 months in cash flow. We wouldn't have gotten there without this thing. So we're all about driving cash flow and maximizing that, and helping to maximize return on shareholders. And I think that this piece of business and business like this do that.

Ali Husain - Treasurer and Head of Investor Relations

And I would just add, not only do we generate the $1 billion, but we return $800 million of that, and given where the cash flows are, the yield on the free cash flow is somewhere around 6% or 7%, which I think is one-and-a-half times what the S&P is yielding. So, all right, let's get the next question.

Operator

Our next question is from Craig Hettenbach with Morgan Stanley.

Vinayak Rao - Morgan Stanley & Co. LLC

Hi. This is Vinayak calling for Craig. I had a quick follow-up on the comm business. You saw some good growth over the last couple of quarters in the communications side. And now from your earlier comments, sounds like the business is taking a pause in April. What visibility do you have in that business? What are you hearing from customers? And if you can touch upon the trends you're seeing by geography for that segment.

David A. Zinsner - Senior Vice President, Finance and Chief Financial Officer

Yeah. So I wouldn't say it's taken a pause. I mean, we do expect it to be flat to up. And so I think it's certainly – as I think and Ali mentioned in his prepared remarks, it's in the nascent part of our recovery. We have a pretty good visibility into the pipeline here, because the design cycles tend to be a lot longer, particularly in areas like the consumer space. And so we kind of understand where our traction is in this space. And as Vince mentioned earlier, based on the way we read how things are going to transpire, given the newer technologies that we're bringing out into the wireless comm space, we think we're going to gain share over the course of the next couple of years.

In addition, I think that the market has paused as well. Clearly, it paused significantly in China. And there is a real need for higher bandwidth and as all these devices that we all hold dear to ourselves require more and more data, video driving a lot of it now. And so our expectation is that there will be some capital spent in the wireless infrastructure space, that's what our customers are telling us, that's what their customers are telling them.

We're excited about our position in that space. We think it will only strengthen. And so my guess is, it's hard to call this for sure, but my guess is we'll be in a pretty consistent recovery phase over the next 18 months or so. And then who knows when 5G comes around, but when 5G comes around, I think we're even in better position, particularly given that a lot of the technology requires millimeter wave, which was one of the key reasons we acquired Hittite.

Vincent T. Roche - President, Chief Executive Officer & Director

I think in some markets, you've got to take a very long-term view to it. It's a space that we've been innovating in for the last 15 years, 18 years, as technologies became more and more digital in terms of their communications modalities across the various generations. So we're gaining strength every year in terms of technology and customer penetration. We know for sure that there's going to be more and more demand for spectral efficiency, as people use more and more and more mobility, higher bandwidth data streams required. So there will be oscillations quarter-on-quarter, but overall, we believe it's a terrific space to be in. We're investing to win in that market in the radio space. And as I said, our position gets better year-by-year in terms of customer penetration and technology and product quality and availability.

Operator

Our next question comes from Ross Seymore with Deutsche Bank.

Ross C. Seymore - Deutsche Bank Securities, Inc.

So, Vince, one for you on the automotive market. It was very helpful earlier when you gave some of those splits of your business. If I summarized it a different way, investors seem to be a little bit concerned that the automotive market from a SAR perspective is peaking. Could you give us any details on if you're seeing any evidence of peaking behavior? And then probably more importantly, how do you think your business being unit driven, as far as the unit build in the market versus content driven going forward?

Ali Husain - Treasurer and Head of Investor Relations

Hey, Ross. Let me take part of that, and then I'll turn the rest over to Vince. I think from a SAR perspective, really what we saw towards the end of our fiscal year was China, particularly the premium vehicle market there weakening. I think what we're seeing at this stage is that North America is still continuing to be pretty strong. The European vehicle registrations are continuing to be up, and I think very importantly for ADI is that the premium vehicle market in China seems to be stabilizing right now. So that's sort of a macro view in terms of the SAR.

And then just secondly I'd point out from another – if you take it sort of from another macro view, is that when you look at the dealer inventories out there, those are in good shape. When you look at again the average age of vehicles, they're above their historical norm. So that would suggest that there is still some pent-up demand from the SAR perspective. But that's I guess our sort of 30,000 foot macro view of what's going on with the SAR. I'll let Vince take the second half.

Vincent T. Roche - President, Chief Executive Officer & Director

Yeah. Maybe just one other piece of additional information. Light vehicle sales were strong. As Ali said, the luxury part of the market seems to have at least stabilized, maybe stalled a bit. But light vehicle sales have been stronger than expected in both certainly North America and Europe. So part of our – we were talking earlier just about the diversity of our business. Our business continues to become more diverse, as we penetrate Asia more aggressively than we have in the past, building on the strength that we've had traditionally in Europe and America. So I think from our perspective we've got a stronger portfolio than we've ever had. It's really going to be a case of – from an ADI perspective how well we penetrate the socket. So irrespective of what happens in terms of SAR, we actually have some good momentum in terms of products and technology, which will enable us to get share. So I think it will be a tale of those two pieces.

Ali Husain - Treasurer and Head of Investor Relations

And if I could just add some examples of the technologies that we're bringing to the market. ADAS systems, as we mentioned in the prepared remarks, were up 22% year-over-year. That today is largely a 24-gig solution, and over the next couple of years, we'll be in 77-gig solutions as that modality rolls out, puts us in a very strong position to grow. Powertrain systems continue to be strong, again as carmakers want to make cars more efficient. And finally on the infotainment front, that's been a good market for us. I don't know if you noticed, but last month we announced a release with Ford Motor Company announcing what we call an A2B Bus, which is basically taking very high-end audio fidelity, in cabin, takes out a bunch of weight out of the car, still keeps fantastic audio quality within the vehicle, and at the end of the day is a cheaper solution for the car manufacturer. So those are just some examples of the things that Vince was talking about.

Okay. Here we go. Next question, operator. Thanks.

Operator

Our next question is from Ian Ing with MKM Partners.

Ian L. Ing - MKM Partners LLC

Yes. Good morning. My question is on the comms business, 20% off of the prior peak at this point. Xilinx talked about their comm segments not likely achieving prior peaks in the near future, they talked about FTD in China being a smaller deployment than TDD. So for ADI, I mean, do you have the potential to reach prior peaks with some different exposure than Xilinx, perhaps more on the microwave side? And what sort of timeframe do you think that could happen?

Vincent T. Roche - President, Chief Executive Officer & Director

Well, we've got a bigger footprint now than we've ever had. I mean, just the combination of the investments that we've been making for the last several years to make sure that we have the most complete solutions in the radio space, combined with the microwave technologies that we've acquired through Hittites. So I think there are three parts we should think about. One is the macro, the macro cell, the small cell. We believe, for example, that we will see growth this year in the macro cells. It will be relatively modest.

We're also very well positioned in small cells, and I think it's becoming pretty clear that in China, China Mobile is going to deploy small cells this year. We have a very strong competitive moat that we've built in the area of the software defined transceivers that specifically address the small cell arena. And the point-to-point space has been modestly growing, seems to have slowed as of late, but they are the three components. And we've got a bigger footprint. We're getting more penetration. I believe it will be more about market adoptions and what the carriers do in terms of CapEx on hardware versus other things, more so than what we do. So I think we're well positioned as growth continues to gain momentum here, in that market.

David A. Zinsner - Senior Vice President, Finance and Chief Financial Officer

And, Ian, not that I'm keeping score, but we're 19% off our peak, not 20%.

Ali Husain - Treasurer and Head of Investor Relations

All right. We'll get to our next caller. Thanks.

Operator

Our next question is from Stephen Chin with UBS.

Stephen Chin - UBS Securities LLC

Hi. Thanks for taking my question. Vince, I want to drill down little bit on the distribution channel. Can you discuss the sell-in, sell through rates in the quarter and what your expectation is in the current April quarter as well?

Ali Husain - Treasurer and Head of Investor Relations

Well, I'll take a first stab at that, and then I can let either Vince or Dave come in. So when we look at the distributor channel this quarter, inventory on a weeks' basis, as I think Dave mentioned in his prepared remarks, were 7.5 weeks, which is pretty consistent over the last several quarters. Deferred revenue, which is a pretty good proxy for inventory in the channel at revenue dollars, was down 1% sequentially. So the channel, I'd say, is behaving itself. I think a lot of the inventory is on the supplier balance sheet. And I think folks are doing a good job in managing the actual channel.

I think when you look at some of the outlooks painted by some of the larger distributors out there, it appears to be a pretty mixed environment. And of course, if you look at that as a proxy for industrial business, as Dave mentioned earlier, if you – sort of back end of the guidance, we're guiding industrial to be in somewhat of a seasonal range, but likely to be sort of at the lower end of that seasonal range. But I don't know if Vince you wanted to add anything to that.

Vincent T. Roche - President, Chief Executive Officer & Director

No, I think what you said is correct in terms of – you can take our industrial business as a good proxy for what's happening in the channel. So the book-to-bill is positive at this point in time. And as Ali said, we've got modest expectations based largely by the fact that the macro backdrop is, to say the least, volatile at this point in time.

Operator

Our next question is from Mark Lipacis with Jefferies.

Mark Lipacis - Jefferies LLC

Hi. This is Mark Lipacis. Dave, you mentioned you're cautious and that there's perturbations in China, but the orders in the non-consumer businesses seem seasonal given the timing of the Lunar New Year. And Vince noted that the China industrial market was the strongest industrial market. So I'm trying to reconcile what appears to be seasonal order patterns with your cautiousness. Are customers or distributors throwing up flags? Or is there some other analysis or signals that's driving your cautiousness? Thank you.

David A. Zinsner - Senior Vice President, Finance and Chief Financial Officer

Yeah. And when I say perturbation I mean what you read in the Wall Street Journal and see on CNBC more than anything. But certainly what we see from an order flow perspective would lead you to be – feel pretty good about the situation from a macro perspective. But I just think we got to recognize that there is uncertainty in the market. I think our customers generally feel the same, feel this uncertainty and just aren't sure what the outcome will look like for this year. And the result I think when those situations arise, it's best to be on the cautious side of things. And if things turn out to be more positive, that would be great. We'll put the money to work at that point. And if it doesn't, we'll have protected our income statement.

Vincent T. Roche - President, Chief Executive Officer & Director

If you look at what our customers are predicting for this point this year versus the same period last year, it was a lot more caution. I think all the big industrial companies are projecting very, very low single digit growth or flatness through the year. So you've got to take all that into account when you're trying to run your business here.

Ali Husain - Treasurer and Head of Investor Relations

Great. Thanks.

Operator

Our next question comes from Doug Freedman with Sterne Agee.

Doug Freedman - Sterne Agee CRT

Hi, guys. Thanks for taking my question. It really relates to your M&A strategy. We've seen in the markets taking a little bit different tack towards deals in the semiconductor space. Those guys that have chosen to lever up and do things have not been received as well. Does this weigh into your thinking at all? And can you give us an update on how you view M&A and what the opportunities you see out there today?

David A. Zinsner - Senior Vice President, Finance and Chief Financial Officer

Yeah. I think that for us, we have a pretty high bar. We have a high bar in terms of it's got to add innovation that's core to what we do. It's got to hit the customer base. It's got to be something that the customers turn around and say, well, that was a good idea. We really needed you to have that technology. And then it's obviously got to check the box on all the financial parameters that we have. And like I said, the bar is pretty high in terms of what we'd like to see from that perspective.

And so I think that in that regard, we take a pretty kind of systematic, disciplined approach to it. That's the reason we did Hittite, and that's the reason we haven't aggressively tried to find other deals just to fill the coffer with an M&A pipeline. What we've done is we've been carefully looking. I would tell you that we've kicked the tires on a lot of different ideas over the last year or so, and not one of them has reached the high bar that we set. That's not to say that there won't be one down the road, and I think when that happens, we'll go to our shareholders, and I think we've – given the bar we set, we'll give them a pretty compelling reason as to why we want to utilize their precious cash to go do that acquisition. And so I think it will end up being positively received in that case. I think when you're doing M&A for the sake of M&A, that's when things tend to turn on you.

Operator

Our next question comes from Tristan Gerra with Baird.

Tristan Gerra - Robert W. Baird & Co., Inc. (Broker)

Hi. Good morning. Dave, a follow-up to a prior question. What's your sense of the timing for the initial ramp in 5G? And what's the percentage content increase ADI has relative to 4G and also what geographies for the highest growth opportunity for the remaining leg of 4G growth?

David A. Zinsner - Senior Vice President, Finance and Chief Financial Officer

Yeah. So I mean usually when you go transition from generation to generation, it's easily into the double digits bomb increase when those transition. I can't tell you when exactly 5G will roll out. I'm going say it is a few years away at this point. There might be little pockets of early adoption, but most of that is a couple years away, I think, for us. But when it comes, we're well positioned for that.

4G is pretty well certainly deployed in North America, although I think there are areas where it needs to be densified. China still has a few things to roll out. They change, I think, sometimes what they're – the way they want to deploy that technology. But over time, over the next couple of years, I think they will be in a good position. The rest of the world is actually, outside of maybe a few areas like Korea or something, are actually in pretty old generations, particularly in Europe. And so I think there's a lot of room for 4G deployment before we even get into where the 5G takes us.

Vincent T. Roche - President, Chief Executive Officer & Director

4G still has a lot of legs. As Dave said, it'll be multiple years before 5G comes into play. And you might be surprised to know that if you take the typical customer that we have in the base station area, the macro base station area, the product replenishment rate of the radio is very frequent. There are many, many new radios developed every month for different regions, different spectral usage and so on and so forth within 4G. So there's a lot of innovation and a lot of edge that we can still bring in terms of technology to 4G. And that's what we're doing.

When we make the step to 5G, the frequencies increase, the data rates increase. It's got to be much more spectrally efficient than 4G. It needs lower latency and so on and so forth, and all to drive the improved coverage and the quality of service. So when that happens, we will have been at the forefront of helping our customers architect what 5G looks like in terms of the radio. So it will be multiple years, but I'm still bullish on 4G and what we can do in that area in terms of bringing ever increasing levels of innovation and increasing our footprint there.

Tristan Gerra - Robert W. Baird & Co., Inc. (Broker)

Great. Thank you.

Operator

Our next question is from Deepon Nag with Macquarie.

Deepon Nag - Macquarie Capital (USA), Inc.

Yeah. Thanks, guys. Dave, the dividend increase that you did is probably the lowest – I think it's the lowest you've done since 2009, but repurchases in Q1 were at a very high level. So is there a change in the way you guys kind of view your mix of returning capital? And then on fiscal Q2, are you going to take any more inventory reserve? Because the gross margin leverage I guess is a little bit lower than I would've thought just given the mix in the ramp and utilization rates.

David A. Zinsner - Senior Vice President, Finance and Chief Financial Officer

Yeah. So, no. I mean philosophically I guess at the top, we really want to deploy 80% of our cash back to shareholders. And I think the way we look at it is we try to maintain a balance. Clearly, the stock has weakened a bit since its peak, and so we recognize that the buyback is probably going to be fairly active for at least some period of time. And so I think that was really the primary reason why the dividend increase was smaller, because we're trying to maintain the balance to get the return to 80%. I wouldn't read into anything more than that. We do have a stated target that will kind of stay between 5% and 10% a year increases in the dividend. This still stayed within that range, but as you point out, was in the lower end, because we think the buyback will be a bit stronger.

From an inventory reserve perspective, we think we have taken care of that situation and that we don't expect that to repeat in the second quarter. I'd say the primary reason why the gross margins haven't – I think they got up to north of 66% probably in the second quarter of last year. And the reason they are about 100 basis points below that is because of the utilization levels. We aren't ramping the utilization up quite as much this quarter versus last year at this time. And fundamentally, it's just I think a mix. There are certain things that get done internally, certain things that we leverage outside partners for, and the way the revenues going to fall out, I think for the second quarter is going to be a little bit more disproportionately to the outside wafers that we get from foundry. And so as a result, we won't be cranking the factory up as much in the second quarter.

On top of that, we are focused on the inventory levels of the product we build internally, and we didn't want that to get too high. So hopefully in the third quarter and fourth quarter, this momentum that we think we have in the B2B space continues. That certainly had more wafers manufactured internally, and so we'd expect to see the utilization come up over the course of the year, and that should be a pretty good tailwind to gross margins.

Operator

Our next question comes from Tore Svanberg with Stifel.

Tore Svanberg - Stifel, Nicolaus & Co., Inc.

Yes. Thank you. I just had a quick follow-up. Could you tell us a little bit about the thinking behind carrying $1.7 billion of debt?

David A. Zinsner - Senior Vice President, Finance and Chief Financial Officer

Yeah. Good question, Tore. So as we came into like that December month, we knew that we had a $375 million bond that was coming due in April of this year. We also thought that we might be using some of the U.S. cash in the near term for an acquisition, and the rates were pretty attractive. The market was pretty excited. And we were particularly excited by the fact that we could get 30-year debt in some cases, or in some amount, at rates that on a tax effective basis would be kind of less than the dividend yield. So we thought that those things combined meant that it would be a good idea to go into the market, get the cash, and be ready.

As it turned out, the acquisition that we were thinking about we didn't end up consummating. We did refinance the bond, so that utilized some of the cash that we raised. The rest of it does sit on our balance sheet in the U.S., but I think we will over time find very good accretive uses for that cash. It was relatively cheap money. We will look to use it in situations where we need U.S. cash for M&A. As I mentioned, we're using some of the cash for buybacks, and so that will obviously be an accretive use of the cash as well. So in terms of net cash, which is the number we are most focused on, we think we'll find ways to kind of bring that down over time.

One of the disconnects we have is we generate two-thirds of our cash offshore. But all of our uses like some of the M&A and certainly the buyback activity utilize U.S. cash. And so we sometimes need to add leverage to the U.S. balance sheet in order to make those happen. And the cash accumulates offshore.

Operator

Our final question comes from John Pitzer with Credit Suisse.

John William Pitzer - Credit Suisse Securities (USA) LLC (Broker)

Yeah. I was going to ask the debt question, but I'll ask another one. Vince, can you talk a little bit just about within the consumer space how we should think about sort of pricing over time and your ability to bring down costs on your solutions that you bring to the consumer market, especially as you go into sort of second-generation and third-generation products from your customer?

Vincent T. Roche - President, Chief Executive Officer & Director

Well, John, we're very discriminating in terms of how we play the game everywhere, not just in consumer, everywhere. But particularly in consumer, we've been very clear that we need to have a strong grasp of the complexity of the application and the quality of the solution that we're bringing. So we're playing really at the high-performance edge. There are many, many things that we can do, but we are very discriminating about the things we take on. And we are – that's the basis in which we are playing. So we are leveraging, if you like, precision core technology that we sell into many, many different sockets and many, many different applications. And I think it was Ali said earlier that if we hit the right places, we get terrific ROI on a technology that we customize in a particular application space in consumer. So I mean, that's the thesis. That's how we play within that space, and when we hit it, we hit it very, very well.

Ali Husain - Treasurer and Head of Investor Relations

Great. Well, thank you, John. Thanks for all our callers this morning. I have to admit I do like this morning call. So as a reminder, our second quarter 2016 results will be issued Wednesday, May 18, 2016, at 8:00 AM Eastern, and the earnings call will begin two hours later at 10:00 AM Eastern. So thanks for joining us this morning. We look forward to speaking with you soon. And for those in Massachusetts, enjoy the school vacation week. Thanks.

Operator

This concludes today's Analog Devices conference call. You may now disconnect.

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