Analog Devices' (ADI) CEO Vincent Roche on Q4 2016 Results - Earnings Call Transcript

| About: Analog Devices (ADI)

Analog Devices, Inc. (NYSE:ADI)

Q4 2016 Results Earnings Conference Call

November 22, 2016 10:00 AM ET

Executives

Ali Husain - Treasurer and Director, IR

Vincent Roche - CEO

Dave Zinsner - CFO

Analysts

Ambrish Srivastava - BMO

Tore Svanberg - Stifel

Tristan Gerra - Baird

Craig Hettenbach - Morgan Stanley

Chris Danely - Citigroup

Amit Daryanani - RBC Capital Markets

Craig Ellis - B. Riley

Stacy Rasgon - Bernstein Research

Blayne Curtis - Barclays

Ross Seymore - Deutsche Bank

David Wong - Wells Fargo

Steve Smigie - Raymond James

William Stein - SunTrust

Vivek Arya - Bank of America Merrill Lynch

John Pitzer - Credit Suisse

Chris Caso - CLSA

Toshiya Hari - Goldman Sachs

CJ Muse - Evercore

Romit Shah - Instinet

Ian Ing - MKM Partners

Harsh Kumar - Stephens

Cody Acree - Drexel Hamilton

Stephen Chin - UBS

Operator

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

I’d 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

Alright, great. Thank you, Jennifer. Good morning, everybody. Thank you for joining ADI's fourth quarter and fiscal 2016 earnings conference call. You can find our press release, relating financial schedules, and the investor toolkit at their usual spot, at investor.analog.com. And specifically about the investor toolkit, it's something we post on our website two hours before the earnings call and it's actually a pretty good summary of our prepared remarks. So, for those that are interested in kind of getting the early scoop, that's probably good place to go, as we file our press release.

With me on today's call are ADI’s CEO, Vincent Roche; and ADI’s CFO, Dave Zinsner. Before we start, let’s do our disclosures. Please note the information we’re about to discuss, including objectives, outlook and the proposed acquisition of Linear Technology Corporation, 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-K. 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've 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. And I'd like to turn the call over to Vincent Roche, our CEO.

Vincent Roche

Thank you, Ali, and good morning, everyone. By almost any measure, ADI had an excellent fourth quarter. To put it in perspective, we achieved record revenue of $1 billion, expanded operating margins to a record 38% of sales and we generated record free cash flow margins of 44%. Throughout fiscal 2016, as you know, caution and uncertainty were the norm across the world. Nevertheless, we executed well in a tough business environment, investing and positioning ourselves for future growth while remaining disciplined and making smart investment tradeoffs.

All told, the actions we took during the year drove free cash flow margins to 33.7%, a 520 basis-point improvement over the prior year. And I’m very proud of the stellar execution by our entire team.

For ADI, it starts with an obsession for customers’ success as I personally spend, as you know, a lot of time talking to and listening to their needs. It’s obvious to me from these conversations that ADI is an exceptional Company and we're more relevant to our customers than ever before. What is also clear is that our customers are seeking true innovation partners, as they grow and develop their businesses in the midst of unprecedented levels of complexity. At the same time, our customers’ hardware engineering talent is stretched thin. As a result, they're increasingly focusing their design efforts on systems and software while turning the analog design challenge to ADI where we have economies of scale and of scope.

With the analog design challenges set to become even more complicated and critical in the area of IoT and Industry 4.0 for example, helping our customers bridge the physical and digital domains in mission critical applications will, we believe, create tremendous opportunities for sustainable profitable growth for ADI long into the future.

Customers choose us because we've been at this craft for over 50 years now. And in our industry, brand matters. The ADI brand is synonymous with high quality and high performance. And our customers rightly have full faith that ADI will support them today and well into the future. We've demonstrated an unwavering commitment to innovation that creates economic value for our customers by investing strongly in our own business.

Since the great recession, ADI has invested $4 billion in research and development alone, primarily in the B2B markets of industrial, automotive and communications infrastructure. We've also made investments in quality, manufacturing, supply chain and field operations because being able to effectively and efficiently deliver high reliability innovation and customer support is just as important as the innovation itself.

In addition to these organic investments, we've been acquiring capability that not only builds our technology base but also enables ADI to move up the value stack. During the year, we announced the proposed acquisition of Linear Technology which once complete will create a high performance analog leader with the combined company having a top-two market share position across all the key building blocks of the analog market, namely data convertors; power management; amplifiers; interface; and high performance RF and microwave. Once the transaction closes, we will have the ability to meet all of our customers’ analog and mixed signal needs in sticky, long life cycle, high value applications in the industrial, automotive and communications infrastructure markets.

During the year, we also acquired some very interesting early stage technologies which we believe will help ADI move up the value stack, as we say over time. The acquisition of SNAP Sensor gives ADI the ability to provide our customers with very high dynamic range imaging capabilities, important in smart city applications, as an example. For smart factory applications, we acquired Innovasic, a developer of the Deterministic Ethernet Switching and Software Solutions to extend our reach in this core market. We also acquired the Cyber Security Solutions of Sypris, giving ADI the ability to provide customers with a trusted sensor to cloud solution with security write down of the node. And just recently, we announced the acquisition of some exciting LIDAR technology from Vescent Photonics that will enable ADI to develop a true solid state scanning LIDAR system complementing our existing RADAR-based ADAS offerings. And these things are very important in autonomous driving applications.

The investments we’ve made and continue to make are helping create economic value for our customers. And I’d like to share a few examples of where ADI’s technology is making a real difference.

In the automotive space, our recently announced A2B Audio Bus structure provides vehicle manufacturers with high-end in-cabin audio fidelity while reducing vehicle weight. We estimate that our solution helps save car manufacturers approximately $30 per vehicle in combined CO2 taxes and fuel efficiency. In the area of factory and process automation, our software configurable input output solutions are solving significant channel density, physical space and thermal challenges while reducing system complexity and installation and wiring costs. And in the healthcare arena, ADI’s vital signs monitoring products are bringing clinical grade care into the home, enabling high-quality remote patient monitoring that reduces or even eliminates the need for and cost of the hospital stay.

Ours is a customer value creation journey, 51 years in the making. We have the intellectual capital and more importantly, we have a talented, passionate and engaged team of ADI to help serve our customers needs today and well into the future. The combination with Linear Technology represents the next phase in this value creation journey.

With our market-leading product portfolios tied to attractive markets, we believe we can create a free cash flow engine that will be unmatched in our industry and help provide investors with an attractive combination of growth and shareholder value from many years to come.

So with that, I’d like to turn the call over to Ali for details on our performance by end market in the fourth quarter.

Ali Husain

Great, thanks Vince. So digging deeper into our results by end market. The industrial market of 39% of revenue increased 6% sequentially; a very strong result in what is typically a weaker period for the industrial business. Revenue from our broad base of small and medium sized customers was better than seasonal and in fact increased sequentially. And the expected rebound in the aerospace and defense sector was also pretty strong. And our healthcare business also posted record quarter as we are now beginning to see the early returns from our investments in the healthcare sector. Compared to the prior year, the industrial market showed actually pretty considerable strength, growing 8% over the prior year, and it was broad based strength across all of the industrial sectors, as we compare the year-on-year performance.

The automotive market at 14% of revenue increased 5% sequentially and that was broad based growth across really all sectors within this market. But I’d say, more importantly, automotive revenues increased 7% compared to the prior year.

Communications infrastructure sales at 17% of revenue decreased slightly from the prior quarter. Both, wireless and wireline application revenues decreased slightly sequentially but increased compared to the prior year, led by growth in a 100 gig plus optical networking applications. The consumer market at 29% of fourth quarter revenue increased 58% sequentially, and decreased 7% compared to the prior year with both sequential and year-over-year results, largely due to portable consumer application sales.

So, now, I'd like to turn the call over to Dave for details of our financial performance in the fourth quarter and in fiscal 2016. With the exception of revenue, Dave’s comments on fourth quarter and fiscal 2016 P&L line items will exclude special items, which in the aggregate totaled $39 million for the quarter. Reconciliations of these non-GAAP measures and our calculation of free cash flow are on schedules E and F in today’s release.

So with that, Dave, it's all yours.

Dave Zinsner

Thanks, Ali. The fourth quarter was once again a very strong and profitable quarter, and we set records for revenue, operating margin, free cash flow generation and earnings per share. Revenue in the fourth quarter totaled $1 billion and diluted earnings per share was $1.05. Gross margins of 66.6% increased 60 basis points from the prior quarter and included a 120 basis-point benefit relating to the sale of previously reserved portable consumer application inventory. Excluding this item, gross margins were in line with guidance, decreasing 60 basis points from the prior quarter, due to mix.

We continue to tightly manage inventories and as a result, inventory on a dollars basis in the fourth quarter decreased $16 million sequentially and inventory on the days basis decreased 17 days to a 105 days. Weeks of inventory and distribution were slightly below seven weeks and we're at the leanest level in six years.

Operating expenses increased 3% sequentially, lagging well behind the 15% sequential increase in revenue. As a result, operating profit hit a record 38.1% of revenue expanding 400 basis points sequentially and 220 basis points over the prior year. Other expense in the fourth quarter was approximately $20 million. Our tax rate in the fourth quarter was approximately 10%, as we adjusted our full year tax rate to approximately 11%.

Excluding special items, our business delivered strong operating leverage, even with low utilization rates. And diluted earnings per share grew 28% sequentially to the $1.05 per share, which was almost twice the rate of sequential revenue growth. We had a record cash generation quarter with free cash flow margins of 44%, expanding 600 basis points compared to the year ago period. Capital additions during the quarter were $41 million and we expect fiscal 2017 capital additions to be in the range of $125 million to $145 million.

During the quarter, we paid a $130 in dividends and our long-term financial model incorporates annual dividend increases of 5% to 10%. At the current stock price, ADI's dividend yield of a $1.68 represents a dividend yield of approximately 2.5%, although maybe a little bit lower now that the stock rose today.

Now, I'll take a moment to talk about our performance in 2016. Revenue of $3.4 billion was stable to the prior year and non-GAAP diluted earnings per share decreased 3% from the prior year, primarily due to lower gross margins and higher interest expense ahead of the Linear Tech deal close. The lower gross margins for the year were primarily the result of a very deliberate and disciplined inventory management program that reduced inventory on a dollars basis by $36 million or 9% and on a days’ basis reduced inventory in the fourth quarter by nine days to a 105 days. Nevertheless, gross margins remained relatively stable to the prior year as we minimized the impact of lower factory utilization rates through pricing and cost efficiencies. The good news is that inventory levels are now in excellent shape.

All told, fiscal 2016 free cash flow margins expanded by over 500 basis points to 34%, setting a new Company record. During the year, we also returned almost $900 million or 77% of free cash flow to shareholders via dividends and share buybacks. Of course, the biggest news of the year was the proposed acquisition of Linear Technology. To-date, we’ve received regulatory clearances in Israel, Germany, Japan and United States. And we now expect the transaction to close by the end of our second fiscal quarter of 2017.

Our integration planning teams are hard at work and we are very pleased with their progress. Vincent put me in charge of the integration effort, and I am confident that our combined Company will be greater than some of its parts.

We expect the transaction to be immediately accretive to non-GAAP EPS and free cash flow, and for accretion levels to increase as we have begin realizing the planned $150 million of annualized run rate synergies within 18 months of the transaction close.

During the quarter, we also made good progress on financing the transaction, locking up a $5 billion term loan facility. Based on our current expectations, we anticipate the all-in coupon rate related to the financing to be approximately 3%.

So, now, turning to our outlook and expectations for the first quarter of fiscal 2017, which with the exception of revenue expectations is on a non-GAAP basis and excludes known special items that are outlined in today's release.

Order rates are currently stable across our business as we enter the seasonally slow January quarter. As a result, we expect revenue in the first quarter to decrease sequentially and be in the range of $840 million to $900 million, but to grow 9% to 17% over the prior year. With inventory levels and utilization rates in good shape, we anticipate gross margins in the first quarter to be between 65.5% and 66%. We expect operating expenses in the first quarter to increase slightly sequentially and for operating profit before tax to be well north of 30%.

We are planning for our tax rate to be approximately 11%, which is our planned non-GAAP rate until we close the Linear transaction. In total, excluding special items, we expect diluted earnings per share in the first quarter to be between $0.68 to $0.78, which would represent year-over-year earnings per share growth of 21% to 39%.

This was a great quarter for the Company, and we are very proud of our achievements. But as Vince always says, we should be often pleased but never satisfied. It is our job to make sure that we continue to exceed expectations. Our customers, employees and shareholders would expect nothing less and neither do we.

So with that, operator, let’s open up the floor for questions.

Ali Husain

Just a reminder to folks on the line, please limit yourself to one question. If you have a follow-up, I would ask that you please re-queue. And again, we do this in the spirit of fairness that everybody who wants to ask a question gets to ask at least one of their questions. And we’re running this call till 11. So, I think that’s plenty of time to get to everyone's question. So, Jennifer, I think you have got the instructions.

Question-and-Answer Session

Operator

[Operator Instructions] Our first question comes from Ambrish Srivastava from BMO.

Ambrish Srivastava

Hi, thank you. I know the rule but I had a quick fact check for Dave and then I had a longer term for Vince. Dave, I apologize if I am missing it, usually in your prepared press release, you do get the end-market breakdown for the coming quarter. I don’t think I saw at this time.

Dave Zinsner

Yes. Maybe we ordinarily do. Okay, I’ll give you two questions, Ambrish. I would say just kind of directionally the B2B businesses which we would consider industrial, automotive and communications will roughly be down mid-single digits. And of course consumer, I think would be roughly in the 30% down range. Does that answer your question, Ambrish?

Ambrish Srivastava

Yes, thank you. My other one was a bit of a longer term for you, Vince. And this is going back to a conversation you and I had a while ago. I know you’ve been on a path to transforming ADI and you’ve talked about inorganic as well as organic, and thinking more of a value creation as opposed to what we are used to, design-in, design-out. You kind of showed it in the consumer side so far that you are not a one socket win. But, give us a perspective of where we are. I know baseball season is over and I love cricket but cricket is bad analogy, there is only two innings. So, where are we in the transformation, Vince? And just help us with that perspective. Thank you.

Vincent Roche

Yes, thanks Ambrish. Good questions. So, look, we are on a journey. We believe -- we said several years ago, we believe that there is enough impetus in our business and that we have the balance sheet as well to help us get this Company towards $4 billion to $5 billion in sales in a reasonable period of time. We are well on track. I believe over the next several years, we will be updating -- obviously when we integrate LTC, we will be updating all the benchmarks around what we expect our revenue to be over time, profits, free cash flow and so and so forth.

So, I don’t know, I am not a cricket fan at all, Ambrish. I don’t know cricket. And I am only an amateur in terms of understanding baseball. But, I would say, we are still in the probably the first quarter of the transformation.

Ambrish Srivastava

Okay. That’s football.

Vincent Roche

So, we have plenty of upsides. As I said, what makes me very optimistic about this business is that the analog domain essentially sets the performance for all the systems that make up this massive information communications technology sector. It’s one of the foundational technologies. Our customers are asking us for more, more and more. And we are getting to the point now where we can be very, very choosey about the problems that we solve. And we can solve those problems across the board from microwave to mix signal to digital single processing, to power sensor technologies. So, I think there is a huge innovation upside that’s the root of this Company. We are in a better and better position with our customers. So, I am very optimistic that we can get this business well-beyond $5 billion in a reasonable period of time.

Ambrish Srivastava

Okay, Thank you. Happy Thanksgiving, guys.

Vincent Roche

Many happy returns.

Ali Husain

Thanks, Ambrish. Next question, please.

Operator

Your next question comes from Tore Svanberg with Stifel.

Tore Svanberg

Yes. Great execution, guys. Dave, can you remind us where utilization is right now? And what are your plans for the next quarter? Obviously you’ve done a great job bringing the inventory day down, but kind of as we look forward from here on, how should we think about utilization in inventories?

Dave Zinsner

So, utilization was in the kind of high 60s in the fourth quarter. I would expect it to be roughly in that range in the first quarter, which is somewhat atypical for us for our first quarter because generally we're working our inventory back down in the first quarter and with industrial usually having a sequential decline in the first quarter as well, it generally drives our utilization down a bit. But given that we've done so well, the operations group has done so well in terms of managing inventory this year, we can keep utilization a little bit higher going into the first quarter.

Operator

Your next question comes from Tristan Gerra with Baird.

Tristan Gerra

Related question on the gross margin guidance, when we adjust for the sale of previously reserved product, you have a sequential trend in gross margin guidance that's better than seasonal. And you just mentioned the utilization rate being better than what you'd see typically in fiscal quarter. Is there anything else in terms of mix that also has an impact on the gross margin, maybe some weakness in base station or anything else that you could give us color on?

Dave Zinsner

I think it's generally utilization that's going to drive it. Because in reality, mix on a year-over-year basis is actually a little bit worse. Because if you remember the first quarter was a pretty difficult quarter for us with regard to consumer came down quite a bit. This year, it won't have as dramatic a decline. And so, mix is a little bit negative but utilization will offset. And I'd say the other thing just anecdotally as the operations group has done a very good job on the spending side, just really managing the expenses there. And so we've incrementally, I'd say, every year have been doing a bit better in terms of spending. And then on top of that there's obviously, as I think I mentioned in the prepared remarks, we've been focused on pricing as well. And so, I think those things have just had an incrementally little bit of a benefit every quarter. And then, of course utilization drives a lot of it and the offset would be mix.

Operator

Your next question comes from Craig Hettenbach with Morgan Stanley.

Craig Hettenbach

On industrial and understanding there is a big macro overlay to industrial but nice to see the broad based strength. Can you talk about, Vince, just maybe some of the applications or products that you're excited about in terms of where you're seeing some investment by your industrial customers?

Vincent Roche

Yes. I mentioned in the prepared remarks there, Craig, for example, in our core businesses, like robotics for example, there's a need to be able to push the speed and the accuracy of these robots to ever higher levels. That's a tremendous digital signal processing challenge. And we've been building complete solutions that are only coming to fruition now for that area to enable much higher speeds in the operation of the robots with lower power, much greater accuracy. So, it's a complete signal chain of digital signal processing technology and mix signal technology. I mentioned in the prepared remarks as well some of these software defined input-output structures that are enabling our customers to deepen the penetration of sensors into their environments and to dramatically reduce the complexity of installation and the costs. Energy is another area. It’s a slow burn market but it’s an area where we have tremendous technology in transmission and distribution and also in the metering of energy.

So, those are just a couple of areas. And I should say as well, we combine, we just lump healthcare into the industrial sector as well. And we have seen -- this is the market where we have been investing, I would say, modestly but very determinedly over the last seven or eight years and we are beginning to really see the returns come good there in terms of revenue and profit. So, I'll give an example. Using integrated silicon photonics and signal processing technology, we've changed the way our customers can implement CT scanning and digital X-ray. We are bringing a clinical grade vital signs monitoring beyond the hospital into the clinic and the home. So, those are all things that are making a big difference to ADI. I should point out by the way as well, we are on a quarter -- we are on a quarter billion dollar run rate now with our healthcare business, with very, very good profits and a good outlook. Again, it’s a slower burn business, but it’s a terrific fit for the future for ADI.

Operator

Your next question comes from Chris Danely with Citigroup.

Chris Danely

I wanted to ask the Trump question since I get it five or six times a day. So, who knows what this guy is going to come up with policy wise but maybe if you could just share with us your thoughts on how you think this impacts you, what your concerns are, what you think any positives could come out of it for ADI and the industry? Any thoughts there would be appreciated.

Vincent Roche

It’s a good question, but we are getting into our 52nd year now as a company. So, we have gone through many regime changes across the world and many, many -- how many American presidents is that. So, I think it’s just wait and see. We don’t know. We hear like everybody else hear the rhetoric. We have yet got to see what the policy is going to look like, but maybe on the margins it will be good, at least for the American business environment.

Operator

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

Amit Daryanani

Congrats on a really nice quarter here. I just want to go back to the Linear transaction for a second, maybe you have more time to go through this and review this. The number one question we tend to get is just how much of -- what sort of manufacturing optimization savings could you get from the transaction over time, and what sort of upside would that yield versus 150 million you talked about. So anything you can talk about just manufacturing integration optimization you can do and if that would be incremental to what you have talked about?

Dave Zinsner

Thanks Amit; that’s a good question. Let me start though since you asked -- opened up the Linear question, why don’t we just start at the beginning -- at the top here. We have actually spent the last several months really focusing on how integration will go as of day one. I would tell you that where we have gotten a lot more optimism is around revenue side. We were already coming into this and this is the reason we do an acquisition like this is to get revenue synergies. We are already coming into the acquisition thinking that we would get hundreds of millions of dollars of revenue upside over time because it takes a while to get that kind of revenue upside. But eventually, I would say that we are even more optimistic about getting revenue synergies, the teams have sat a number of times and talked through where there might be opportunities for the combined Company to really address markets and deliver products that we hadn’t in the past. And fruits of those conversations have been very, very positive.

On the manufacturing side, I think that right now, we’re going to go in with the footprint that we have. And what we do and what we’ve always done is optimized that to our needs. And we’ll continue to look at it. So, I don’t know beyond -- I think we had roughly thought that there is about $50 million of manufacturing synergies through purchasing power and so forth. Whether there will be more several years down the road, we’ll just have to wait and see. But for now, I would call it about $50 million. And then, we expect there is probably another $100 million of OpEx synergies. There is a lot of early wins that we’ve identified through the efforts and planning the integration, obviously the public company expenses. But there is a lot of things that we spend in terms of outside services and so forth that we don’t need to spend two of. And so, I think we’ll get some very quick cost savings out of that activity.

So, if anything, I think we’re very positive. I would tell you that the other thing we talked about when we announced the acquisition was that we thought our tax, blended tax rate will be 19.5%. I think today, now, we believe that’s more like 15%. So that actually pushes up the near-term accretion number from about 10% to probably about 15%. So, if anything, we’re more optimistic about the near-term and incredibly optimistic about the long-term.

Operator

Your next question comes from Craig Ellis from B. Riley.

Craig Ellis

Thanks for taking the question and congratulations on the excellent execution, guys. Just looking at the model, bottoms up and going back a bit to Ambrish’s question. So, if my model is correct, not only did you have record margins in the quarter but auto and industrial also had record quarters. And as I look at the outlook, the 13% midpoint year-on-year growth, relative to ADI’s history and global GDP growth, I think we’d typically look at the analog industry growing at a 2 to 2.5 times multiple of global GDP growth. You are growing at four times that. So, as we look at the business and where it is now and the early pay-off in some of the platform investments the Company has made, are we seeing the Company start to move into a phase where its growth rate relative to its own history and relative to the industry is now at a nice premium to what we would have seen in the post Lehmann and even pre-Lehmann periods?

Vincent Roche

Yes. I think firstly, you’ve got to take growth over a longer period of time, it’s a longer integral.0 But, yes, as I’ve said, what makes me very optimistic about things is that we are innovating like never before and we’re solving big meaningful problems of greater impact. And our customer relationships are such that I think we’re very, very well-positioned to be able to partner with them to really uncover what they believe to be the most intractable challenges, both in terms of their innovation and their commercial impact. So, yes, I think we are innovating in a way that gives us tremendous opportunity for growth. And as I said, we’ve got the customers with us. So, I think I would expect -- we’ve said that our long-term growth model is two to three times GDP. I think we’re well positioned to at least deliver that organically. And as I said, when Ambrish asked the question earlier, we'll be updating our models over the coming couple of quarters, once we integrate LTC here. So, we'll give you more color and visibility.

Operator

Your next question comes from Stacy Rasgon with Bernstein Research.

Stacy Rasgon

I guess I also had a housekeeping question. Dave, you mentioned that you thought consumer would be down in the ballpark of 30% sequentially next quarter. But, just mathematically, that doesn't give me the B2B down mid single-digits, B2B specific items will be down more than that. So, were you just sort of rounding on the consumer number or is there something else going on within that?

Dave Zinsner

No, it's surrounding on the consumer number.

Stacy Rasgon

So, you expect it to be down more?

Dave Zinsner

A little bit more.

Stacy Rasgon

Got it. So, that’s the housekeeping question, if I could ask the real question now. Just last year, you gave us a little bit of color on content increases for Apple and obviously the business consumer was down a little bit this year but not much with the content decrease offsetting the inventory reduction. What do you guys see for content increase on the next cycle for that product?

Dave Zinsner

I think it's too early to tell right now. I think we feel good about our content right now, whether there'll be any additional items, is I think difficult to say right now.

Operator

Your next question comes from Blayne Curtis with Barclays.

Blayne Curtis

Actually just a follow-up there on the consumer side. The 30ish decline seems fairly normal, so just wondering if you can compare and contrast this year versus last year. And then, you have additional components, are you seeing any yield issues or anything else like you saw in this year or is it fairly smooth?

Dave Zinsner

Yes, we don't -- it's fairly smooth. I think what you saw kind of on a year-over-year basis, as we came down a little bit while increasing content. So, the driver of the opposite kind of force here was obviously the inventory build that happened last year that doesn't appear to be happening this year. So, it's kind of tracking as you would normally expect.

Operator

Your next question comes from Ross Seymore with Deutsche Bank.

Ross Seymore

On the OpEx side of things, I realize you only have a couple of quarters left before Linear comes into equation. But, Dave, can you walk us through why you're guiding it up sequentially? If I look historically, I can't find the quarter in the last four, five years where it was actually up. And then, how do you plan to manage the organic OpEx up until that Linear integration?

Dave Zinsner

Well, I'll take the second question first which is very carefully -- I mean, we're not looking to build or add a lot of resources right now because we're going to inherit a lot of resources from Linear Tech and we want to optimize the combined workforce that we're going to have going forward. So, we're very, very, very cautiously managing OpEx, I would say, for the most part keeping headcount flat, maybe there's one or two people here or there that we do need to add for one reason or the other. There's a dynamic within our compensation plan -- variable compensation plan that makes this phenomena happen every so often. And that's a situation where on a year-over-year basis we have pretty meaningful growth which is a component of our variable comp. And so, while, as you point out, we do a pretty good job with the fixed expenses, bringing them down in the first quarter on a sequential basis, and generally the same thing happens with the variable compensation. In this particular quarter, that's not going to be the case because of the year-over-year component is going to actually drive a higher bonus payout. So, that’s really the dynamic there. Otherwise, it would have been largely as you would have expected it to be managed in the first quarter.

Ali Husain

I think as you mentioned, Dave, in prepared remarks, the operating margin in the first quarter is still going to be I think in the midpoint around 32%, just pretty strong. I think we will have to go back five or six years to see those kinds of operating margins in the first quarter. Okay, good question. Next caller, please?

Operator

Your next question comes from David Wong with Wells Fargo.

David Wong

Your B2B segment, industrial, automotive, comms, they have all swung from year-over-year decline a couple of quarters ago to solid 6% to 7% growth in October. Sounds like your January comm guidance assumes about the same. Are you seeing any sub-segments of these accelerating or actually strengthening from that very good October level?

Dave Zinsner

I think they are all pretty much behaving, as you might expect. There are areas that we’re obviously seeing the strength in general. Vince mentioned the healthcare space, clearly aerospace and defense business has been good. Areas around IoT that we focused on have done well. There are sub-segments of the auto space like ADAS and powertrains and so forth. Vince mentioned A2B platform that we have in auto for infotainment area. So, all those things are doing probably on the margin little bit better. But I would say it is a very, very broad based situation with the B2B space and pretty much every sub-segment is doing well.

Operator

Your next question is from Steve Smigie with Raymond James.

Steve Smigie

I was hoping to get some quick color on LIDAR opportunity. What do you see that opportunity for you guys as and what does your acquisition bring to the table versus some of the competition out there?

Vincent Roche

Yes, good question. So, basically, the technology we have required is liquid crystal optical wave guide technology. And it’s a solid state approach to a very, very difficult problem, basically using a solid state approach to optical beam steering. That’s critical if you are going to really push the resolution of LIDAR in future. And in contrast to other beam steering methods, for example like MEMS mirrors, the spinners that you’ve seen running around highway 101, there are optical phase arrays. The technology we have acquired doesn’t have any sensitivity to vibration for example. So technically, we have got great frame rates, no blind spots, and we can run them and we steer the beam as well.

So, this technology we believe puts us firmly on the LIDAR roadmap. And combined with our RADAR-based advanced driver systems technology at 24 and 77 gig really gives us two of the very critical technology modalities to enable not only greater safety which everybody craves in transportation but also puts us well on the path to enabling our customers to get closer to realizing autonomous driving as a major trend in the transportation sector. So that’s essentially what we see. And it’s a potentially beyond $1 billion semiconductor time for this thing for us. So, it could be potentially a wave. And that’s why we bought the technology. It is reasonably early stage but with the technology is working, now we’ve got to get it installed and make it work in the application.

Operator

And our next question comes from William Stein with SunTrust.

William Stein

Great, thanks for taking my question. I am hoping you can address the reasoning behind the greater optimism for revenue synergies. Specifically is this more of an inside out view when you sit down with engineers and think about the products that you might be able to deliver or is it more customer driven where you’re hearing feedback that requests a combination of products, let’s say?

Dave Zinsner

I would say it is a combination. Vince can add some color if he wants. But I would say, it’s a combination of clearly the business units, call the engineering force and the business units do see opportunities for products that they could make that would be special. But I think a lot of it comes from just the sales force that the combined company looking at the other company’s portfolio and looking at their jobs what they could do with those products in their geographies, their customers and so forth. I think that’s really where we see a lot of kind of near side opportunities.

Vincent Roche

Yes. I think maybe as well in some -- particularly of the larger customers, there is an open door invitation to do more together with the portfolios that we have on hand as well as getting our engineering teams together to figure out how to create even more value in future together in terms of how we invest in R&D and apply it.

Operator

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

Vivek Arya

Thanks for taking my question and congrats on the great execution and the recovery in the B2B segment. My question though is related to the consumer segment. And what is the right way to model that segment for the next two years? If you were in our shoes, would you model that segment to be flat, up or down? Just given the large influence of one of your customers in that segment, that’s really hard to model that. So, I was just wondering how you would be modeling it if you were in our shoes? Thank you.

Vincent Roche

Well, from a topline perspective, I’d say if we could get 10% growth compounded for the next few years in that business, we’d be very, very satisfied.

Vivek Arya

But, do you see -- do you have visibility for that, Vince?

Vincent Roche

Well, look, you really have visibility into anything. I mean, we work hard on building great products; we’re working very, very hard on deepening our penetration, not just in one customer but in several customers. It’s a rapid cycle business as well. And things can change, markets can change, products can hit, not hit products; products get -- can even at the customer level be brought to market or cancelled. So as best we can tell, we’re happy with the position we’re in, in terms of the products and technology we have, the relationships we’ve got with the critical customers in this space. So, I am optimistic that we can grow this business at the level I’ve said, and time will tell. We don’t know. We can’t predict because also it’s a market with relatively fickle customers on the other side of thing. But I think we’re well positioned to pick the upside and that’s pretty much what I’ve got to say about it.

Dave Zinsner

I mean, one thing I would add is that we do track kind of the opportunity set. We certainly have the opportunities to do what Vince said. And it is a matter of markets and applications taking off and so forth. But from an opportunity perspective, we're optimistic about what we can do in the consumer space.

Operator

Your next question comes from John Pitzer with Credit Suisse.

John Pitzer

I guess, Vince, an earlier questioner rightly pointed out that within your B2B business, industrial and auto kind of established new all-time quarterly highs in the October quarter. I was hoping you could talk a little bit about the communications sector, still about 40 million below peak revenue run rate a few years ago. I know not all of Hittite gets wrapped up the comps but especially given the success at least on the design side from the Hittite acquisition, I'm just kind of curious as how you view the outlook for the comps business. Why is that the business that's still kind of struggling relative to past ties and what are kind of the growth drivers you see from here?

Vincent Roche

Well, again, I think you've got to take a very long-term view to the consumer space. We have been playing in this business from 1G into 4G; we're helping our customers with 4.5G. We’re at the early stages of helping them architect 5G technologies as well. It's an important market for ADI. And with Hittite, we're able to bring a level of completeness to our customer solutions. We're seeing the growth we expected out of Hittite that we had thought was there. We're getting the growth. We're well-positioned with our customers. And we're grinding out results in 4G. I think we're getting share in 4G. And on some of the older technologies, some of the 2.5, 3G technologies, clearly, there's price erosion, which offsets to some extent the growth that we got on 4G. But, I think the customers are facing increasingly difficult challenges in this space. We're helping them solve them at an increasing level of sophistication.

So, it's a way for the future. And we'll grind out the results quarter-by-quarter, year-by-year. And I think as I said, we're in an increasingly good position to gain share in the space, particularly as we begin to push our products as well towards single chip radio solutions in future. So, I think there're very few companies standing in the radio who can build a sustainable business for the long term and ADI will be right at the top of that stack.

Operator

Your next question comes from Chris Caso with CLSA.

Chris Caso

I wondered if you could talk about what you consider to be normal seasonality for the April quarter. And I ask because last year was the first quarter of the substantial revenues from the consumer segment but that was undergoing the inventory adjustment. If we normalize for the inventory adjustment, what would your expectations be for normal April?

Dave Zinsner

It’s a good question, Chris. We're kind of in new territory. So, I'll take a crack at it but don't hold me to it. I would expect, as is typical, the industrial and automotive sectors to have pretty good sequential growth. I think the industrial sector usually has about 10% and usually the automotive sector is a little bit below 10% but they're both pretty strong. Comms will do what it does; it's more cyclical than seasonal I think in most cases. And then, the consumer business which is the big wild card, I am going to guess that it’s down probably the same kind of level sequentially as it was in the first quarter, probably in the 30% plus or minus or something like that in the second quarter again and of course will have rebound after that in the third and fourth quarter as it seasonally does. But it’s hard to say but that will be my guess.

Operator

Your next question comes from Toshiya Hari with Goldman Sachs.

Toshiya Hari

Great, thanks for taking my question and congrats on a very strong quarter. I had a question on your incremental gross margins. I think for the October quarter on a year-over-year basis, most of your revenue growth dropped through to the gross margin line. And also for the January quarter, if we take the midpoint of your revenue and gross margin guide, again, I think close to 90% or 100% of your revenue growth is dropping through the bottom line. So, I guess, I am curious, is this just product mix or are there other factors that play here? Thank you.

Dave Zinsner

Yes. I think drop-through works when there isn’t a lot of like a changes going on around working capital and so forth. And I think that kind of masking things a bit. Like for example in the fourth quarter, as I talked about, we had this inventory release which drove up the gross margin. So, you have to kind of strip that away before you even look at it. And then in the first quarter, we are -- because we normally have this kind of utilization decline in the first quarter, we are not going to have that because of such of the really good discipline we had through the year this year in terms of inventory management; it’s a utilization level that’s kind of atypical for us. So, I am not sure drop-through is the best way to look at it. It’s more a function of, at least in the first quarter, it’s a more function of utilization levels. And they are going to be in the mid to high 60s. And that’s going to be really beneficial relative to where we were last year, at this time, which is kind of unusual for us.

Operator

Your next question comes from CJ Muse with Evercore.

CJ Muse

I was hoping to revisit the earlier comments regarding a 10% CAGR for consumer. If you look at your top customer in that bucket, I think 13% of your total revs in fiscal 2016 that would imply your other consumer business decline about 25% year-on-year. So, curious, the 10% CAGR, is that a reflection of your vision to rising content as you have very large customer there or is it reflection of seeing greater breadth with other consumer customers as you look out over the next one, two, three years?

Vincent Roche

Well, I think it’s a combination of all of the above. It’s a long term projection. As I said, we have certainly got the customer engagements. We have got the technologies and products. And I think we are solving problems that really matter. So, what I am indicating is that to my mind it’s probably more of a how the market performs than individual, if you like dynamics around engagements and individual customer. So, it's really more about the market. So, I think what we are talking about is a long-term expectation. We are investing at a rate that should enable us to get those kind of growth rates. I will say as well that we have funded our B2B business; I mean, we are spending more than 90% of the Company's R&D on our B2B businesses to make sure that we drive growth and capture the opportunity that’s available to us in those sectors. So, we’re all the time making trade-offs and investment between the various applications in the B2B area. And we are very carefully picking up the vital few opportunities in consumer where we think our technology makes an enormous difference to the user experience.

Ali Husain

Just a clarification, the outside of the portables business within consumer, so outside of portables consumer was up sequentially and was about stable to the prior year. Okay, next question?

Operator

Next question comes from Romit Shah with Instinet.

Romit Shah

Yes, hi. Just regarding the merger, it sounds like early indications are good. But one of the things that’s come up is just employee retention, something to that extent was mentioned in the proxy. And one of the -- for some of us who have followed Linear over the years know that it’s kind of a different culture West Coast company. So, I am just curious, how are you guys incentivizing the Linear people to stay at the organization? And Dave, as we put our merger models together, should we assume that OpEx and stock comp sort of step up on a like-for-like basis after the deal closes?

Dave Zinsner

Well, we do have our retention plan in place for them. So, near-term, we’re not too worried about it. But I would tell you that my own view on this, since I can probably opine is that engineers stay with the company or come to a company based on what they are doing and whether they are doing exciting things and have granted the opportunity to work on really difficult problems and do amazing things. And that’s the environment we intend to create for both the ADI and Linear Tech engineers. So, I am not particularly worried about it. Our compensation plan in the near-term for ADI and Linear Tech people is to maintain what both of them have. Over time, they will be how homogenized but I think in a way that we wouldn’t see a negative impact of.

Vincent Roche

Yes, I’ll just add a little more color to what Dave has said, Romit. I spend a lot of time as many of our leaders have with the LTC engineering community, the business community, the operations community and we share a very similar view of the world. We understand our each others’ businesses very, very well. We share a very similar value system, how we believe value gets created and captured. And I think there is tremendous excitement by the way, all through both companies incidentally about how we can combine the complementary technology suites of both companies to do really marvelous things in future.

As Dave said earlier that our sales forces are really jumping at the bid to get the two bags, for the ADI people to get the LT power bag and the LT says people to get the ADI mix signal bag and really capture the opportunity that we think is a available to both of us over the next three to four years. And I think as Dave said, a part of retention is a sense of equity and fair treatment in terms of compensation. And we pay a lot of attention to that. But the soft side of the adventure that people can undertake here and work together to do amazing things into the future, solving really critical meaningful problems of the world, that’s what people want to do. And I will tell you as well, we pay lot of attention to retention. And I'm pleased to say that things are very, very stable on both sides of the fence.

Operator

Your next question comes from Ian Ing with MKM Partners.

Ian Ing

You mentioned pricing efficiencies helping gross margins year-over-year, looking for color on that. You've a pretty capable team in place now and for a while you've been -- I've been assuming you have been posting by value of solutions?

Dave Zinsner

I mean it's basically that. I mean we're -- as Vince mentioned I think in one of the questions, we're increasingly putting more and more robust technology in the products, some cases algorithms, some cases other software, some cases it's just hardware but it's just really solving a really challenging problem. And what we do is work to try to get commensurate price for that value that we create. And not surprisingly in a big organization, sometimes a little bit of that slips through the cracks. And what we've been doing over the last three years is plugging those holes. And so, we're not looking to gouge our customers by any means, we're looking to find the right optimal level of price per value and that’s what we do every day. I think we've done increasingly a better job at that over time.

Operator

Your next question is from Harsh Kumar with Stephens.

Harsh Kumar

On that answer you gave, there seems to be some trend amongst semiconductor companies that they can actually get paid very well for what they're doing. Historically, it's always been downward pricing but now, I think some of the companies are trying to raise prices and maybe get paid fairly. I'm curious, you mentioned, you touched upon in the previous answer, but I'm curious where your philosophy is as a company with that and how much of an impact did pricing have in margins for the last quarter?

Dave Zinsner

So, I think, Harsh, I would say that some companies who have been drifting into the 40s and maybe very low 50s in terms of gross margin, they got to get a whole new kind of philosophy in place for pricing. I mean, we already had 60 plus percent gross margin, so we were actually pretty good at executing a strategy around this. It was more just cleaning up a little bit around the edges where we probably weren't executing as well. Hard to put a number on it for the quarter. I would say though that on the average over the last say four years, our ASPs are probably up 30%, 40% probably. So, it's obviously been a pretty big impact in terms of our gross margins.

Operator

Your next question is from Cody Acree with Drexel Hamilton.

Cody Acree

Maybe just any more color that you could give on the wireline business, and you made some comments about strength you're seeing in 100 gig?

Vincent Roche

So, we have a reasonably significant business in the optical space and providing precision measurement and control for the various parts of the optical system. So, it's grown well for the Company over several years. And I think as the need for data center, infrastructure build-out continues and medium and long-haul, backhaul connectivity continues to be pressured, we see it as a good bet for the future and probably at the higher end of the spectrum of growth that we've put into our model.

Operator

And our last question comes from Stephen Chin with UBS.

Stephen Chin

I had a quick question on wireless infrastructures. I know that was down in the quarter. Was that broad-based softness in that business or were there any pockets of the positive demand? And also related to that, how would you characterize the current I guess level of rollout 4G and 4.5G overall, are there any more greenfield or upgrade opportunity left around the world in next couple of years? Thanks.

Vincent Roche

Yes. So, I guess in the quarter the macro base station and the backhaul were down for the quarter. Our small selectivity was up. I think China is reasonably strong. And our transceiver pipeline by the way across the board, not just in base station technology but across the board is continuing to build a nice pipeline of opportunity. And also, we are converting a pipeline into decent revenue. I think we are still in the reasonably -- I mean 4G is going to be around for a long, long time to come. The largest part of the world by the way is still on 2G, 2.5G and 3G networks. So, 4G will have a long life ahead of it. And as I said, we will be grinding out share gains there in an increasingly thinning atmosphere here, if you like in terms of suppliers. 5G is on its way. As I said, we’re in the earlier stages of helping our customers to architect 5G solutions. But I think it’s going to be many, many years out yet. So, I think it will be -- I don’t expect to see capital deployments and the carriers change an awful lot. So, I think it will be a slow and steady increase in the build out of 4G. And I think that will be the environment till we get the 5G and see another specific step function ramp here.

Ali Husain

Alright, thanks Stephen. It looks like it's the end of the call. We had a good quarter. The deal here for Linear Tech continues to stay on track, progressing well here for close. Inventory, as Dave has talked about, is in great shape, gives us good gross margin leverage going into 2017. Our business is now showing some really good momentum, especially in the B2B markets. You guys saw the results of some pretty some operational execution this quarter with our free cash flow margins up pretty significantly. So, we appreciate you guys calling in. And we’ll look to talk to you soon. Thanks. Happy Thanksgiving.

Vincent Roche

Thank you.

Operator

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

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