NXP Semiconductors NV Management Discusses Q3 2012 Results - Earnings Call Transcript

Oct.25.12 | About: NXP Semiconductors (NXPI)

NXP Semiconductors NV (NASDAQ:NXPI)

Q3 2012 Earnings Call

October 25, 2012 8:00 am ET

Executives

Jeff Palmer - Vice President of Investor Relations

Richard L. Clemmer - Chief Executive Officer, President and Executive Director

Peter Kelly - Chief Financial Officer

Analysts

John W. Pitzer - Crédit Suisse AG, Research Division

James Covello - Goldman Sachs Group Inc., Research Division

Vivek Arya - BofA Merrill Lynch, Research Division

Ross Seymore - Deutsche Bank AG, Research Division

Christopher J. Muse - Barclays Capital, Research Division

Christopher Caso - Susquehanna Financial Group, LLLP, Research Division

Joseph Moore - Morgan Stanley, Research Division

Vijay R. Rakesh - Sterne Agee & Leach Inc., Research Division

Gareth Jenkins - UBS Investment Bank, Research Division

Harlan Sur - JP Morgan Chase & Co, Research Division

Philip Scholte - Rabobank Equity Research

Operator

Good day, ladies and gentlemen, and welcome to Third Quarter 2012 NXP Semiconductors NV Earnings Conference Call. My name is Sonia, and I will be your coordinator for today. I would now like to turn the representation over to your host for today's call, Mr. Jeff Palmer, Vice President of Investor Relations. Please proceed, sir.

Jeff Palmer

Thank you, Sonia and good morning, everyone. Welcome to the NXP Semiconductors' Third Quarter 2012 Earnings Call.

With me on the call today is Rick Clemmer, NXP's President and CEO; and Peter Kelly, our CFO. If you've not obtained a copy of our third quarter 2012 earnings press release, it can be found at our company website under the Investor Relations section at nxp.com. Additionally, we will have posted a supplemental earnings summary presentation and an excel document of our historical financials to assist in your modeling efforts. This call is being recorded, and will be available for replay from our corporate website.

Please be reminded that this call will include forward-looking statements that involve risks and uncertainties that could cause NXP's results to differ materially from management's current expectations. The risks and uncertainties include, but are not limited to, statements regarding the macroeconomic impact on the specific end-markets in which we operate, the sale of new and existing products and our expectations for financial results for the fourth quarter of 2012. Please be reminded that NXP undertakes no obligation to revise or update publicly any forward-looking statement. For a full disclosure on forward-looking statements, please refer to our press release.

Additionally, during our call today, we will make reference to certain non-GAAP financial measures, which exclude the impact of purchase price accounting, restructuring, impairment and other charges that are driven primarily by discrete events that management does not consider to be directly related to NXP's underlying core operating performance. Pursuant to Regulation G, NXP has provided reconciliations of the non-GAAP financial measures to the most directly comparable GAAP measures in our third quarter 2012 earnings press release, which will be furnished to the SEC on Form 6-K, and is available on NXP's website in the Investor Relations section at nxp.com.

Now I'd like to turn the call over to Rick.

Richard L. Clemmer

Thanks, Jeff, and welcome everyone to our earnings call today. As is our practice, I will address revenue trends in our various markets and channels with Peter providing more color on profitability and other financial metrics. Looking at the third quarter, we are very pleased with our performance. Overall, the quarter developed basically in line with our expectations, even with the deteriorating economic environment, with the product revenue coming in at $1.11 billion. This represents a sequential increase of 9%, in line with the midpoint of our tightened guidance range. Total NXP revenue was $1.17 billion, a 7% sequential increase, in line with our guidance. Furthermore, our third quarter results mark an inflection point in year-on-year growth comparisons as product revenue increased nearly 15% versus the year ago period, confirming the growth we have been highlighting. Our performance during the quarter was a clear reflection of the company's specific growth of opportunities we have previously identified coming to fruition. We are optimistic about the contributions of these specific opportunities, including ID and our mobile design wins which were responsible for the bulk of this sequential growth, but we see the uncertain macro environment is creating real headwinds for the more cyclical portions of our business. Taken together, the overall growth of the company may be impacted over the next couple of quarters, notwithstanding the contributions from key high-volume design wins.

Irrespective of the macro environment, our strategy continues to be focused on providing unique and differentiated product solutions to our customers which over the longer term period, should enable NXP to outpace the cyclical growth of the overall semiconductor market.

Turning now to our segment performance. HPMS revenue was $901 million, a 12% sequential increase and up 24% from the year ago period. Within our ID business, revenue was $275 million, up 18% sequentially and up 72% from the third quarter of 2011, clearly better than our original expectations.

We continued to experience healthy order trends across most of the portfolio, with our core ID business growing 14% on a sequential basis and representing about 75% of the total ID revenue.

Within the core ID, automatic fare collection, infrastructure and tags and labels were all up in the quarter, while our bank card business experienced strong double-digit growth as it trend towards contactless bank cards continue to accelerate. Within our eGovernment product line, sales were off slightly on a sequential basis, consistent with our expectations after the strong trends during the first half of 2012. During the third quarter, our next-generation SmartMX2 secure element platform was awarded the industry's first common criteria EAL 6+ security certification by the German BSI. This is clearly a significant event as the intellectual property and capabilities embedded in our smart MX platforms are at the core of why NXP is the trusted the global leader in identification and security technology.

To date, we have shipped over 1 billion SmartMX-based products into the marketplace with 86 countries leveraging our products for its ePassport solutions. Turning to our emerging ID business, which includes mobile transactions and authentication, revenue was up 30% sequentially and represented about 25% of the overall ID group revenue. Nearly all of the emerging ID growth in the quarter was due to NFC-based mobile transactions. Our design win momentum in mobile transaction continues to build as we continue to be tracking over 200 design opportunities, with roughly half of those programs in mass production. Furthermore, during the quarter we achieved 100 million unit shipment milestone for our industry-leading PN5444 NFC controller. Demand for this product is being driven not only by handset OEMs but also by consumer product manufacturers who are adopting NFC to enable short-range secure media-sharing solutions in a wide variety of products. The ID group continues to excel with a solid outlook even in the tough environment.

Now moving to our Portable & Computing end-market, revenue was $220 million, up 24% sequentially, and 31% up from a year ago period as our success in the mobility space comes to fruition. During the second quarter, we experienced strong sequential growth due to the ramp in previously discussed design wins with demand for both high-speed interface solutions and logic devices as new mobility programs we have previously highlighted began to achieve their full ramp. The sale of MCU products were down slightly in the quarter, more reflection of the weaker demand within the broad industrial market.

Turning to the Infrastructure & Industrial, revenue was $165 million, up about 13% sequentially, essentially in line with our expectations, while revenue was up about 1% versus the year ago period. During the third quarter, growth was driven primarily by an improvement in demand for our high-performance RF product sold to basestation OEMs. Both lightning drivers and silicon tuners were up modestly with our #1 leadership TV Tuner business at 9% of GreenChip power solutions were flat sequentially, a reflection of the challenging Notebook PC market environment.

Within our Automotive business, revenue was $239 million, down 2%, slightly below our original expectations, but in line with the historically seasonality for Automotive business. Versus the third quarter of 2011, revenue was up 7% primarily due to share gains in OEM-based auto entertainment in keyless entry portion of the portfolio. From the product perspective, we experienced good sequential demand for entertainment products with in-vehicle networking and fixtures[ph] flattish with keyless door entry products declined modestly in the quarter after stronger trends in the first half year. We experienced very good trends with U.S. and major Asian suppliers while we achieved new -- where we achieved new record sales levels. This was offset by a weaker trend with European OEMs particularly in the mid to low-end of the market as well as some impact from exchange rates.

Finally, turning to Standard Products business, revenue was $213 million, down 3% sequentially, that was slightly below our original expectations. Versus the year ago period, our Standard Products business was down 13% as the broad-based market has continued to weaken throughout the year, even with some partial offset in new trust product areas.

Turning now to our distribution channel performance, total NXP sales into and out of distribution were aligned and were both up 4% from the prior quarter.

Total distribution sales represented slightly less than 50% of total product sales, fairly consistent with long-term trends. We continue to tightly manage distribution inventory within our target range, with total months of supply on hand remaining at 2.4 months, basically flat with the prior quarter. Absolute dollars of inventory in the channel were up about 6% on a sequential basis as we position specific products to service certain high-volume programs by distribution. Due to the uncertain macro environment and our distribution partners being the primary channel to service the smaller, broader-based customers, we anticipate a more conservative bookings environment over the next quarter or so.

From a geographic perspective, demand profile was similar to last quarter. All regions with exception of EMEA were up, with a particular double-digit strength coming from both the China and South Korean markets, a direct reflection of our success with the key mobile handset customers as well as contact with banking customers in China. In EMEA region, which accounts for about a quarter of our product revenue, we experienced weakness across the entire product portfolio, with the worst performance seen in the more broad-based exposed business like Standard Products into the lesser degree Identification and Automotive.

In summary, the third quarter was a very good quarter for NXP. Many of the programs in mobile space we have worked diligently on are paying dividends, and we believe there's more to come when additional programs ramp up in mid 2013. Our focus will be to manage these areas of the business within our direct control, especially in light of the clearly weakened macro environment. Specifically, we are focused on managing our costs, driving cash generation and managing our debt. We believe if we are successful, our actions will result in a very good bottom line earnings growth. Now, I'd like to turn the call over to Peter to discuss the financial details of the quarter.

Peter Kelly

Thank you, Rick, and good morning to everyone on today's call. As Rick has already covered the drivers of the revenue during the quarter, I'll move directly to the highlights of the P&L. Overall, it was a strong quarter. Revenue improved 7% sequentially, non-GAAP net income improved over 25% sequentially and net debt was reduced by just over $100 million. Subsequent to quarter end, we retired $202 million of our 2013 debt and late yesterday, announced that we have improved our liquidity by expanding our revolving credit facility to $805 million. We also announced that we intend to tender for up to $500 million of our 2018 9 3/4 senior secured debt. For the third quarter, revenue was $1.17 billion, in line with the midpoint of our guidance. We generated $542 million in non-GAAP gross profit, an increase of just over 7% sequentially. Our non-GAAP gross margin was 46.3%, slightly better than the previous quarter.

Now let me turn to the operating segments. Within the HPMS segment, revenue was $901 million, up over 12% on the previous quarter. And operating margin was 23% of revenue, which at $208 million, was up over 18% sequentially. Non-GAAP gross profit was $465 million, an increase of nearly 9% sequentially.

This represented 51.6% of revenue, a 170 basis point decline on the previous quarter driven by the relative mix of our volume drivers, as I discussed on our recent analyst day. Within our Standard Products segments, revenue was $213 million, down nearly 3% sequentially. And operating margin was 15.5%, which at $33 million, represents a 3% sequential improvement. Non-GAAP gross profit was $73 million, a 9% improvement over the prior period. Total operating expense was $311 million, up $8 million on a sequential basis and in line with the midpoint of our guidance range. From a total operating profit perspective, non-GAAP operating profit was $232 million, an increase of nearly 14% on a sequential basis and represents a 19.8% operating margin. Interest expense was $65 million, a little better than expected as we've paid down $50 million of our 2013 Super Priority Notes early in the quarter. And our noncontrolling interest was $16 million, a little higher than expected as a result of improved performance in our SSMC joint venture. Taken together, total NXP non-GAAP earnings per share was $0.56, in line with the midpoint of our guidance. I would note that included in our non-GAAP net income was $12 million of stock-based compensation or about $0.05 per share.

Now, I would like to turn to the changes in our cash and debt. Cash at the end of the third quarter was $702 million, a sequential decline of $135 million, as a result of debt reduction actions. Our total gross debt improved by $237 million in the quarter down to the level of $3.58 billion. So overall, our total net debt at the end of Q3 was $2.88 billion, an improvement of $102 million versus the previous quarter.

On September 7, we called $202 million of our 2013 Super Priority Notes with an effective call date of October 8. We have since retired these notes. We exited the quarter with a trailing 12 month adjusted EBITDA of $989 million, and our ratio of net debt to trailing 12 month adjusted EBITDA at the end of Q3 was $2.9 million.

Turning to working capital metrics, days of inventory were 97 days, a decline of 9 days. Days receivable were 37 days, a decline of 1 day sequentially, while days payable was 79 days, a decline of 7 days. Taken together, our cash conversion cycle improved to 54 days from 57 days in the prior quarter. As I mentioned earlier, we increased the size of our revolver to EUR 620 million or approximately $805 million, and along with our excellent working capital management and the cash in our balance sheet, I believe we now have very strong liquidity.

Cash flow from operations was $192 million, a result of strong revenue growth, improved operating profitability and positive working capital metrics. Net CapEx investment during the quarter was $92 million, resulting in positive free cash flow of $100 million. As you no doubt have now realized, our Treasurer and I have been busy during this past quarter and will continue to work on our liquidity and debt. And I continue to expect to reduce on that debt as our performance drops cash through to the bottom line. And largely as a result of our most recent actions, we now expect interest charges in 2013 to be in the range of $200 million to $220 million.

Now, I would like to provide our outlook for Q4. As Rick mentioned, our view of the macro environment has clearly deteriorated since our last update. While we are very encouraged by the progress in ramping up several key design wins in multiple areas of our business, the weak demand environment is having an impact on the most cyclically oriented portions of our business.

As we've said in past updates, our philosophy we guidance is to provide our stakeholders with the latest and most accurate view we have on potential business outcomes during the quarter. In this environment, it is an even more challenging undertaking. With these views as a backdrop for the fourth quarter, we currently anticipate product revenue will be in a range of down 3% to down 9% sequentially. At the midpoint, we expect product revenue to be down about 6% sequentially, reflecting the following trends in the business. On a percentage point basis, Automotive is expected to continue to be challenged by the macro environment and should be down about mid single-digit sequentially. Identification continues to demonstrate strength and is expected to be flat sequentially. Portable & Computing is expected to be down about 10% -- to be down about 10% sequentially, primarily due to macro weakness impacting the broad-based General Purpose Logic and Microcontroller business, offset by continued performance of key mobile design wins. Infrastructure & Industrial is expected to show seasonable -- seasonal declines and be down in the upper single-digit rates. Standard Products will continue to be impacted by the macroeconomic environment and is expected to be down in the upper single-digit range. We anticipate revenue from the combination of our Manufacturing segments and the Corporates and Other segment to be approximately $45 million. Taken together, total NXP revenue should be in the range of $1.059 billion to $1.126 billion or about $1.093 billion at the midpoint. Additional inputs to help you tune your models are as follows: net debt will be about flat quarter-on-quarter as we use the expected cash generated from operations to fund the redemption costs associated with the tender offer of the 2018 senior secured notes. We anticipate non-GAAP gross profit to be in a range of approximately $491 million to $524 million. We anticipate operating expense in Q4 to be in a range of approximately $305 million to $309 million. If taken together, this should translate into a non-GAAP operating profit in the range of about $187 million to $216 million. Net interest expense should be $53 million or $56 million, depending on the results of our tender. Cash tax expense should be approximately $11 million and noncontrolling interests should be about $17 million. Stock-based compensation is expected to be about $16 million, or about $0.06 per share, which is included in our non-GAAP results. Average diluted share count should be about 253.3 million shares and taken together, our guidance implies non-GAAP earnings per share in a range of $0.41 to $0.53 per share, or approximately $0.47 per share at the midpoint of our guidance range. Now we'd like to turn to your questions. Jeff?

Jeff Palmer

Sonia, could you please poll for questions, please?

Question-and-Answer Session

Operator

[Operator Instructions] The first question comes from the line of John Pitzer, Credit Suisse.

John W. Pitzer - Crédit Suisse AG, Research Division

I guess my first question for Rick, relative to the ID business, and the Portable & Computing business, could you just give us a little bit of breakdown of the buckets within that and how you see growth going into the calendar fourth quarter. I guess specifically, I'd be interested on the PNC side. How much do you -- what percent is core today versus kind of some of these new products that are ramping?

Richard L. Clemmer

Well, John, I think when you look at it, as we talk about the growth that we have in the business in Q3, of the 9%, there's maybe a percent or so that is kind of reflected in our I&I business associated with the basestations. But really, the bulk of growth comes from the combination of the growth of our ID business and mobile transactions which is roughly half of that 8%. And then significant design wins that we've talked about on the interface and switch site associated with Portable & Computing, which is roughly the other half associated with it. As we look at those, that ramp was a very significant ramp in Q3 and obviously was a significant contributor to the growth that we had with high-performance mixed signal being up 24% on a year-over-year basis. If we look at moving into Q4, we would expect that ramp is basically taking place. And so it'll be -- those specific programs will be relatively flat in Q4. And with our typical seasonal pattern, combined with the really anemic economic environment, more specifically in China for us, we see an outlook that will be down in the rest of our business driving the total reduction, that Peter talked about, of 3% to 9% for Q4 on a sequential basis, which by the way, will still be up over 25% from a year ago basis.

John W. Pitzer - Crédit Suisse AG, Research Division

And my follow up maybe for Peter. Peter I know Standard Products is a relatively small part of the business, but the model didn't work as I would have expected in Q3. On the plus side you guys did a much better job on gross margins. I'm kind of curious if that was mixed or if these are kind of structural cost changes that can go forward and I was a little bit surprised that the gross margin benefits didn't necessarily translate that out the operating lines. If you could just help me understand the Standard Products business a little bit better, that'll be helpful.

Peter Kelly

I guess there is -- I guess, a potential structural issue, if you like, John, in the sense that -- Standard Products at the moment, from a utilization perspective, is running quite weak. So the fixed costs tend to be quite high. So I think the biggest impact in Standard Products right now is, it comes in 2 areas: one, the macroeconomic environment is pretty weak, so pricing is tough, not -- certainly not any worse than we've seen in the previous quarter. But the loadings on their fabs is quite anemic at the moment. So until we see a turnaround, I don't think you're going to see a big fall through in the Standard Products here.

Richard L. Clemmer

Yes. So, John, maybe I could just add a little more color to that. There's -- some of the really low-end products that are very marginal, even gross margin, that we actually didn't participate in. We walked away from those orders. We did not want to continue to participate in that. So some of the aggressive price competition, primarily led by some of the Chinese manufacturers, we actually did not participate in as we've really tried to focus on our thrust areas. And even Standard Products, really, again are more focused on our smartphone customers where they really need more increased DSP protection etc. So that was one of the factors. We are doing a little bit on the R&D side. Not very significant dollar-wise. Investing in linear, really in the Standard Products base because of the inherent technology that we have in the significant market opportunity that we see associated with that. So we're investing in trying to be sure that we can get that business back within the target models that we believe that we can operate in. And It's just a contribution of how we get there, but clearly, we walked away from a reasonable amount of the true low-end business based on the aggressive price competition that we continue to see in that space.

Operator

The next question comes from the line of James Covello, Goldman Sachs.

James Covello - Goldman Sachs Group Inc., Research Division

First question, you guys have had some terrific wins in high-profile, in the interface segment of your business. I guess a couple of questions around that. First, how comfortable do you feel about the IP around your interface products, such that no one could come in and sort of replicate that? I know there's been some noise around that in the market. Secondly, how do you kind of handicap the pluses and minuses of retaining some of the high-profile design wins you've had in future generations of products that you've already won versus, on the upside, the opportunity to pick up new products, maybe with some of those same customers with this technology?

Richard L. Clemmer

Thanks, Jim. I think that this really is a clear demonstration of our technical capability. I think, from our overall position, we believe that our IP is clearly adequately protested -- protected as we have a very strong IP portfolio and we clearly will utilize that to be sure that we protect our product position associated with it. So we're not significantly concerned about someone coming in. We think that our IP position, which we will be prepared to use to our fullest extent to protect our product's capability, will put us in a great position associated with it. Clearly for us, the opportunity has rolled us out to more and more successful smartphone and tablet customers and ability to drive the fundamental capability. So proving that technology and really being a significant player in the smartphone and tablet space, really puts us in a different position to be able to drive some of the volume and the increase in demand.

James Covello - Goldman Sachs Group Inc., Research Division

Okay. And then if I could ask a follow up on the debt. I understand the comment about the forecast for 2013 interest expense being between $200 million and $220 million. It looks like that would assume no additional repayment of debt over the course of 2013, given essentially that's close to the run rate that we're on, exiting the fourth quarter. And so, are there things that you could do that aren't on those assumptions? Or is the idea that you've kind of done what you can, for the time being, on the paydown of incremental debt?

Peter Kelly

No. I mean, I think there's -- while we have the level of debt that we have, there's always more we can do. That just happens to be my best view right now.

Richard L. Clemmer

But clearly, our priority is continuing to pay down the debt. And we're going to generate a reasonable amount of cash as we move forward over the next few quarters and we'll continue to use that to focus on how we continue to reduce our debt.

Operator

The next question comes from the line of Vivek Arya, Bank of America, Merrill Lynch.

Vivek Arya - BofA Merrill Lynch, Research Division

It's interesting that I think because of the mix in HPMS this quarter, there's been some pressure on gross margins, but operating margins have actually grown quite nicely. Is that the new trend rate where gross margin perhaps stay below the targets but operating margins are ready to hit the targets? Or was that just a function of mix during this particular quarter?

Richard L. Clemmer

No. That's what we've talked about at the analyst day. It's what we expect to continue to see. We have not backed off of our gross margin target -- models. But as we talked about was some of the new higher-volume design wins that are not necessarily at the highest levels of gross margin, but deliver a very good bottom line. We expect to see some of that transition taking place, but very confident that we can make the improvements in operating income. Peter?

Peter Kelly

Yes. I know, I think, what I said in the Analyst Day is that I believe we can see a very clear track to get into our operating margin model relatively quickly. Gross margin, given the profile and the mix of our business at the moment, is a little bit more challenging. But, yes, absolutely, you should continue to see good performance from an operating margin perspective. And we do need to continue to work on gross margin.

Richard L. Clemmer

And it was not a one quarter phenomena.

Vivek Arya - BofA Merrill Lynch, Research Division

Right. And I think, Rick, you also mentioned in your prepared comments that the conditions could stay tough for a couple of quarters. Was that a general macro comment? Or was there anything specific to NXPI that you see? And I guess within that, if you could remind us what Q1 seasonality looks like.

Richard L. Clemmer

So I think it's really more of a reflection of the anemic economic environment we see. Clearly, China is very critical to us as a company, with as much of our business that flows into greater China, as it does. And so what we've seen, is we've definitely seen a slowdown take place in the market in China as more in line with the rest of the world. There's some discussion that after the elections, and then a few months after that, when they begin to provide the economic stimulus, we could see an improvement of the environment in China. But it's not something that we have a divine perspective of. I mean, we've really been talking about this for 3 or 4 quarters, an anemic economic environment. And we saw about a 3 or 4-month period of time where, clearly, China improved. It's not the case today. With that fundamental anemic economic environment, we're not optimistic about a real growth in the fundamental business, with the exception of the ramp up of these more specific design wins that we've talked about. But if you look at -- seasonally -- our seasonal pattern, which is hard to really talk about seasonal basis in the semiconductor business with the inherent of fundamental cyclicality, but we're typically down in Q4, as we talked about, and down in Q1 on a sequential basis, then with a really strong rebound in Q2 and Q3 before we then roll off slightly in Q4 and down in Q1. So that's kind of our typical seasonal pattern. But I'm not sure that there's anything that's very typical seasonal in the semiconductor business.

Vivek Arya - BofA Merrill Lynch, Research Division

All right. And one last one, if I may. If macro conditions remained sluggish, as they are, should we expect to see bigger drawdowns from the distribution on -- or essentially more destocking in the China. I think mentioned selling them -- sell out for roughly the same, around 4% sequential growth in Q3?

Richard L. Clemmer

To be fair, that's always a challenge with our distribution partners. They would like to be sure that they reduce their inventory to the absolute lowest level possible. We'd like to be sure that they maintain adequate inventory to be able to supply our customer base. If you'd look at us, track us over the last year or so, we had been in the range of 2.4 to 2.7 months of inventory for the last 5 or 6 quarters. So we're clearly at the bottom end of the range that we've been in over this period of time and would not want to see those inventory levels go down significantly from where they are today. But -- and we think anything from 2 to 3 months of inventory is actually a very reasonable basis associated with it. So we feel comfortable that we're at the right level of inventory. That may not be the case in every different product area. You have to look at the absolute details associated with it, but we would not expect to -- we would not want to see a significant reduction associated with the distie inventories. But that's always a challenge in working with our partners associated with their turns and earns programs.

Operator

The next question comes from the line of Ross Seymore, Deutsche Bank.

Ross Seymore - Deutsche Bank AG, Research Division

Just a question first, I think, for Peter on the gross margin side of things. Given your revenue guidance and what it sounds like being some conservatism on the inventory side of things, I'm a little surprised that the gross margins is holding in as well as it is in fourth quarter. Can you walk us through the puts and takes of your guidance?

Peter Kelly

The biggest impact we have on our gross margin at the moment, Ross, is really mix. We go from -- as we go from Q2 to Q3, the fall through is a little bit more -- a little bit higher than we would like, but actually where we expected it to be. So we're probably about $12 million short and that was, as I've said, that was driven primarily by mix. As we go into Q4, you see the fall through is only -- even as we reduced, the fall through is about 45%, which maybe is a little bit better than you expected. But it really is driven by mix. So there's nothing big from a cost perspective or a cost reduction perspective that is driving that number.

Richard L. Clemmer

So if I could just add one thing, Ross, if you really think about the gross margins, one of the key factors associated with that is factor utilization. And in our IC wafer fabs, we continue to be in a pretty good factor utilization, 92%, 91% plus. And so that continued strength of the factor utilization on the IC space continues to give us some ground basis, give us some foundation associated with our gross margins in HPMS. So I think that's really the key factor associated with it for us.

Peter Kelly

To be honest, Ross, we would -- as you know, our challenge at the moment is to continue to improve our gross margin. But it's going to be a while before you see us at the level that we'd like to see it at.

Richard L. Clemmer

And to be specific, I was talking about HPMS. Clearly in Standard Products, we're operating at lower factor utilization and it's clearly one of the pressures that we do have on gross margin, Ross.

Ross Seymore - Deutsche Bank AG, Research Division

If the HPMS side, specifically, if the utilization sounds like it's staying pretty flat in the fourth quarter, what are your expectations on inventory? And I guess I'm a little surprised that you'd keep the utilization that high, given your macro commentary.

Peter Kelly

Well, I think you have to think about our manufacturing strategy, Ross. We don't actually build everything internally in the -- from an HPMS perspective. So for example, quite a lot of our ID revenue now is built in external factories and quite a portion of our P&C revenue is built in external factories. And they are both areas that are doing relatively well.

Ross Seymore - Deutsche Bank AG, Research Division

I guess one final quick one, then. On your new product areas, I know new product ramps don't typically have seasonal, and seasonality these days is a difficult topic to begin with. But how should we think about those sorts of seasons -- those markets acting seasonally, considering that many of them are very consumer-oriented?

Richard L. Clemmer

Yes, I think we'll follow the normal smartphone and tablet seasonal patterns, Ross. You should think about it that way. We clearly ramped very aggressively in Q3. So we're kind of at the runway on the first 2 design wins at the -- in Q3. And so as we said, we'd expect that to be relatively flat for Q4, but then -- following kind of the seasonal patterns. And then with, really, the next major design win ramping, kind of middle of 2013. Although some smaller design wins that we'll actually have beginning to ramp between now and then, but not really as significant in moving the needle on the overall growth.

Operator

The next question comes from the line of CJ Muse, Barclays.

Christopher J. Muse - Barclays Capital, Research Division

I guess, first question on gross margin. I guess, if you look at the wins that you have in ID and Computing and you look at your hybrid outsource strategy, how should we think about the uplift there as those wins come to fruition and you see greater magnitude there in the model in calendar '13? Is that something we should see starting kind of first half? Or is that more of a second half story?

Richard L. Clemmer

I'm not sure, CJ, I understood correctly. I guess the -- on some of these high-volume design wins, clearly they won't be the same profitability levels as kind of the fundamental rest of our business, but will drive more incremental growth. So we haven't talked about the specifics associated with those. But clearly not at the same levels. But a big chunk of that has clearly ramped in the Q3 results associated with it. So as far as any balancing associated with that, we've seen that in the Q3 results. It won't be a big factor, swinging one way or the other, as we go forward on a sequential basis from that Q3 base.

Peter Kelly

Yes. I think what I said in the Analyst Day is we see a path to exiting 2013 on an operating margin level of 25%. One of the challenges for us will be to continue to improve our gross margin percent. But the next milestone for us is to achieve a gross margin with a 5 in front of it. And that's something we're working diligently towards. But I think it'll be a while before you see that.

Richard L. Clemmer

For the total bottom line.

Peter Kelly

For the total bottom line, yes.

Christopher J. Muse - Barclays Capital, Research Division

That's helpful. And I guess as a follow up, can you walk through some of the trends that you're seeing particularly on the industrial and auto side? And what you can share in terms of your thoughts of who -- if and when we'll see a recovery there?

Richard L. Clemmer

Well, industrial, I think you should talk about them separately, frankly. I think the industrial side, we're seeing just the overall impact of the absolutely poor or anemic economic environment across the board. And you tell me when the economy's going to improve, and I'll tell you that's when industrial area is going to improve. I am hopeful that as China gets through their government change and they begin to implement some of the programs that early next year we could see an improvement associated within marketplace in China. But that's a hope, as I said. In Automotive, clearly Automotive, there's some pressure, but we just talked about -- we had record shipments in Q3 in both North America and China. So I think that really talks about our portfolio and where we are and it's really going to be dependent upon the number of cars manufacturer, with clearly the projections on the number of units manufactured next year kind of slipping down a little bit. Kind of flat to low single-digit, with the kind of the expectations, which I think we're a little -- a few points higher than that maybe 3 or 4 months ago. So I clearly think that we see a reduced outlook, but not a precipitous decline associated with the automotive market.

Operator

The next question comes from the line of Chris Caso, Susquehanna Financial Group.

Christopher Caso - Susquehanna Financial Group, LLLP, Research Division

I just wondered if you could address some of the earlier comments on gross margins? And just to be clear, the margin targets that you set out for the end of 2013, the 50% operating margin -- I'm sorry 50% gross margin, 25% operating margin, are those still achievable in light of the current macro conditions or do we think we need to wait a little bit before we achieve those?

Peter Kelly

Well, I mean, just to be clear. We said 25% operating margin exiting the full year if the macroeconomic environment doesn't deteriorate, right? I didn't actually say when we get to the 50% on gross margin. So I'd like to continue to maintain that wiggle room. The reality is, if the macroeconomic environment continues to decline the way we've seen it in the last couple of months, yes, I think it would be a challenge. But...

Richard L. Clemmer

But if it doesn't worsen from here...

Peter Kelly

We'll be okay.

Richard L. Clemmer

We still feel very confident that we can outgrow the semiconductor market for 2013. And so the real question is, how bad does the overall economic environment get?

Peter Kelly

Yes.

Richard L. Clemmer

If it doesn't deteriorate significantly from here, then probably we're in that range. But if the economic environment were to continue to deteriorate, and some of the world's economies moved into a true recession, then clearly that would have an impact associated with it. But I don't think we've seen a precipitous enough decline in the economic environment that we would see any major change.

Peter Kelly

Yes. And clearly, we've demonstrated now that we can outgrow the general market. And there's no reason that we should let that one continue.

Christopher Caso - Susquehanna Financial Group, LLLP, Research Division

All right. That's fair enough. My crystal ball on that isn't any better than yours. As a follow up, if maybe you could address the PC market, that's one of the areas where we've seen some others see some larger than normal declines here in the fourth quarter. Could you talk about -- and I guess as I look at your Portable & Computing business, it's still down year-over-year despite the handset design wins. Could you address that and sort of where we are with that? What's your exposure and what your outlook is for that part of the market?

Richard L. Clemmer

Actually, we should clarify. If you look at our P&C business, we're up 31% from a year ago in Q3. And if we're flat, it'll still be strong increase year-over-year in Q4. So I think we are experiencing the growth from those design wins that allows us to have that kind of fundamental growth on a year-over-year basis is significantly associated with it. If you look at the absolute PC, because PC -- when we talk about Portable & Computing, we're actually talking about more on smartphones and tablets as opposed to specifically PC side. But we do have products that go in PCs. Some of our interface products, some of our standard products and some of our logic products that do go into PCs. But really probably the most significant area with the concentration into the network PC business is our GreenChip basis, on the power supplies associated with that. And as we talked about, that business was flat for us in Q3. So we're not expecting to see a huge decline. But again, it's more focused on the notebook side. And what we've really found out is, is that some of the inventory gyrations associated with that space has more of an impact than just the fundamental PC demand, to be honest. But it's not a significant factor in our overall business, other than kind of the standard products and logic and discretes and some of the interface parts that we ship into the PC market itself.

Operator

The next question comes from the line of Joe Moore, Morgan Stanley.

Joseph Moore - Morgan Stanley, Research Division

You mentioned in the Industrial business at the high-performance RF sold to basestations were strong. Can you just give a little more color on that? How much of that is sort of your product cycle design wins versus strength in the market?

Richard L. Clemmer

It's really only associated with our design wins. If you look at -- as we move forward in 3G and LTE, we have a significant share of the design wins. It's kind of most of the key customers have decided that our technology is kind of the technology of choice associated with it. So as the industry basestation deployment moves more towards to LTE and 3G, clearly we will have a much larger share than we did in the 2G and 2.5G markets where we had a relatively low market share. But those design wins have been years into fruition as we've worked on them. And now we see that taking place specifically in the Q3 results. But what we found in the basestation market is, is it is probably one of the more volatile in the quarter-by-quarter basis of any segment of our business. So having those design wins is really the first step associated with it. And then how we manage the supply chain associated with the volatility in orders, or lack thereof, of basestation deployment throughout the infrastructure, is frankly probably one of the more significant challenges. But we've made excellent progress in the high-performance RF. And I think that we're the true leader in technology on the 3G and LTE basestations.

Operator

Next question comes from the line of Vijay Rakesh, Sterne Agee.

Vijay R. Rakesh - Sterne Agee & Leach Inc., Research Division

I think you've managed your costs pretty well and the hybrid model has been helping gross margins also. Can you talk about what other initiatives you have in moving the operating margin goal from 18% to 25%?

Peter Kelly

I'm sorry, the line wasn't very good there, could you just repeat your question?

Vijay R. Rakesh - Sterne Agee & Leach Inc., Research Division

I said you managed your cost pretty nicely here. And the hybrid model is helping your gross margins, but can you talk about what initiatives you have in moving the operating margin from 18% to 25%?

Richard L. Clemmer

What can we do.

Peter Kelly

There's a number of things we can do. But one of the things that really helps us is, as we grow with these specific design wins, how we grow -- and in how we grow with our ID business in particular, there are businesses where we've -- we get relatively weaker gross margin than our normal entitlement. But the volume could resolve fixed costs in a much better way. So the pull through that we get is pretty substantial, actually.

Richard L. Clemmer

Yes, I think it's probably worth pointing out that with the very anemic economic environment that we see, we're being very selective with some of our investments. Clearly we're -- we continue to step up our investments in our ID business and focus on the smartphones and tablets space. But in a lot of the other areas, we're basically pushing out some of the increased investments until we see a more robust economic environment where we feel like we have the capability to make those investments. So I think that's really a factor for us, is being very focused and very selective on our R&D investments. And clearly, we want to be sure that on the SG&A side, we move towards best-in-class from overall semiconductor performance viewpoint.

Vijay R. Rakesh - Sterne Agee & Leach Inc., Research Division

Got it. And one last question. When you look at your interest payments, it's already running at that $200 million, $220 million level for next year. I think there was a previous question to that. Any idea what cash flow you -- any reason why you're not going to start to look at some of these payments -- paydowns again later next year or middle next year?

Peter Kelly

You guys are tough. So only a quarter ago, I was saying $240 million to $260 million. So I thought you'd be pretty pleased with $200 million to $220 million. But, yes, as we generate the cash, I will absolutely look at what we do with that. And we're extremely committed to paying down our debt. So...

Richard L. Clemmer

And we actually have some debt that comes due in 2013 that we'll pay down from just our operating cash flow.

Peter Kelly

Yes. Right.

Vijay R. Rakesh - Sterne Agee & Leach Inc., Research Division

Got it. And what is the cap rates for next year? Did you give that out, yet?

Peter Kelly

What we typically talk about is 5% of revenue through the cycle.

Richard L. Clemmer

Thanks, Vijay.

Operator

Next question comes from the line of Gareth Jenkins, UBS.

Gareth Jenkins - UBS Investment Bank, Research Division

I just wanted to -- question on the MCU market to the trends you're seeing there, particularly emulation to the 32-bit versus 8-bit. I think you cited at your Analyst Day that 8-bit was expected to be down around 14%, I just wonder if you've seen any further deterioration on that? And any further acceleration in the 32-bit or recover, I should say? And then secondly, I just wonder if you could give a sense of book-to-bill, basically, on the major areas as we head into the quarter, what the booking is looking like, and how that's moving.

Richard L. Clemmer

So first off on the microcontroller side, we talked about 32-bit being weak in the -- at 32-bit for serving 32-bit ARM base, serving the industrial market actually being weak in Q3 still. So I think that's probably -- it is weak and until the general economic environment improves, we would not expect to see a robust recovery associated with the 32-bit ARM base microcontroller business. And I'm specific about that because a significant portion of our ID business obviously is secure microcontrollers as well. So I'm just trying to be specific about the 32-bit ARM based microcontrollers for the industrial space. And I'm sorry, I forgot what the second part of your question was?

Peter Kelly

Book-to-bill.

Gareth Jenkins - UBS Investment Bank, Research Division

Book-to-bill.

Richard L. Clemmer

You know, Gareth, we don't provide a book-to-bill number on our call. Primarily because our business has very different patterns across different end-markets. So really if we give you a number, it's really not very insightful. And that it might actually cause you to draw the wrong conclusion. So we really -- it's not our metric that we provide on our earnings call. The one thing that we should say is, is that orders have been weak for the -- for Q3, I think we've said that. And they continue to be weak. We feel comfortable with the guidance that we've said for the Q4 timeframe. But clearly orders are weak and we have to be sure that we continue to perform to be able to execute the revenue guidance that we've laid out for Q4.

Gareth Jenkins - UBS Investment Bank, Research Division

And just as a follow up, I mean you've talked kind of at length about inventories and your own inventories and the disties inventories but have you any sense of the OEM inventory levels? I mean it feels like there's still a fair bit of inventory sitting at the OEMs , in both autos and industrial. But have you got any sense of that?

Richard L. Clemmer

Autos, I think when it comes down to many factors. There's inventory levels that head throughout the value chain. I understand that there are some cases where there's inventory of high-end cars in certain regions. So clearly that will be a factor and have to be worked down. I think that as we look at flat to 1 or 2 percentage point increase in overall automotive shipments in 2013, that comprehends the expectation associated with normalizing the inventory in Automotive space. In Industrial space, everybody has a theory about where inventories are. I don't really believe that with the industry -- that all of our end customers, the way they are today, that there's a huge amount of inventory because a lot of our customers are on a pull basis and I just don't believe that they have a significant ramp up of inventory in place. I see a lot of the press, but we certainly have no specifics that would confirm that.

Operator

Next question comes from the line of Harlan Sur, JP Morgan.

Harlan Sur - JP Morgan Chase & Co, Research Division

On the ramp -- it's good to see the ramp of your first 2 high-speed interface products with your smartphone customer, and it sounds like, Rick, you're still on track to ramping your third interface product kind of middle of next year. I guess, my first question is, is NXP sole sourced on all 3 of these products?

Richard L. Clemmer

Well so, Harlan, first off, we should be specific. The first 2 design wins, one of those is a very sophisticated interface part and other one is a simple switch that is in it. So I just want to be clear associated with it. If you look at the design win that we talked about that will ramp in mid 2013, it's actually a microcontroller associated with it, with unique applications associated with it. But we think that we're in a very solid position. Our customers have various sources of supply. We think that we're in a very good position associated with these. And we'll continue to move forward in supporting all of our customers with the deployment of this technology.

Harlan Sur - JP Morgan Chase & Co, Research Division

Great. And then as it relates to your RF -- your high-power RF -- power amplifiers grew quite nicely in the third quarter. Just wondering what's embedded in your guidance for those particular products in your outlook for the fourth quarter?

Richard L. Clemmer

Well, we don't expect to see the -- with the current expectations from customers, we wouldn't see that growth. We'd see -- as we talked about earlier, that particular segment is very choppy associated with it. And we don't break down the specific guidance on our high performance RF but the -- we're, I guess the real question is, is when will the ramp up of basestations take place on 3G and LTE? I continue to believe that the fundamental requirements of data processing are going to drive a further increase in demand in basestations. And as that takes place, we feel very comfortable with the design wins that we have we'll be in a leadership position of ramp up of revenue. But it's going to continue to be choppy and we're certainly not planning on any growth and maybe a slight decline in Q4 associated with basestations.

Peter Kelly

Yes. Just to add to Rick's comments there. When we talk about our guidance from Q2 to Q3, we mentioned that the increase in basestations was probably because we think some of our customers have gotten pretty lean in terms of their inventory, so they needed to restock a little. So you do see those swings that Rick talked about. And yes, Q4 will definitely not be as strong as Q3 for the base stations.

Richard L. Clemmer

But going into 2013, we're very optimistic as the -- as 3G and LTE basestations ramp, it will be in a great position, Harlan.

Jeff Palmer

Sonia, we'll take one more call, please.

Operator

The next question comes from the line of Philip Scholte, Rabobank Bank.

Philip Scholte - Rabobank Equity Research

Given your comments on your macroeconomic view, are there other any additional measures you are taking directly to protect margin in terms of cost savings, closing down specific parts of fabs? Anything in that respect?

Richard L. Clemmer

Well, we announced the -- a couple of quarters ago that we're going to take our 3 fabs and 9 meg [ph] in the Netherlands and move that over an extended period of time into one 8-inch facility to continue to drop further cost reductions associated with that. So we continue to work on that and work towards that. We'll always be working on our factory loadings and ensuring that we drive our cost reductions associated with it. But that's kind of the fundamental requirement in the semiconductor industry. And we'll continue to work on programs. As I said, we're very focused on being sure that we move to top-tier SG&A performance. And clearly, that's an area that we'll continue to work as well.

Philip Scholte - Rabobank Equity Research

Right. And maybe as a follow up, do you provide a geographical breakdown of the Automotive part?

Richard L. Clemmer

We do not. The real problem with that is, is as we ship to our customers, we're not sure where they actually deploy that. Because they actually move product around. So anything that we would tell you on a regional basis, we think would be misleading. But it is important to realize that we had record shipments into North America and China in the Q3 timeframe in our Automotive business.

Operator

Thank you, I would now like to hand the call over to Mr. Clemmer for closing remarks.

Richard L. Clemmer

Thank you, operator. So we thank you for your continued interest in NXP. In summary, we believe that our Q3 results demonstrated measurable success in executing our long-term strategy. Specifically, achieving product revenue growth of 9% in this overall economic environment, clearly better growth than our peers, really confirms the strategy that we've put in place and have been discussing with you. We delivered improved operational performance resulting in a 25% sequential improvement in net income. And then the resulting $100 million of free cash flow generation clearly continues to drive our focus on deleveraging our balance sheet and continuing to reduce our debt with the repayment of $200 million of high coupon Super Priority Notes. With the fundamental anemic economic environment continuing to challenge sustained revenue growth, we think that our progress in new areas of engagement, position NXP in a positive fashion that will support better than industry performance. Thank you so much.

Peter Kelly

Thank you, everyone. And we'll speak to you in the future. Thank you, operator.

Operator

Thank you for your participation in today's conference. This concludes the presentation. You may now disconnect. Good day.

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