Analog Devices' (ADI) CEO Vincent Roche on Q2 2016 Results - Earnings Call Transcript

| About: Analog Devices (ADI)

Analog Devices, Inc. (NYSE:ADI)

Q2 2016 Results Earnings Conference Call

May 18, 2016 10:00 AM ET

Executives

Ali Husain - Treasurer and Director, IR

Vincent Roche - CEO

Dave Zinsner - CFO

Analysts

Tore Svanberg - Stifel

Ambrish Srivastava - BMO

Jeriel Ong - RBC Capital Markets

John Pitzer - Credit Suisse

Stacy Rasgon - Bernstein Research

Craig Hettenbach - Morgan Stanley

Craig Ellis - B. Riley

Vivek Arya - Bank of America

Vince Celentano - Raymond James

Ross Seymore - Deutsche Bank

Romit Shah - Nomura Securities

Doug Freedman - Sterne Agee

Philip Lee - Citi

Harlan Sur - JPMorgan

Mark Lipacis - Jefferies

Ian Ing - MKM Partners

Stephen Chin - UBS

John Pitzer - Credit Suisse

Steve Smigie - Raymond James

Operator

Good morning and welcome to the Analog Devices Second Quarter Fiscal Year 2016 Earnings Conference Call, which is being audio webcast via telephone and over the web.

I would like to now introduce your host for today’s call, Mr. Ali Husain, Treasurer and Director of Investor Relations. Sir, the floor is yours.

Ali Husain

Great, thanks, Jennifer. Good morning, everyone. Thanks for joining the Analog Devices second quarter 2016 earnings conference call. You can find our press release, relating financial schedules, and the investor toolkit, which includes additional information that we believe will be useful for investors and all that is at investor.analog.com. As usual, I’m joined by ADI’s CEO, Vincent Roche; and ADI’s CFO, Dave Zinsner. So, before we start, let’s get recent 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 with that, let’s get started.

Revenue in the second quarter totaled $779 million, which was up 1% sequentially and down 5% from the prior year. On a sequential basis, our business to business or B2B markets of industrial, automotive and communications infrastructure experienced broad-based demand, growing 9% sequentially and more than offsetting a weak consumer market.

So, let me give you a little color on our performance by end market. While overall macro trends were fairly mixed during the quarter, ADI’s highly diverse industrial markets grew 11% sequentially and represented 49% of revenue. All of the major application areas within industrial such as factory automation and industrial instrumentation grew sequentially in the seasonally strong second quarter and we also had a particularly strong performance in the aerospace and defense vertical. The automotive market at 18% of sales grew 9% sequentially in the seasonally strong April quarter; growth was broad-based across all of our automotive focus applications of safety, ADAS, powertrain and infotainment.

Turning now to communications infrastructure, last quarter we talked to about a nascent recovery in this market and we’re happy to report this trend continued during the second quarter. Revenue from communications infrastructure customers at 23% of sales increased 4%sequentially, with both wireless base station and wireline applications revenues increasing over the prior quarter. After troughing in July of last year, communications infrastructure revenues have grown at a slow and steady pace, and we believe we’re still in the early stages of a recovery in this market. So, in total, ADI’s B2B markets of industrial, automotive and communications infrastructure grew 9% sequentially in the second quarter.

In the consumer market, revenues decreased 37% sequentially. At current quarterly run rates, we believe that our consumer business is at trough levels. In total, consumer represented 10% of revenue in the second quarter.

So, now, I would like to turn the call over to Dave for details of our financial performance in the second quarter. With the exception of revenue and other expense, Dave’s comment on our second quarter P&L line items will exclude special items, which in the aggregate totaled $33 million for the quarter. When comparing our second 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, with that, Dave, it’s all yours.

Dave Zinsner

Thanks, Ali and good morning everyone. Our strategy to focus on diverse products, customers and markets enabled really good performance in the second quarter. We also repurchased $214 million of our stock in response to price volatility, which enabled the third consecutive quarter of share count reduction. Revenue in the second quarter totaled $779 million, and diluted earnings per share was $0.64 with both results above the midpoint of guidance.

Gross margin of 65.8% increased 360 basis points from the prior quarter, primarily on lower inventory reserves and on factor utilization rates that increased to the low 70s. Inventory on a dollar’s basis decreased $5 million sequentially and on a days’ basis increased to 138 days, as we staged inventory for an anticipated consumer of revenue ramp and manage Hittite related last time buys. We expect both dollars and days of inventory to decrease over the next two quarters.

Turning to inventory in the distribution channel, inventory distribution on a dollar basis was modestly higher than in the prior quarter, and weeks of inventory in distribution decreased to seven weeks from the prior quarter’s seven and a half weeks. Operating expenses increased 3% sequentially to $272 million, in line with our plan. Operating profit before tax of $240 million increased 12% sequentially and as a percent of sales expanded 300 basis points to 30.8%. Other expense in the second quarter was approximately $13 million and that represents the run rate of our net interest expense. Our second quarter tax rate was approximately 12%. We expect our non-GAAP tax rate for the remaining two quarters of the year to be approximately 12.5%. Excluding special items, diluted earnings per share of $0.64 increased 14% over the prior quarter.

Our business franchise forms the foundation of our strong balance sheet. At the end of the second quarter, we had $3.8 billion in cash, net cash of $2 billion and a leverage ratio of 1.3 times EBITDA. We also have $1.7 billion of liquidity in the U.S. which we plan to use for investments in our business and for general corporate purposes including dividends, share repurchases and acquisitions.

During the second quarter, free cash flow as a percent of revenue increased 190 basis points from the prior year to 37.8%. Excluding a onetime item, over the last 12 months, ADI has generated $1 billion in free cash flow. And over this period, we have also returned that $1 billion to shareholders through dividends and share buybacks, effectively returning a 100% of free cash flow, over the past 12 months.

During the quarter, we paid $130 million in dividends to shareholder. And earlier this week, our Board of Directors declared a cash dividend of $0.42 per outstanding share of common stock. This will be paid on June 7, 2016 to all shareholders of record at the close of business on May 27th. At the current stock price, this dividend represents an annual rate of about 3%.

M&A is a key part of our strategy to accelerate technology leadership and revenue growth. During the quarter, we acquired SNAP Sensor, giving ADI the ability to provide very high dynamic range industrial imaging solutions in smart city and smart building applications.

So in summary, this was a good quarter on several fronts. The diversity and breadth of our business coupled with strong execution enabled revenue and diluted earnings per share results that were above the midpoint of guidance, and our capital allocation strategy enabled a significant return of cash to shareholders.

So, now turning to our outlook and our expectations for our third 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. We are planning for another quarter of sequential revenue growth in the third quarter. In our B2B markets, we are seeing stable order rates across the industrial, automotive and communications infrastructure sectors. And as a result, we are planning for aggregate sequential demand in these B2B markets to be largely seasonal in the third quarter. Importantly, we expect our B2B markets in the aggregate to grow in the mid to high single digits on a year-over-year basis in the third quarter.

In the consumer market, good design traction in the portable sector leads us to plan for sequential revenue growth in this market, although it is likely that this revenue growth will be back-end loaded and occur late in the third quarter.

In total, we are planning for revenue in the third quarter to increase sequentially and be between $800 million and $840 million. We expect gross margins to remain stable to their second quarter levels, despite utilization rates in the low -- in the 60s range, as we expect lower spend levels and manufacturing efficiencies to offset the lower absorption. We estimate that operating expenses will be up slightly in the third quarter but that they will lag our expected sequential revenue growth, and we expect even greater operating leverage in the fourth quarter. Based on these estimates and excluding any special items, diluted earnings per share are planned to be in the range of $0.66 to $0.74.

We firmly believe that our future success is within our control. To that end, we are partnering with customers and innovating with impact to drive business success and more importantly, shareholder return. With a strong business model and a focus on the right end markets, we are confident that we can drive ADI’s non-GAAP EPS to up to $5 by 2020.

Ali Husain

Great, thanks Dave. All right, folks, before get to the Q&A, let’s run through the format. Please limit yourself to one question. If you have a follow-up, we ask that you please re-queue and again, we do this in the spirit of fairness that all callers get to ask at least one of their questions. And we plan to run the call until 11. So, I think we’ve got plenty of time to get to everyone’s questions. And so with that, operator, let’s start the Q&A session, and folks on the line can ask questions of either myself, Vince, or Dave or myself.

Question-and-Answer Session

Operator

[Operator Instructions] Our first question comes from the line of Tore Svanberg with Stifel.

Tore Svanberg

Just a question on your communications business; you said it’s been steadily improving since I guess almost a year ago now, but that was still in the early days of some good momentum there. So, can you just elaborate a little bit on that, perhaps maybe both on the wireless and on the wireless side please?

Dave Zinsner

Yes. So, Tore, as you point out, I’ll start and Vince maybe finish up. But, we troughed around the third quarter of last year and obviously a lot of the weakness last year was related to China investigation. That seem to run its course and we’ve been steadily improving up to the levels that I think we saw right around in the second quarter of last year. I think our position in the marketplace is quite strong. We literally have any OEM that’s building base stations or wireless infrastructure communication equipment users or radios. We also expect that over the next few quarters, we’ll start to see a more meaningful rollout of small cell activity in China. We think that will be a good growth driver. We have the lead position from a technology perspective in integrated transceivers, which is going to be the technology of choice in that space. So, I think we are in great competitive position. The smart cell activity is going to help drive the momentum just aggregately in the marketplace. And then this whole headwind that we saw in China has started run its course obviously and we’re starting to see the recovery there. So, the momentum and the wind is behind ourselves at this point in communications space. Obviously it can be lumpy at times. But, right now, based on the order flow, we are quite optimistic about the comm space.

Operator

The next question is from Ambrish Srivastava with BMO.

Ambrish Srivastava

I had a question on the guidance, and I’m just trying to understand the consumer guidance and we’re notoriously bad in trying to predict Apple [ph] units. But if you look at the guide, it looks like it could be a factor of either lower units than what most of us were modeling for or lower ASP or just the overbuild looks so high that it’s taking a longer time for all that to bleed through the channel; what’s the right way to think about it? Thank you.

Dave Zinsner

I think the way to think about -- I guess you are talking about the third quarter. I think really the third quarter, as you compare it against the third quarter of last year, is really the dynamics around when the buildup is going to occur this year versus when it occurred last year. I think because we were new player in that particular application with a new product, our customer ramped a few months earlier than typical for their semiconductor vendors in an effort to make sure they had everything in the pipeline they needed. I think now, we’re going to be more consistent with most of the other semi-vendors out there that supply into this particular application. And really that means that we really don’t see the demand pick up until the July timeframe. So, it’s probably going to be more of end of third quarter and more into the fourth quarter this time versus last year where it was more of a ramp in the third quarter.

I would point out that we have -- or I should say, we suspect we have more dollar content in that particular application this year versus last year. And so, from a form perspective, we will actually be in a better position. And so, it obviously again depends on how this demand of the end product goes. But, assuming that goes fine, we will actually see pretty good growth.

Operator

Your next question is from Amit Daryanani with RBC Capital Markets.

Jeriel Ong

Hey, this is Jeriel on behalf of Amit. Thanks for letting me ask a question. I guess looking to industrial business; it’s been down year-on-year for a few quarters now. It looks like, given guidance, you might grow year-on-year in July quarter. Will we see the growth accelerate, as you get into the back half of 2016 and then into 2017?

Dave Zinsner

Well, industrial is hard to predicted out four weeks. So, I don’t know that we are ready to predict what it’s going to do out several quarters. I would say that yes from our guidance, you can interpret that we suspect the industrial business is going to be up year-over-year in the mid single digits or so, Ali? Yes. And as a result, we think we are back in a recovery phase there. It has been weak probably related to kind of the phenomena around oil and gas weakness and maybe some currency issues; that seems to have run its course. And as a result, we think we are back on our recovery trend in the industrial space. The one area of that business has actually beaten the kind of the macro headwinds has been the aerospace and defense business. That’s done very well for us, even despite the weakness we see out there on the macro side. And as it looks out into the future, it looks like that business will continue to be a pretty strong business for us.

Operator

And our next question comes from John Pitzer with Credit Suisse.

John Pitzer

Dave, I just want to talk a little bit about the gross margin guidance for the July quarter. If I look on a year-over-year basis, gross margins are going to be down a little bit, year-on-year, despite the fact, that I think you said in your prepared comments that the B2B business should be up actually kind of high single digits year-over-year. Can you just help me kind of square that circle and help me better understand, why margins wouldn’t perform better if B2B is showing such good year-on-year growth?

Dave Zinsner

It’s a good question, John. We’re actually going to bring utilization down in the third quarter into the kind of 60s level; it was actually I think in the 70s last year. And that’s really -- when we look at our inventory levels, even though most of the inventory build was related to things within our control like ramping up or the consumer ramp and also for build up related to some foundry transfers that are going to occur related to our Hittite business, we really wanted to keep inventory in check. And so, we thought it would be a good idea to bring the inventory down in the products to get -- or related to the products that get manufactured internally. So, that’s really why we approached it that way. We’re probably going to bring it down -- I don’t know somewhere 10 percentage point range at least. And that normal would have a 100 basis-point negative impact on us but what we’re going -- what we think we can do is take some of the cost out of the factory in the third quarter. And we think we will make some improvements from an efficiency perspective. And those things combined will offset a lot of that headwind. And as result, we think it will be generally flat.

Operator

Your next question is from Stacy Rasgon with Bernstein Research.

Stacy Rasgon

Hi guys, thanks for taking my question. I wanted to dig a little bit on automotive. Over the last couple of quarters, you sort of talked about expecting a bit of a second half lift in that business, but now you’re sort of talking about seasonal in aggregate for Q3. Frankly, given the rest of the guidance you’re talking about, if industrial’s up like in the mid single digits year-over-year and the overall B2B is up in the mid to high, like I’m coming up with auto probably flat to down year over year, and probably down decently sequentially, which I think would be seasonal. But neither of those seem consistent with a lift in the back half. So you’re sort of backing off on that statement you made previously, or like how should we be thinking about automotive as we move through the rest of the year?

Vincent Roche

Stacy, we’ve had stellar growth. We’ve pointed out before that there is one particular area that we’ve had a headwind. We believe that headwind has a basis. We’ve had good growth in areas like infotainment, advanced driver assistance; in the powertrain area, we’ve had good growth. Specifically in active and passive safety, we’ve had some issues. And as I said, I believe the headwind has abated there. So, my sense is that with the programs we have in place, we will start to see -- we have bottomed out in the auto MEMS area in terms of the decline. So, we will be back on a growth track over the coming months and into the, during 4Q. So, I think the worst is behind us there and will get back into a decent growth pattern from here on in through FY17.

Stacy Rasgon

Is it, your Q3 outlook for auto was probably flat to down year over year then?

Ali Husain

No. Stacy, let me just point out -- let me just make a slight correction here. I think when Dave was talking about mid to high singles in the third quarter on a year-over-year basis, I think the comment was specific to the B2B market. Industrial, we expect to be up on a year over year basis in the very low single digits. And so, as a result, I think when you look out to the third and fourth quarter, what we’re expecting to see the automotive business, it is to see some modest year over year growth that we think we can accelerate through the back half of the year here. It hope that helps; does that help?

Stacy Rasgon

Yes, thank you.

Operator

Your next question is from Craig Hettenbach with Morgan Stanley.

Craig Hettenbach

Thanks. Just a question on the increase in cash return, just really setting up the last couple of quarters, I mean clearly you guys are generating a lot of cash and have a very strong balance sheet. But, just wanted to kind of get your sense of how much is opportunistic versus how much may be providing a read on the M&A side, what might be out there and how you’re approaching that?

Dave Zinsner

We still have $3.8 billion of cash. So, it’s not like it’s massively influential to how we’re thinking about M&A. We’re still interested in acquisitions and that part of our strategy. Obviously, we have a high bar on those acquisitions, so they don’t come every quarter. But, we do want to have some dry power available to us, to make those opportunistic acquisitions that A, can be very strategic for us in terms of driving growth and they are very synergistic with what we’re doing from a customer perspective but B, also deliver a very good financial performance and hopefully accelerate our earnings growth.

As far as, just the level of buyback that we had in the last couple of quarters, I’d say it’s a couple of things. One, it’s somewhat programmatic, in that when the stock has these dips in the stock price, we take advantage of that and buy stock back. And so, I’d say over the last couple of quarters, there were those periods of time where that happened and on the average, we bought a bit more back than we had been in the past. And also, we just fundamentally believe that best is yet to come for us. And we think that $5 target is a doable target for us. And if that’s a doable target, then buying at this price is a pretty attractive price. So, those two things combined drove us to be a little bit more aggressive with the buyback over the last couple of quarters, kind of in response to both the stock as well as our expectations on value.

Operator

And your next question is from Craig Ellis with B. Riley.

Craig Ellis

I wanted to follow up on the increase on both automotive and industrial. Those businesses in the outlook look like they are back to nice year-on-year growth. So, my question is since those are both businesses that have significant application diversity, where are you seeing the strongest year-on-year gains? And where within those businesses do you still have sub segments that would be below last year’s level and what’s the prospect for those to reach new highs? Thank you.

Vincent Roche

Well, specific to the industrial area, we have seen tremendous growth in the aerospace and defense area over the last number of quarters. That’s been also both through the acquisition of Hittite; that’s helped us a lot. We have been able to combine the franchises of both companies and keep more growth up there. I would say broad-based instrumentation across the globe has done well. And if you extract oil and gas from the factory and process automation sight of things, we have seen good growth there too. And geographically, I would say in the recent term here, both the Europe and China have seen particularly strong growth. On the kind of the muted [ph] side there, I would say, on the slower growth side of things, the automotive test equipment and energy sectors have been more turbulent. Energy is flatter but the ATE things are quite turbulent. So that’s kind of the picture in terms of the puts and takes on the markets, the sub sectors and geographies there.

As I said earlier in terms of automotive, we have seen stellar growth in infotainment, in powertrain and advanced driver assistance. And we have been dealing with this headwind on the automotive safety, the passive safety and active safety side of things. Geographically, if I look at automotive, again, America has been very respectable, Europe has been stronger, and China and Japan have been relatively flat. So that gives you, I think a picture of both of those sectors from a sub segment and geographic standpoint.

Operator

Your next question is from Vivek Arya with Bank of America.

Vivek Arya

Just on the Q3 outlook, I think you may have addressed it at different parts of the call, but could you just give us some more color on each of the B2B segments, how you expect them to trend on a sequential basis? And more importantly, how that compares to what you thought say two or three months ago about those segments? Thank you.

Dave Zinsner

Yes, sure I can take a crack at it. So, industrial, I would say sequentially is probably going to be up in the low single digits. Automotive is likely to be down in the low single digits. I would point out that that’s probably better than what you normally see seasonally, even we have July in our quarter and that tends to be a soft month for the automotive market. And then comm is probably close to mid single digits, somewhere in that range.

I would say, it’s pretty consistent with where we thought we would be a few months ago. Nothing has changed. The macro is hanging in there nicely. The water flow in all three of these markets has been pretty good. We are obviously always running the business cautiously, any event that something in the macro gives us a hiccup, but that hasn’t happened. And we are I guess pleasantly surprised or happy that that’s how things panned out for us. And so hopefully this continues.

Operator

Your next question comes from Steve Smigie with Raymond James.

Vince Celentano

This is Vince Celentano on for Steve. I had a question, has there been any more progress in gaining your force touch technology adopted at OEM, either within mobile or other end markets? I guess in general, what’s your plan going forward with this technology?

Vincent Roche

That product source is based on a core technology that we use in multiple applications and industrial automotive and so on and so forth. So it’s not a case -- the product sector is specific to one application but the technology is usable in many, many different applications. It’s based on our precision signal processing expertise that we have been developing for decades. So, as I said, we are all the time looking to diversify, be it consumer be it industrial but whichever sector, all those products are based upon the core high performance precision signal processing platform that we have been developing for decades.

Ali Husain

Vince, just as a point, we don’t comment on individual customers or products. So, appreciate the question, but will move on our next.

Operator

Your next question is from Ross Seymore with Deutsche Bank.

Ross Seymore

Hi guys, you gave great color on the wireless side of your comms business. Can you just give us a similar update on what you are seeing in the wireline side? And maybe remind us what the split between those two portions of your comms business end up being these days.

Dave Zinsner

Yes. So, two thirds of our business is wireless and then the other third is wired. There are several applications within wired but probably the most prominent is control that goes into the optical signal. Obviously that market is doing quite well because there is a move towards 100G and that’s obviously beneficial for us. So, it’s been on a pretty steady -- so, good news on this one is it hasn’t had the lumpiness that the wireless business has had. So, it’s been on a pretty steady growth trajectory. It moves around based on seasonality but year-to-year, it’s been pretty steady and solid.

Vincent Roche

Yes. We’ve been successful moving between the various generations of optical transceivers from 2.5 gig right up to a 100 gig now and beyond. So, we’ve built a nice franchise, again based on our signal -- our position signal processing portfolio where we are providing sophisticated very, very precise control of the optical signals. So that’s the primary part, as Dave said, of our wireline business. Other aspects in which we have a good position are in the data packs and control packs in cable infrastructure, but far wireline is dominated by the optical technology that we -- the optical products that we provide.

Operator

Your next question is from Romit Shah with Nomura Securities.

Romit Shah

I just wanted to talk about consumer -- my understanding is January 2015 was the last quarter before you guys started booking force touch revenues. And in that quarter consumer was about $95 million; this last quarter consumer was down to $80 million. So, it implies that the business overall has got about 16% from that January 2015 baseline. And I guess excluding force touch, your legacy consumer business is down even more than that. And so, hoping that you can guys talk about the performance of that business and legacy consumer in particular and your expectations going forward.

Vincent Roche

Legacy consumer has been for -- it’s a huge number of different applications. We have a steady strong business in areas like high-end digital consumer for home and for enterprise and that’s been doing well and continues to do well. It’s a very, very modest investment for the Company. So, my sense is that’s been growing at kind of low single digits for many, many years. My expectation again given that it looks a lot like our B2B business in terms of design cycles, product cycles, that will continue to be a modest growth story for ADI in the years ahead. And it leverages; we do very, very little specific product development for that sector. In terms of the remainder of the business, it’s lumpier by nature. And we have a good -- as best we can tell, we read the signals pretty well and we’re managing supply and demand on the basis of what we’re reading in those more volatile portable consumer applications.

Romit Shah

I appreciate the comments. I don’t that I’m coming away with the clear understanding for why the legacy business has contracted this much over what’s been about five or six periods.

Dave Zinsner

Well, it has been a headwind for six years or so, six or seven years, so, mainly because of the digital still camera business which has been kind of -- obviously everybody is using their phones to take most of their pictures. And so that business is waned a bit. It’s down at this point now as we sit in 2016, pretty nominal level at this point. And so, I wouldn’t anticipate it being much of a headwind going forward. There is a certain amount of people that will always buy new digital SLR cameras. I’m looking at Ali because he’s one of them. So, I think at this point now it’s probably stabilized.

Operator

Your next question comes from Doug Freedman with Sterne Agee.

Doug Freedman

If I could ask a question regarding the consumer business as well, when we look at sort of the business coming back in with handsets contributing materially here, how do we think about the incremental margin, both up but as well as when it ramps down, especially given the actions you seem to be taking as far as managing the factory, which may be not coincident with the fab with the ramp up that you are going to see in revenues?

Dave Zinsner

So, this -- all of this product gets manufactured in a foundry, a third-party foundry. So, it doesn’t necessarily affect utilization levels. So, really, it comes down to what we price the product at and what we pay the foundry in the back end to produce the parts. And the margins are respectable margins. And there is a little bit of mix degradation by having that business, but it’s not significant. I think it runs in the tens of basis points, up or down, based on whether we have it in a quarter or we have a meaningful amount of a quarter or not a meaningful amount of quarter. But other than that, I don’t would expect we have much volatility gross margins from it.

Doug Freedman

I guess another way, Dave, just to ask the question, if you were to exclude the impact of this business year on year, do you expect gross margins to be up next year?

Dave Zinsner

Excluding consumer, would we expect gross margins to be up?

Doug Freedman

Yes, to exclude the impact of the consumer ramp up and ramp down, would I expect some gross margin improvements year on year?

Dave Zinsner

Yes.

Operator

Your next question comes from Chris Danely with Citi.

Philip Lee

Good morning, guys. This is Philip Lee calling on behalf of Chris. You guys have mentioned just the inventory was down seven week this quarter. How was this versus may be last year and how do you expect it to turn for the rest of the year?

Dave Zinsner

Typically, the second quarter tends to be a trough of the inventory levels just because it tends to be a really big quarter for ship out and we’re kind of on a ship in basis kind of running it pretty consistently. So, I wouldn’t glean to much from it, other than the fact that it’s at a healthy levels, seven weeks is exactly where it should be in the second quarter and not very healthy. My guess is that in the third quarter, it will start to trend back up to seven and half weeks and stabilize until next year second quarter.

Operator

Your next question comes from Harlan Sur with JPMorgan.

Harlan Sur

Good morning, guys. Thanks for taking my question. On the strength in industrial, you mentioned aerospace and defense as an area of particular strength. Was this segment up year over year and was it more commercial or defense related programs that are driving the strength? I know that there are some programs, both in commercial satellite and radar, there is also some defense program initiatives like some fighter jet upgrades and so on, and what the program pipeline looks like for the reminder of the year? Thank you.

Dave Zinsner

Okay, I’ll take a little bit of crack at that and anybody can join in. It was up year-over-year in the second quarter like we will be up year over year for the full year, unless something changes significantly. Most of the growth that we’ve seen has been in high performance RF specific to military applications. We’ve got a lot of that technology obviously when we acquired Hittite; they were already servicing that market in a relatively meaningful way. And their design wins over several years ago are starting to translate into revenue. And that’s obviously driven the growth in that business. The expectation over the next three to five years is quite positive. I think the areas that where radar applications are deployed are areas where the military is spending more in. And so as a result, that coupled with the fact that how we have a really commanding position in that marketplace, we thus assume that this market for us is going to be a nice driver of growth over the next three to five years.

Vincent Roche

Commercial aircraft, another space where more and more of our technology is being used for all different kinds of signal processing radio upgrades, control and so on and so forth. And also satellite, commercial satellite is an area that’s becoming more and more dominant, if you like and particularly for commercial application. So, I think overall when you look at what’s been happening and what will happen, that aerospace and defense business will continue to grow for the company at good rates.

Operator

Your next question comes from Mark Lipacis with Jefferies.

Mark Lipacis

Hi, thanks for taking my question. Perhaps for you Dave; you were successful in the past in finding tax efficient ways to use overseas cash for M&A. And I was wondering if you would describe the M&A environment today as being a target rich one and of the targets that you’re looking at, is there a good potential to use overseas cash tax efficiently, like you have in the past? Thank you.

Dave Zinsner

Good question. Well, I mean there are lots of ideas in the pipeline; it goes through a number of stage gates. And as it gets closer and closer to the point at which we’re going to pull the trigger on it, those bars get higher and more difficult to get through. So, I think that from an ADI prospective, I don’t think anything has changed in terms of whether you see us to a kind of acquisition on a very frequent basis; I just don’t think that’s our model. But, there are areas that we think make a lot of sense in terms of acquisitions and those are the areas we’re focused on. And so, I expect, we’ll be doing them from time to time to help augment what we’re doing organically. From a tax perspective, it’s always that specific as to which cash we can use, it depends on where it’s located and where their operations are and so forth. But, the extent that it checked all the boxes, I am sure we could do something similar to what we did with Hittite.

Operator

And your next question comes from Ian Ing with MKM Partners.

Ian Ing

I had a question on Hittite. I mean what was the magnitude of the last time buys in the April quarter? What are the expectations in subsequent quarters? And as customers start looking at developing 5G infrastructure, are there some opportunities here for Hittite and microwave products? I know largely microwave is for back haul at the moment in communications? Thanks.

Dave Zinsner

Yes. Hittite will help us a lot in the 5G space. And given our strong position in 4G and our strong relationship with all the OEMs who are developing 5G application, we think we are in a great position to really take a commanding position in the 5G space. On the -- I don’t have the number off the top of my head, unless you know Ali off the top of your head, but second quarter represent a peak amount of builds that we were going to have associated with Hittite. And so as quarters progress now, it should slowly be coming down. I am going to guess it added somewhere between 7 and 10 days to our inventory levels because of those transitions. And as I said, you’ll see a kind of a steady progress. So, one thing is we built up a lot of inventory for stuff that has long lifecycle. And so, it will take some time for us to get all the way down to zero, I think five years, maybe even seven years to get down to zero. But the good news is that the headwind expect of the inventory build is behind us and that will become the tailwind going forward.

Operator

Your next question is from Stephen Chin with UBS.

Stephen Chin

A question on the communications wireless business; I was wondering just given some of your comments around small cells, I was wondering if you could talk little bit about your revenue sensitivity to deployments regarding small cells versus base stations, just given the different levels of content and also the unit deployment? And also, do you have any visibility to put beyond the current quarter, regarding CapEx for either small cells or macro base stations?

Vincent Roche

Yes, I think we are in a very good position in both macro cells and small cells. There is -- more and more of the usage of seller equipment is in building, there may be a switch to small cells over time, but it’s not going to be a gross switch from macro to small. I think there is always going to be a mix of both. So, we are very well positioned, irrespective of whether our customers are deploying macro or small cells. And in terms of content, obviously the small cell has less content than the large cell but we have in terms of the radio we’ve got almost the entire radio in the small cell, given the strength of our software defined transceivers technologies. So, I think what you will see is the deployment will be -- will continue on the macro side, there will be an upsurge in small cell over the remainder of this year into next year. And we are very well positioned irrespective of whether it’s macro or small. What was the second part of the question?

Stephen Chin

CapEx.

Vincent Roche

CapEx, I think the way to look at the CapEx discussion is in terms of innovation. Innovation in play stations is really happening at the radio level to increase spectral efficiency and flexibility. So, there is an increasing amount of the hardware spend going into the radio over time. And with the strength that we have in the franchise, we have got in terms of mix signal and RF and microwave technologies, I think we are very well positioned given the strength of our relationships and the fact that we skewed R&D over the last five years more heavily towards wireless applications. Irrespective of what happens, I believe it will be a fairly stable CapEx environment in terms of the ratio of services software and hardware. But, I think we are well positioned as a Company to grab additional share there, given, as I said, the strength of our technology and customer positions.

Operator

Your next question is from Ambrish Srivastava with BMO.

Ambrish Srivastava

I just had a couple of follow-ups. Just on the A&D strength, is this more primarily a Hittite benefiting from your channel or is it more a result of the last time buys? And then, a little bit longer term, when do we expect to see jointly developed products between Hittite and ADI? And I realize it takes a while for that to pan out. And then a second quick follow-up, Dave, you mentioned that in consumer you will have more content. Is that because you are -- imagine ASD going up, are you designing out sockets from that somebody else had?

Dave Zinsner

So, on the aerospace and defense side, I would say -- I would characterize the growth as product design back in the Hittite days in lot of cases, some on our own products back many years ago that now -- it takes a while for that stuff to turn around and become revenue. And so that’s really what’s driven the performance at this point. It hasn’t been related to Hittite being a part of ADI yet. The opportunity pipeline has significantly expanded because of the acquisitions of Hittite and because of our ability to both sell more of what Hittite sells or makes into that market and also what we make and drive that into that market. And so, I think that we’ll start to see some revenue synergies next year and probably relatively modest next year but begin to ramp significantly over time. And it’s probably on the opportunity side of peak revenues; it’s probably $100 million of opportunity, so not all of that will close on. But, it’s a significant amount of synergies that we were able to get by combining to Hittite and Analog Devices.

Vincent Roche

Yes, in terms of your product development question, the combination of Hittite, maybe on the design side of things, we acquired the technology to enable us to broadly apply microwave technology and build a real leadership franchise in the high end of communications infrastructure, general communication, even industrial instrumentation. So, we already have very, very good synergy between the design teams and looking at the next 5G application; in the 5G application, the next generation of defense driver assistance where there is a lot of microwave technology needed. So, we will start to see the first combined products hit the market over the coming year. And beyond there, I think you will see more complete solutions from ADI, the combination of the old ADI and Hittite together in many, many different markets.

Dave Zinsner

Okay. So, then on the consumer side, we can’t comment specifically on whether or not we are displacing somebody, and if so, who. But I can tell you that we have more sockets in the next generation than we did in the last generation. And that’s what’s driving the bomb to be higher at this time.

Ali Husain

And Ambrish, just slight housekeeping note from me. When you talked about the last time buys, those are last time buys that we made on foundry. So that didn’t impact the revenues really in the aerospace and defense side. So, okay, thanks for the question next caller.

Operator

The next question is from Stacy Rasgon with Bernstein Research.

Stacy Rasgon

One more quick follow-up on consumer; you said that the ramp was going to happen late in Q3, which seemingly would imply potentially a fairly big Q4 sequential ramp, as you annualize that or can you give us some feeling for what the trajectory of that consumer business into Q4 ought to look like? And do you think that it could be -- would it be up or would it be down year-over-year versus last year, because I think Q4 of last year was the peak?

Ali Husain

Yes. Definitely, hard to predict exactly how the trajectory is going to work out. But, I would say, it’s going to be -- you could, if we end up shipping in the last, say two or three weeks of July, we are going to probably be shipping at that level through the entire fourth quarter. So, you can interpret that what you want, but it’s going to be a meaningful ramp in the consumer space in the fourth quarter, at least as things have lined up so far.

On a year-over-year basis, I think given the fact that there was probably a shift in I think you can safely say in the fourth quarter versus what was consumed and that drilled a lot of inventory in the channel. I think on a year-over-year basis, we’re likely to be down in the consumer space. But, I think from a sequential basis, it will look quite nice.

Stacy Rasgon

And so just to clarify, so we’re talking something like $30 million sequential increase in Q3, all of which maybe happening potentially in last couple of weeks? So, I think if we are annualizing that for three months in the following quarter, if you are shipping at that rate, I mean this could be -- you were talking something like a $100 million and maybe more sequentially into Q4 that we could see in terms of increase. Is that the right way to think about that?

Ali Husain

It’s obviously tough to predict but you are probably in the zip code at this point.

Stacy Rasgon

Okay, thank you.

Ali Husain

And by the way, if that did happen as Dave mentioned I think in the prepared remarks, the operating margin leverage we expect to see in the fourth quarter would be pretty strong.

Alright, thanks Stacy. Next caller?

Operator

Your next question is from John Pitzer with Credit Suisse.

John Pitzer

Just staying on the topic of consumer and for both Dave and Vince, investors have been somewhat critical about your exposure here over the last two or three quarters, because it tends to be volatile, it tends to be commoditized; we always worry about how long you can hold on to the business. You guys have done sort of a great job talking about the trajectory for this fiscal year. And when you initially got this business, I think you talked about two years of visibility. I’m wondering if you could just talk longer term how we should think about the consumer bucket. And Dave, you’ve talked about in the past your need just to be strategically engaged with certain customers to broaden out your footprint. Maybe you can talk about your ability to have broadened out that footprint with this customer as we go into FY17?

Dave Zinsner

Yes. So, obviously, they don’t give us a ton of visibility, but next year, it’s as much as we can tell looks to be in pretty good shape for 2017 for this customer. And as I said, we actually got more socket this time around and healthy prior socket all of which are high performance parts that -- and that’s really we are trying to focus on with that customer or any customer, quite honestly not only in the consumer space, but outside of the consumer space in the B2B markets. And that we’re going to maintain that strategy going forward. And I think there is enough to win at that customer in the consumer space to drive growth in the consumer business. And as you point out longer term, there -- and it’s not even just this particular customer but there are a handful of customers that have certainly consumer exposure, but that are more broadly focused in other markets, because a lot of this stuff is conversing. And so, we want to be attached to those customers as they think of new ideas that we can come up with new technologies to help to find their parts and make them better. And that’s what we’re going to do. And so that’s where we direct our research and development dollars. It worked out for us here. And like I say, there will be other things that we do for this customer and other customer and other markets that will help them and help us.

Vincent Roche

As the user experience becomes more and more sophisticated in these applications; that’s in our wheelhouse. We play on the edges of physical and the digital. So, it gives us more opportunity. But, as Dave pointed out, we’re looking for the really hard to solve problems in these applications were we can, hopefully get multiple generations worth of momentum and where we can get the kind of margin performance ratio that we expect.

Operator

Your next question is from Vivek Arya with Bank of America.

Vivek Arya

Thanks for letting me ask another question. Just, Vince, longer term, is the current top line growth rate acceptable to you, and if it is not, do you think it’s time to consider larger and more transformative acquisitions? And how do you think about whether it’s accretion metrics or anything else that we should keep in mind, because the macro environment stays somewhat sluggish, and you managed to navigate through that quite well. But, I’m just curious whether even with this navigation, is the top line growth acceptable to you? And if not, what can you do about it?

Vincent Roche

We’ve said publically that we are committed to generating over $4 of EPS by 2020; we remain committed to that. And when we first offered that target to the investor community back in ‘14, we said that we expected our revenue, our top line to grow at the rate of two to three times GDP, whatever that is. And we remain optimistic about that. We’re investing at a level in terms of R&D and field engage -- customer engagement, and given what we see in terms of the design activity, the customer engagement activity, we remain committed to that top line target. Another component of obviously being able to get towards that EPS target over time is to do careful M&A. And so that is the mix. And we’re committed to our targets; we believe in the growth story. And as I said, we’ll use our balance sheet wisely to get some more high performance technology that will enable the Company to grow at an even greater rate over time.

Dave Zinsner

As far as the acquisition measures we use, there’s probably 15 of them that we use. Obviously accretion plays a factor in it. We look at kind of the relative valuation of the cash flow of a business that we’re looking at to determine whether we’re paying a good price for it. We want businesses that grow and that help us drive our growth faster than we are growing today, so that’s a key component that we believe that that can happen. And obviously we think -- we’re looking for things where we can get synergy, sometimes that’s cost, sometimes that’s cost and revenue. And so those are things that kind of influence us. Sometimes when we’re doing tuck-ins like SNAP Sensor, which we talked about in the prepared remarks, there isn’t much in terms of financial to hang your hat on in the early stages. And so then it really comes down to whether or not the technology really moves to make a difference in our customers’ applications and ultimately the user experience. And that tends to rule the day, when it comes to those tuck-ins.

Vivek Arya

Is there any push from customers to have more integrated solutions? That’s where I was coming from, that is you’re the leader in converters, does it help to gain access to other areas, because that’s what your customers might be asking you to do?

Dave Zinsner

Yes, it’s integrating all the time. We’re developing -- we’re moving in more and more to a system’s levels solution. And so that requires us to have more and more technology, some of which we do acquire, a lot of which we actually build internally.

Vincent Roche

I think what we acquire depends very much on the type of segment we’re addressing. The reason we bought SNAP Sensor was to help us move up the stack to make our solution more complete. We’ve got a very strong DSP high performance signal processing technology platform and product base on to which we needed to add some algorithmic value in that particular imaging application. So, what we acquire and what customers are asking us to do very much is application and market segments dependent.

Operator

Your next question comes from Steve Smigie with Raymond James.

Steve Smigie

Great, thanks for the follow-up. So, last quarter you mentioned that orders were positive but that customers were a little bit worried about the overall weaker macro. Have you seen any changes in their in general outlook since the last call?

Dave Zinsner

No, I think they are pretty much the same; they are cautiously optimistic. The macro is held in there, the order flow has been good. Customers think they are going to -- I think in aggregate think they are going to see modest growth this year. But, they’re obviously very cautious; they are keeping their inventory levels lean. We see obviously that at the [indiscernible] level as well. So that’s -- I think it’s pretty consistent through the whole year really.

Operator

Your next question is from Ross Seymore with Deutsche Bank.

Ross Seymore

Dave, one follow-up to a question you answered earlier on the gross margin side. I know you said you are taking utilization down by roughly 10% sequentially in the third quarter. Can you just talk a little bit about why you are doing that considering that you said that the comms business is in the early stage of recovery; you’re now past the headwinds on the auto side where you had the design loss on the passive safety et cetera. If everything in your core is starting to grow year-over-year, what led you to the decision to cut utilization that substantially?

Dave Zinsner

I mean I know that’s significant, but we had a 138 days of inventory and we want to get that level down, and we felt like we should address it now rather than wait. I would -- like I said in the prior question or answer to the prior question, I think a lot of the inventory is related to product that was manufactured in foundry, but nevertheless, we’ve got work all of the levers to get the inventories to where want them to be. And it seems like an appropriate place to pull it down.

The comms one doesn’t influence us a ton because there isn’t much of that that gets done in internal foundries or internal fabs. Really, it’s in the industrial space, which is kind of plugging along kind of a low growth rate at this point. So, it seemed like we weren’t taking a big risk by adjusting the production. I would say that, I think it’s a one quarter event. When you take down inventory levels, you take down the utilization rates generally, you shut the factory down. And so we will be taking I think on average two weeks of shut down in our internal fabs. I would suspect that we will be back to not doing that in the fourth quarter. And so utilization should come back up again in the fourth quarter.

Ross Seymore

And one other housekeeping one. You were gracious enough to say your content is going up with a specific customer. Relative to what you had in the prior generation, did the content increase just order of magnitude a similar amount ass the prior socket, half, double; any sort of color directionally would be helpful.

Dave Zinsner

Yes, I probably have to avoid these kind of pricing and things. It’s not to the level of the prior socket; let’s put it that way.

Ali Husain

Well, it looks like Ross was our last question, so that will close out the call. As a remainder, our third quarter 2016 results will be issued on August 17 at 8:00 a.m. similar to this quarter, and we will have the earnings call at 10:00 a.m. So that does it for us here. Thanks for joining us this morning, and look forward to talking you soon.

Operator

Thank you. This concludes today’s Analog Devices conference call. You may now disconnect.

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