Cypress Semiconductor Corp (NASDAQ:CY) Q4 2018 Earnings Conference Call January 31, 2019 4:30 PM ET
Colin Born – VP, Corporate Development & IR
Hassane El-Khoury - President, CEO & Director
Thad Trent – EVP, Finance & Administration, CFO & Principal Accounting Officer
Conference Call Participants
Vivek Arya - Bank of America Merrill Lynch
Karl Ackerman - Cowen and Company
Sujeeva Desilva - Roth Capital Partners
Vijay Rakesh - Mizuho Securities USA
Rajvindra Gill - Needham & Company
John Pitzer - Crédit Suisse
Blayne Curtis - Barclays Bank
Christopher Rolland - Susquehanna Financial Group
William Stein - SunTrust Robinson Humphrey
Craig Hettenbach - Morgan Stanley
Harlan Sur - JPMorgan Chase & Co.
Charles Anderson - Dougherty & Company
Harsh Kumar - Piper Jaffray Companies
Good afternoon, and welcome to Cypress Semiconductor Fourth Quarter 2018 Earnings Release Conference Call. Today's conference is being recorded. If you have any objections, you may disconnect at this time.
I would now like to turn the call over to Mr. Colin Born, Vice President of Corporate Development and Investor Relations. Sir, you may begin.
Thank you, Brendan. Good afternoon, and thank you for joining our Q4 2018 earnings conference call. With me today are Hassane El-Khoury, CEO; Thad Trent, CFO; and Mike Balow, Executive Vice President of Worldwide Sales and Applications. Hassan will make some introductory remarks, Thad will provide a financial overview, and then we will take your questions.
All information discussed in our earnings release and on this call is based on preliminary unaudited results, and we encourage you to review our 10-K once it is filed.
During the call, management will make statements about our first quarter guidance, our long-term financial model and other future matters that should be considered forward-looking. Actual results might differ materially from the results anticipated in our forward-looking statements. Please refer to our earnings release, the risk factors in our most recent filed 10-K with the SEC and our other SEC filings for a more detailed discussion of risks and uncertainties that could cause these differences. All forward-looking statements are based on the information available to us as of today, and individuals are cautioned not to place undue reliance on our forward-looking statements.
In addition, we undertake no obligation to update these statements. Please note, the financial measures to be discussed by management today are non-GAAP measures, unless they are specifically identified as GAAP measures. Reconciliations of non-GAAP measures to their most comparable GAAP measures and others certain limitations of non-GAAP financial measures are included in our earnings release and our investor presentation deck, both of which are dated today and available on our website at investors.cypress.com.
I will now turn the call over to Hassan.
Thank you, Colin, and thanks, everyone, for joining us today. 2018 was a solid year for Cypress as we continued to execute on our Cypress 3.0 strategy by focusing on the higher-growth markets of automotive, industrial and IoT. In spite of some headwinds that arose towards the end of the year, we successfully grew the business by 7%, which is within our stated long-term growth target of 7% to 9%. This increase was fueled by the continued expansion of our content in the automotive market, which was up 13% in a year when automotive units are expected to increase approximately 1%.
In addition, we saw 11% growth in our industrial business, well above our targeted 3% to 5% range, thanks to our world-class portfolio of connect and compute IoT solutions. Our enterprise business was up 8%, largely driven by the continued build-out of 5G infrastructure.
We were successful in achieving our gross margin targets, exiting the year at 47.8%, an improvement of 1,080 basis points since we launched our Cypress 3.0 strategy in 2016. We are extremely proud to have hit these targets, which resulted from a lot of hard work, including: rationalization of our supply chain; moving from 2 factories to 1; the introduction of critical new products at/or above our gross margin targets; and a restructuring of our memory business to exit lower-margin commodities and focus on more stable and predictable specialty storage products serving the automotive, industrial and enterprise end markets.
The pending joint venture with SK Hynix system's ic is another step in this transformation and aims to further reduce our exposure to volatility in the commodity memory market, especially consumer, which is about half of our NAND revenue today. After closing this JV, we expect over 90% of our specialty storage revenue will come from automotive, industrial and enterprise, where pricing has been stable over the last couple of quarters. We expect this stability to continue in 2019.
2018 was also an excellent year of new product execution for Cypress. We introduced our next-gen PSoC 6 MCU, which delivers ultra-low power and secure computing for IoT applications; our Traveo II triple core and secure MCU architecture, which greatly expands our automotive feature set and addressable market at a significantly improved margin profile; our new family of 28-nanometer WiFi Bluetooth combos, offering the industry's lowest power connectivity and most advanced 11ax WiFi 6 connectivity. We introduced our Semper NOR Flash for automotive and industrial applications, adding compute to our specialty storage solution; and finally, a variety of USB-C products tailored for specific high-growth platforms.
We further enhanced our software offerings through the launch of our ModusToolbox and Cirrent platforms. ModusToolbox supports IoT developers with the most compelling ecosystem of combined MCU and connectivity tools, SDKs and services. Cirrent software and cloud services uniquely improves the WiFi setup experience for end customers, thereby, enhancing our connectivity products' appeal to OEMs and creating a new revenue opportunity for Cypress.
Cypress is significantly stronger, exiting 2018, which is timely, as it appears we are heading into some challenging times in the industry. Thad will discuss the specifics of our outlook later, but I want to provide some insight into how we are approaching these challenges. The outlook remains uncertain as there continues to be a fair amount of cautiousness in our channel, especially those serving China, where end demand has clearly been impacted. In the rest of Asia, the U.S. and Europe, we broadly felt the impact as customers cautiously navigate the uncertainty surrounding the trade conflicts, tariffs as well as the disruptions related to factory relocations.
We have been more cautious with our inventory management in the channel, ensuring we release shipments against backlog only as we get more visibility on end customer demand as we balance sell-in and sell-through. While backlog for the second half of the year seems to be stabilizing and cancellations remain within normal limits, I remain cautious in our outlook until we have a more stable environment to count on. The good news is that customers continue to invest in developing new products using Cypress solutions. Overall, design wins at Cypress in 2018 were up 24% year-over-year, 37% of which were from new products. Design win growth was led by MCD, which was up 32% year-over-year. As an example, the design win funnel for our Traveo II automotive product, I mentioned earlier, has reached $1.2 billion in the last 3 quarters since we sampled the product. Highlighting the product's competitiveness in its market, I will also add that this funnel is highly accretive to our automotive margin. While low-power and secure connect and compute technologies are rapidly being added to many of the electronics in our everyday lives, we believe we are still in the very early phase of the IoT build-out. As an example of our expanding addressable market, penetration of IoT technologies in smart home and appliances is only 20% today and expected to double by 2022.
WiFi has become the de facto standard for the IoT, and Cypress is well positioned to capitalize on the strength with industry-leading 11ac WiFi Bluetooth combos. Also, WiFi Gen 6, or 11ax, is coming very soon, and Cypress is ready. Gen 6 is not only faster than 11ac, but also adds more advanced spectrum management and scheduling technologies, which improve overall network capacity and efficiency. We expect the first generation of WiFi Gen 6 solutions to be deployed in phones and routers in 2019.
With this infrastructure in place, the stage is set for Cypress to capitalize on the billions of WiFi clients and edge devices that will soon follow. In fact, the advanced WiFi technologies are already being designed into connected cars with RSDB solutions. Finally, Cypress continues to be in a pole position for the continued ramp of USB-C. During 2018, we shipped our 2 billionth USB device, regaining our #1 share. And in 2019, we expect USB-C to continue its march towards ubiquity as it moves into more devices, charges, docks, automobiles, PCs, phones and cables. At the end of the fourth quarter, 592 platforms are in production with Cypress USB-C solutions, up from 490 last quarter.
In summary, we had an excellent year in 2018 with financial and product execution that have strengthened our company. While Cypress has not been immune to the recent economic malaise, we maintain our focus of delivering our targeted operating income as we remain well positioned to win within some of the most compelling trends across high-growth automotive, industrial and IoT businesses and design activity supporting our strong positioning in many of the key megatrends happening in 2019 and beyond. That gives us a lot to be excited about for the years ahead.
With that, I will turn it over to Thad, and then we can take some questions.
Thanks, Hassane. I'll start out with providing an overview of our results for the full year 2018, then step through the Q4 results and wrap up with guidance for Q1. Starting with 2018. 2018 was another exceptional year as we executed our Cypress 3.0 strategy. In spite of the headwinds that emerged towards the end of the year, we achieved many new milestones as we structurally changed Cypress to be more stable and predictable. Our 2018 revenue was an all-time record at $2.5 billion, increasing 7% over 2017. Our automotive business increased 13% year-over-year, growing 10x faster than worldwide automotive units as we continue to gain content in the connected car of the future.
Our gross margins for the year improved 460 basis points, the 46.8% and we exited the year achieving our target of 47.8% in Q4. Since embarking on the Cypress 3.0 journey, gross margins have improved 1,080 basis points. In 2018, Cypress achieved 22.8% operating margins, delivering $1.36 in earnings pressure, which increased 53% year-over-year and 8x faster than revenue, demonstrating the leverage in our model.
On cash flow, we increased our free cash flow 16% over 2017, and our net leverage ratio is now 1.0x compared to 4x in 2016. This is now giving us flexibility on our balance sheet, and as part of our ongoing effort to return capital to shareholders, we augmented our dividend by reinitiating our share buyback activities in Q2. In 2018, we repurchased 2.3 million shares for $35 million. We also announced the divestiture of our highly commoditized NAND business through a joint venture with SK Hynix system ic. This transaction is expected to close by the end of Q1 and provides an ongoing cash flow stream through 2023. These results are only possible with the dedication of our worldwide team focused on execution and delivery.
Moving to results for the fourth quarter. Revenue was $604.5 million, representing an increase of 1.2% year-over-year and a decrease of 10.2% sequentially as compared to normal seasonality of down 3% to 4% in the fourth quarter. The primary reason for the shortfall was slowing China consumer and industrial revenue, although we started to see some softening in other regions. We're also reporting another quarter of record automotive revenue, increasing 3% sequentially and 19% over Q4 of 2017.
Inventory in our distribution channel, which accounted for 71% of revenue in Q4, decreased from 7.7 weeks to 7.2 weeks of inventory. On a dollar basis, inventory in the channel decreased 14% as we actively managed replenishment orders to match end demand. We continue to see our Asia-Pac distributors remaining cautious or in a wait-and-see approach to the market uncertainties. And as I mentioned, Q4 gross margin came in at 47.8%, an increase of 240 basis points from Q4 2017, and up 80 basis points sequentially, even with the lower revenue base. Gross margins improved in both divisions sequentially, and utilization of Fab 25 increased in Q4 to 85%.
In addition to the gross margin expansion, we also managed spending in line with the revenue decline, resulting in operating margins of 24.5%, and non-GAAP EPS of $0.35 for the quarter. So turning to the divisions. MCD revenue was $355.8 million, slightly down from Q4 of 2017 and down 14% sequentially from Q3. We saw broad declines across most business units, offset by auto MCUs and USB-C, both growing low single digits sequentially, despite headwinds at major handset customers -- at our major handset customer. Excluding this handset customer, 2018 USB-C revenue increased 52% over 2017 as adoption of this new standard continues to accelerate.
Wireless IoT declined more than seasonal due primarily to weakness in consumer end markets and declines in Nintendo. Despite the macro headwinds in Q4, non-Nintendo revenue increased 20% year-over-year in the second half, demonstrating the strength in our broad wireless IoT penetration.
MPD revenue was $248.7 million, up 3.5% over Q4 2017 and down 4.2% sequentially from Q3. We saw a fairly dramatic decrease in NAND of 32% sequentially due to oversupply and price declines, many of our competitors in the market have also reported. However, unlike our peers in the NOR market, Cypress' NOR business saw 7% sequential growth, thanks to our focus on the high-end, high-density specialty storage applications at customers serving automotive, industrial and enterprise infrastructure. In fact, during 2018, Cypress' average NOR density per chip increased by 15% year-over-year and is currently over 4x higher than the average for the overall NOR market. It's also worth noting that over 2/3 of our 2019 NOR business is already under a long-term contract, providing improved visibility.
Let me give you some additional numbers for your models. Our Q4 operating expenses were $141 million or 23% of revenue. OpEx was down $9 million from Q3 as we actively controlled spending as we saw the market softening.
Q4 operating income was 25%, increasing 23% over Q4 2017 to $148 million. Our OIE was $10.8 million, flat from Q3. Our non-GAAP tax expense in Q4 was $6.3 million, up from $2.8 million in Q3, primarily due to true-up associated with newly issued tax regulation on the U.S. tax reform. Our diluted share count was 374.9 million shares. This includes 1.5 million shares for the in-the-money portion of our convertible notes. Please note that we updated the convert dilution reference table on our IR website to assist you with calculating the share impact at various stock prices. This resulted in net income of $131 million or $0.35 per share at the high end of our guidance range.
Turning to the balance sheet. Cash and short-term investments totaled $286 million, and we have $540 million undrawn on our revolver. Accounts receivable was $324 million, resulting in DSO of 49 days. Cash from operations was $142 million or 24% of revenue. Net inventory increased $3 million sequentially to $292 million and days of inventory increased to 84 days due, primarily, to the abrupt market downturn. We expect inventory days to increase, once again, in Q1 due to the current market conditions as well as an inventory build to support our ongoing optimization and consolidation of our manufacturing footprint.
Our Q4 adjusted EBITDA was $165 million or 27% of revenue. Total debt was $936 million, and approximately 80% of our debt is now fixed rate with the converts and interest rate swaps we have implemented. Our net debt is $650 million as we have been increasing cash on the balance sheet.
As I mentioned earlier, our net debt to EBITDA leverage is now 1.0x on an LTM basis. CapEx was $5 million, which included the benefit of $5 million for a building sale executed in Q4 and depreciation of $17 million for the quarter. We repurchased $15 million in shares during Q4 and have $176 million remaining on our authorized buyback.
As a reminder, our long-term model is to return 50% of free cash flow to shareholders through the dividend and the buybacks. Now turning to guidance for the first quarter. Taking into account the market uncertainty, we're expecting Q1 revenue of $520 million to $550 million. This assumes a full quarter of NAND revenue at $25 million to $30 million for the quarter. We again entered the quarter over 90% booked, but as I mentioned earlier, we will manage our distribution backlog and shipments to closely match end customer demand. The book-to-bill declined from 0.8% in Q3 to 0.77% in Q4, with both divisions below 1.0%.
Consistent with normal seasonality, we expect Q1 gross margins to decline to be in the range of 46% to 46.5%. This also includes the dilutive impact of the NAND business in the range of 40 to 60 basis points. As always, gross margins will vary with product and customer mix. We expect Q1 operating expenses between $141 million and $143 million for the quarter as we continue to control spending. Net OIE will be approximately $10 million. Tax expense will be approximately $4 million. CapEx is estimated to be $13 million and depreciation of approximately $17 million.
We anticipate the fully diluted share count to be 377 million shares. As a result, earnings per share is expected to be in the range of $0.22 to $0.26 for the quarter. To wrap things up, in spite of the headwinds facing the business, we remain optimistic about the opportunity to increase shareholder value over the long term by continuing to execute our Cypress 3.0 strategy. We have restructured our business over the last 2 years to enable us to be successful in any environment with differentiated products serving in many of today's most exciting megatrends.
With that, I'll now turn the call back over to the operator to begin Q&A.
[Operator Instructions] And our first question is from Vivek Arya with Bank of America Merrill Lynch.
Good job on the Q4 execution, and especially good to see the growth on the automotive side. Hassane, for Q1, can you give us some color on what you are seeing in different end markets versus seasonal trends? Of course, macro impacts seem to be broad-based, but if you could just walk us through your different products and end markets, where you see trends seasonal versus nonseasonal? And as part of that, if you could also specify the NAND contribution of Q4 and Q1? I think you gave for Q1. I didn't hear a Q4 number.
Yes. So I'll give you a little bit on the trend, and then I'll pass it over to Thad to give you a little bit on the numbers in the Q4 and Q1 for NAND. So if you look at -- if you listen to our commentary, there's still a lot of uncertainty outside. But looking at it, China consumer, a little bit on the industrial, we're still seeing softness and a wait-and-see from customers. And what this is causing us to do, across all of our markets, is to be very cautious about when we ship into the channel. So what you saw is channel inventory has been coming down, which is through active management of it. Our weeks of inventory has also went down. What we are trying to prevent is us shipping and then the lack of visibility causing the POS not to happen. And that's across, primarily like I said, China consumer and some of the industrial. We're seeing some of that cautiousness in other regions, not to the extent of China, but it's not specific to a market or a submarket as we've always been used to. That's on top of the normal seasonality that you'll see, which is Q1 is typically down, then you'd see Q2 up, Q3 up then the Q4 quarter is slightly down for the -- after the holiday bills. We're not seeing any changes like that. It's just at a different level. I made a comment in the second half of the year, I would say backlog is balanced. But the cautiousness from our side is, I'd like to see more visibility on the end demand across these markets before we start shipping at a normal rate, which today at least you could believe if you hear my comments properly, we're not shipping at the normal run rate that the backlog is at. We're throttling until we see visibility on a 1:1 sell-in and sell-through.
Yes, Vivek, this is Thad. On the NAND business. So I mentioned that NAND, we saw a steep roll-off in Q4, primarily because of oversupply and price declines there. The revenues was down 32% sequentially. As you look forward in the Q1, we expect the revenue to be $25 million to $30 million for the quarter. We expect more pricing pressure. We expect it to be dilutive to overall gross margins and that's why I said it would be 40 to 60 basis points lower on a consolidated basis. So for Q4, you can, kind of, think about the dilutive impact as that roll off from the Q4 numbers is a couple of pennies on EPS.
All right. And for my follow-up, Hassane, autos was a very strong driver for you last year. Looks like you outgrew a lot of your peers. Give us a sense of what happens if, let's say, we get into a negative unit situation this year. I understand content is really what drives growth, but do you think it can be strong enough to offset the unit headwinds? And as part of that, if you could give us some color around what you are seeing in automotive markets in the different geos.
Sure. So to answer your first question, the answer is, yes. Our content story, I've been mentioning our content and our -- not 1:1 alignment with units for the last few years. Now we've really hit the mark because now the units are flat to probably going backwards in 2019. With that, we're still very bullish on our automotive position. We have been bullish through 2018, and we outgrew the market 10x the unit growth. I see that happening in '19 as well, regardless of what the actual unit is going to be. If the unit is actually a decline, so if we see going backwards on the unit, Cypress automotive is still expected to grow not at the same rate as we did, but think about it as a -- just a slight lower growth from us. But I remind you, our long-term target for our auto business is 8% to 12%, that I've outlined in Analyst Day of 2017. And that was based on low single-digit unit growth. So if the units go flat or even go slightly down, you are still going to see mid- to high single-digit growth in our automotive business, and that's the visibility we have, both today and in our future funnels, specifically on Traveo II that I give you some data points on. So I'm very comfortable with where our automotive is. I've always been comfortable with our position through the last 2 years, and moving forward, I have the same comfort. What the market does the market does, our focus is on growth, taking share and playing in the new content that didn't exist a few years ago.
Our next question is from Karl Ackerman with Cowen and Company.
Hassane or Thad, I know you don't want to guide quantitatively beyond one quarter. But I'm curious whether you endorse the broader view from your peers that we should see demand acceleration in the second half? And I guess as a follow-up, would you expect the order headwinds within distribution to abate by the second quarter? And perhaps, maybe importantly, when would you expect the plethora of design wins you've announced in the second half of 2018 to manifest into revenue?
Yes. So I'll give you my view of it, and then I'll have Thad add to it, if he has any thoughts. Overall, yes, I see a different backlog trend, different demand, different order trend in the second half of the year, even in -- slightly before that. So that puts comfort for us. However, there's still the uncertainty in the market. Although cancellations are within the normal limits, as I mentioned, that's not what causes the cautiousness on my side. It is the potential pushouts, meaning if there are still tensions, if there's tariff, if there's more disruption, although the orders are there, nothing prevents outside of the change window that we have with customers to push it out over a quarter boundary. And that's where we can't have inventory be trapped because we are recognizing revenue on sell-in. We don't want inventory to be trapped in the distribution channel. We want to see visibility on the customer pool, which we do, and that's when we ship into the channel, so it goes straight to the customer after that. That's the latency that we are looking for. That's the cautiousness you hear from me. But from an order, Thad mentioned, we're walking into the quarter 90% booked. But that's not what I'm worried about. It's not whether or not we're getting the order, it's whether or not the orders will get released and pulled by the customer at the -- on the other side. But the view of backlog, I do share with the peers, it's a better view in the second half of the year than it was in Q4 and Q1 as far of the slope or even the direction of the backlog. So call it, half the problem is behind us potentially, the second half has -- is demand going to follow through with it and pull.
Yes, I would just add, I mentioned the inventory in the channel was down 14%. If you look at our revenue through the channel in Q4, it was down about 12%. So we clearly are undershipping natural demand. We'll continue to monitor that. In terms of just what's happening out there, I think both our distributor customers as well as our direct customers are ordering late. They're very cautious. I think that pattern is -- has -- I think everybody is adjusted to that new order pattern. But I think it's just too early to tell long term what's going to happen here. There's still too much uncertainty.
And the second part of your question, you mentioned about when do we start seeing the revenue of the design wins that we have announced in the second half 2018? We're actually starting to see them at a run rate basis. So in 2018, those contributed to, obviously, half of the year of a ramp or slightly before -- below that because of a softer ramp up. We're going to see that on an annual basis in 2019. The example I gave last quarter about the GM, the Global-B, that started ramping. We're going to see a full year of that, specifically in this case in the automotive, which gives me the confidence and the bullishness while I mentioned at the prior question about automotive is going to grow for us, regardless of what the units would do because all that is new content for us. We were not in the prior generation. Any unit growth in this for us in this case specifically, a 5x content growth. So we're going to -- we're seeing those. We're seeing those in the first quarter. We're seeing those in the backlog and the order pattern. We just will start shipping them and get them on an annualized basis.
Our next question is from Suji Desilva with Roth Capital.
I know the visibility is cloudy here, but can you give us some sense of what do you think the outlook is near term for MPD versus NCD -- MCD? I do understand the NAND is a headwind in MPD. So aware of that factor, but any color there would be helpful.
Yes. So the Q1 is normally seasonally down. And that's going to be across the divisions. The strength, one thing if you compare MPD, I would caution everybody not to compare to the MPD peers. Because I think we've proven over the last 2 quarters, we're not trending like our peers. Everybody is -- call it, the bottom has fell with our -- some of our peers in the commodity memory. We are not. We have been growing, and we will continue that trajectory. Q1 being a seasonally down quarter, I wouldn't put a trend on that. But overall, if you look at the design win trend, they are led by MCD and they are led by MCD and across a lot of the -- their businesses. So growth long term will remain from MCD. But MPD is holding its ground because of the stability of the ASPs as well as still some constraint in demand for the high density.
Yes. Suji, we're expecting both divisions to be down in Q1, and obviously, more than seasonal.
Got it. And then my other question is really around the gross margin, and kind of, looking at the peak to trough, this potential downturn -- this downturn versus prior peak to troughs and how you're managing it. And I can tell that you're being very cautious about moving inventory into the channel until there's an order and you decide of it. But if you could talk about how you plan to mitigate the weakness impact on your gross margin? And also, whether there's any flexibility in the OpEx? You already -- you just had the NAND transaction, anything like that to help in case the downturn does ends up being deeper and more prolonged.
Yes. I think you've seen us do a good job on managing OpEx, right? We did it in Q3. We did it again in Q4. If you look at our guide, we're keeping a lid on it, right? So we can adjust there. I think we've got a proven track record of being able to manage OpEx. On the gross margin side, just to remind you, a normal seasonal Q1 is typically down about 100 basis points, and that's just kind of a product mix and unfavorable mix throughout the year. So for the quarter, we're down slightly more than that. But like I said, the NAND is having the negative impact on that, and that's part of the reason that we're divesting that business. So our Fab 25 is fully utilized at 85%. We'll be able to manage through that. We're moving production inside/outside. We're managing our, kind of, manufacturing footprint to make sure we can weather through the storm. And I think you'll see us be very prudent when it comes to spending on the COGS line as well as on the OpEx side of things.
Yes, and we're monitoring everything very closely. Obviously, as things change, we will adjust real-time. I've always talked about -- since the last couple of quarters, about our focus on our model earnings, our operating income. And that will modulate and -- to get through a whatever this downturn or softness or delay, however you want to call it or label it, we'll get through it and we'll come out on top, while we manage our investments properly, which is we're still investing in our strategic products. We can't get eyes off the ball. We have to maintain that because they are winning and we are well positioned in the market, so we have to plough through that. While everything else, we are tightening our belts on anything other than demand creation and strategic R&D projects. We'll keep doing that until we have visibility in order to get the stability of income and the predictability that you have come to see from us for the last couple of years.
Now one thing, Thad said about the other recovery is going to be a natural recovery for the gross margin as soon as the NAND transaction when we close it, that drag will no longer be on the overall company. So you can, kind of, think about that as the only step function you'll get in gross margin. Everything else is mix and cost related, which we have proven over the last couple of years, we're very good at.
Our next question is from Vijay Rakesh with Mizuho.
Just a question on the NOR side. Obviously, a good job on 4Q. Looks like it grew sequentially versus many of your peers in Taiwan. They've been hurting. You've mentioned, 2019 almost 2/3 booked or under long-term contracts. Can you give us some more color on how the inventory in the channel looks there? And are you sole-sourced for a lot of these contracts?
Yes. So 2/3 are in long-term agreements. They're very similar to the playbook we've had in prior -- in 2017, 2018. So I'm not too worried about the contracts. The customers have seen the value that we provide, both on the high density and the ability to supply and not be distracted by the low-density commodity shipped by bits by the pound type business. We've walked away from that business 2 years ago. We have stayed the course, and I've always reminded everybody, when the market turned, we did not want to turn with it. That happened. Everybody went down. We stayed up. That's both on units and ASPs, and we see the ASPs been very stable through 2019. Therefore, I will make the call now, we have a very different NOR business than anybody else in the market today. The numbers show it, I don't have to talk about it anymore. That's on the NOR. If you look at automotive, if you look at enterprise, if you look at the businesses we are in, which is over 90% of that post-transaction, post-JV, those are high-reliability proprietary products that go for years to be qualified into the socket. So per socket, per project, we are single sourced. And that gives us the confidence and the credibility of our outlook, specifically for NOR. It's a very different business that Cypress has. We've been saying it for two years, and I'm sticking with it.
That's very helpful. Just going on the IoT side, as you look at 2019, any thoughts on how you expect the growth there year-on-year? And any thoughts in competition? You mentioned some good drivers there with .11ax and WiFi 6.11ac, et cetera. If you can give us some more color there?
Yes. So I'll give you the reason I made some of the commentary about the market penetration and the market expansion. We're still at the beginning of the IoT expansion. The example I gave was the home appliance or the smart home, we're only 20% penetrated. We, meaning, as an industry into the market. 20% penetrated, that penetration is going to be doubled by 2022. So the growth is there. I'm not going to predict a gross specifically to that business because we just talked about all the uncertainty and where we are. We need more time to get that visibility. What I can tell you is I'm very confident in our design-ins and those are the leading indicators. What the market does on pull and design and deployment, the market will do, it's hard to predict today. We've been very well at predicting it for the last couple of years, and we've come at/or ahead of that. But forward looking, it's hard until we get a little bit more visibility where the market and where the uncertainty is going to land.
What I'm focusing on today is making sure the momentum of new products and design-in is there. And that's the reason you hear me talk about the Gen 6 WiFi. That is the second phase. We see that deployment in the infrastructure, meaning, the gateways and home gateways and so on and phones, starting in at the end of this year, 2019. Think about 2020 and beyond is when the edge devices, which is where we play, will start going to WiFi 6. The beauty of it is, we've already got silicon, we've sampled customers, and we'll keep pushing that. So when the ramp happens, we will be there already. That's why the future is what I'm focused on as far as investments and deployment. 2019 is going to be what 2019 is with our market share and our growth opportunity that we already have. Thad mentioned, in a year, where we saw a lot of softness towards the second half of the year, that second half of the year ex Nintendo, our broad IoT market grew 20% from the second half of '17 to the second half of '18. That should give you at lease an indication of our position and our market share versus competitors in the broad market.
Our next question is from Rajvindra Gill with Needham & Company.
Just a question, Hassane, on the view of the backlog in the second half. You have a better view or the nature of it's better, say, what you saw in December, and it's kind of similar to what some peers are mentioning. What is the reason for that? Why all of a sudden is the view getting a little bit better, given that the macroeconomic environment continues to be uncertain? I'm just trying to get a sense of what's the basis of that comment about the backlog or the order is there in the second half than what you, kind of, saw the sharp abruption that you saw in December.
Sure. So what we saw in the September time frame was very abrupt and it -- the slope of it was way better right after the September. Although it's still negative, trending down, it was a much slower rate. When I call now stabilizing and better visibility to the outlook, if you look at it, there's still demand out there. We're not talking about a slowdown in demand that matches that backlog, it wasn't a 1:1. That's why you saw us draining inventory in the channel. Because customers were pulling at a, call it, faster rate than we were putting into the channel and that's the cautiousness on our part. That's how we chose to run the business to maintain control of weeks of inventory in the channel given that we are on a sell-in revenue recognition, we need to be in line with that in and out rate. So the second half, you can think about it as a lot of changes happened in the supply chain from our customer. Some were drastic like moving sites or moving factories. Some are -- they are draining some of the inventory that potentially could have been on their shelves. Bottom line is, inventory in our channel, inventory for us has been coming down. And now we're going to start seeing a replenishment potentially at a 1:1 rate of demand. But demand did not stop as drastically as the backlog did. And that's the cautiousness that we have seen. We talked about it, call it, wait and see. It wasn't wait and see because demand wasn't there. It was wait and see about when to order it. So we see those, some pull-ins, some last-minute orders. We see that. And we're just setting ourselves up to be able to navigate it and manage it.
Okay. That's very helpful. On the wireless IoT side, you'd mentioned, Hassane, that ex Nintendo wireless grew 20%. How are you thinking about the overall IoT growth rate this year? Kind of, what are the vectors of growth? How are they different this year, say, versus last year? And just to kind of clarify, you're expecting the new 802.11ax to be in smartphones by the end of 2019 and, kind of, more of a 2020 story. And -- but before that, in the meantime, you'll have some business in the gateway and infrastructure on the new standard.
Yes. Let me clarify my commentary. First, on the IoT, as I mentioned earlier, I'm not going to give an IoT specific as we're not breaking it up that way anymore. And with the uncertainty, that is impacting that business with China consumer, I'm not going to give a specific guide for that. What I am talking about is my bullishness on our position in the market. So whatever the end market does, we're going to come out on top because of our position already in the market. So where is the growth coming from for that 20% ex Nintendo? It is broad. It is what we've been investing in since the acquisition to take that business broad. Now that business is starting to grow across all of its markets, whether it's industrial and consumer and automotive. The growth is across a lot larger customer base. That's why we wanted to highlight the ex Nintendo to highlight the strength that is in the underlying business. We're going to start -- keep seeing that deployment across a lot of products.
On the 11ax specifically, to clarify, we, at Cypress, are not participating in the cell phone and the routers and the infrastructure. What we are participating in, which is our business, is the edge devices, the smart home devices and the gaming devices and the automotive devices. Those will go to ax, but they will go after the infrastructure is deployed. So there -- our partners will deploy into cell phones and will deploy into set-top boxes and will deploy into home routers. And the end of 2019 is when that deployment will start. Our devices will be in the 2020 because they need to connect to an ax. Although, by the way, our 11ax product is just like all our other products backwards compatible. So it does 11ax, ac, ng, b, whatever letter else you want, it is all backwards compatible, but to take advantage of ax, you need the phone and/or the base station to be ax. And that's what I was referring to. Does that help answer? I guess it is, yes.
Our next question is from John Pitzer with Crédit Suisse.
Hassane, in your prepared comments or I think maybe in an answer to a question, you talked about how you're undershipping relative to backlog as you try to manage channel inventory. I'm just kind of curious how much do you think you're undershipping in the December quarter? How does that look in the March quarter? Is the undershipping greater than December or less than December? How do we think about kind of the channel inventory levels exiting the March quarter, at least as you contemplated relative to your guide? And I know that this is a difficult question because the business has transformed itself so much over the last several years. But how would you, kind of, compare this correction and how you're trying to manage it with prior corrections?
John, it's Thad. I'll take the question on the channel inventory. So in terms of dollars, the channel inventory was down 14%. As I said earlier, if you look at our revenue through the channel, in Q4, it declined 12%. So we've undershipped that natural demand. And some of that is with the distributors ordering less. They're holding less inventory, and you can see that in terms of weeks. Our targeted weeks of inventory for a distribution channel range 6 to 8 weeks. But if you look over really the last several years, we've really bounced somewhere between, let's call it, right around 7.5%, plus or minus. We're at 7.2%. I think assuming that there is a -- if you assume some revenue ramp in Q2, I would expect this -- the weeks of inventory to start coming back up into that high 7% range, kind of, where it's been here recently. But I think this -- we're going to be very careful on it making sure we're not going to overship that natural demand. We're going to be monitoring it very closely in the sell-through very closely, to make sure we don't have a glut of inventory sitting in the channel.
And that's going to be very important as we get closer to the second quarter. Because the second quarter is seasonally up quarter for us, historically. So we have to manage the ins and outs just because of the potential pushouts. Nothing out of the ordinary but that's why I call it very cautious. It's easier to...
Right. Just relative to the world. I'm sorry.
How As you said, just relative to how you see the world today and understanding that it's a volatile environment, do you anticipate any further, sort of, utilization actions in your own fab? Or do you think that, that 85% that you talked about the Fab 24, is kind of how you're going to manage through the remainder of this correction?
Yes. I think we can maintain it in that 80% plus. And again, I remind you that 85% is fully utilized. It also will depend on where the softness comes from, right? And what happens long term. But we think we can keep the fab at a point where it's not necessarily going to have a major drag on gross margins. That's really the change -- to your earlier question, that's the change from previous downturns. If you go back to 2015, we had 2 fabs running the 50% utilization. Today, we're going through this downturn and we got fab fully utilized. So it gives us a lot more confidence in being able to maintain those gross margins.
Our next question is from Blayne Curtis with Barclays.
I just want to follow up on a prior one. I just want to make sure I understood what you're saying. So sitting here in January, have you seen your bookings rate start to recover? And then as you look to Q2, can you just tell, Hassane, as to what you consider kind of normal seasonal, I think you've been up high single or low double-digit sequentially. And then, obviously, get the handicap weather, how are you going to ship to that? But any color on that would be helpful.
So the backlog, I'm going to call it stable. Because I can't talk about cautiousness and be forward looking on the backlog. I'm comfortable with how the backlog is behaving, however, I remain cautious about shipping to backlog until I see the end demand. So that's something I will reiterate, and that's how we're setting up, that's how we're managing the company for: one, to make sure we don't overbuild inventory and put it in the channel because that is not what we stand for. Number two is maintaining our OpEx within where we need it to be in order to maintain a stable and reliable operating income. Those are the things we can't control, and we are controlling and executing to what we can control. What happens on the top line, we will adjust, up or down. One thing I will tell you, it's not a rate of decline, that is very stable as far as the backlog. We're getting orders, orders are tied to design wins we have had. So we're able to correlate the credibility of the orders. So we're getting more and more comfortable with the backlog. The cautiousness I referred to is purely not shipping and having backlog in the channel over quarter boundary. There will be some of that before the ramp that we expect in Q2. But I'm not going to give a Q2 guide. That's way too far and with the visibility we have, that will not be prudent.
And then I just want to ask you on the NOR business. You mentioned 15% density growth last year. Kind of curious how you think about ongoing density growth for that business. And then you have 2/3 is long-term contracts, just any kind of thoughts of pricing this year as you have to sign up new contracts? Do you think you can -- when you look at more of the consumer-related NOR, pricing has come down? How much can you resist that trend when you're selling to your end markets?
Sure. So as far as the density, the answer is, yes. We do see in the forward-looking years, including '19, the density -- the average density, call it, will keep going up. Our plan and our strategy has been to focus on the high density. So therefore, that delta between the market average density and the Cypress average density will always be a factor larger for us than it is for the rest of the market. And that keeps that, call it, the glass ceiling from a lot of our competitors. And by the way, we already introduced and sampled with customers our 4x nanometer NOR. So we're ahead as far as -- even on the technology side, not only on the density side. So we don't see that changing. That's part of the strategy we deployed couple of years ago. We're sticking with that strategy. It has paid off -- it's actually paying off today compared to our peers more than in the last 2 years. As far as the pricing, we see pricing stable. The NOR, call it, the softness in NOR because of demand and -- supply and demand, started a couple of quarters ago. In every one of these quarters, we have reported up, having the LTAs give us that stability. But you don't hear me talk about the consumer NOR anymore, which is where a lot of that pricing fluctuation happens. All of our -- most of our revenue from NOR comes from auto, industrial and enterprise. Those are inherent long-term pricing curves.
Automotive, we give pricing 2, 3 years out. And the beauty of it when we won those designs last year and the year before, we started at a higher price than we would have otherwise. The price trend that we are seeing is normal than any other market we have in a normal market, call it, low single digit down, which is what we do every year anyways. Where we get more share from a customer, we negotiated new. Nothing is different, especially in the automotive market. I lose no sleep about NOR pricing or our position in NOR because we didn't stumble on it, we drove to it.
Our next question is from Chris Rolland with Susquehanna.
I think some good commentary you guys had on USB-C. Our data points were, kind of, pointing to an inflection in handsets this quarter as well. And you guys talked about all those new design wins and products that you had quarter-over-quarter, which seems like extremely strong growth there. Perhaps talk about where we are in terms of the attach on handsets for USB-C? And then your ASPs, how they are trending? Are they still holding up? You guys were obviously a leader here, are you maintaining those ASPs? And are you maintaining that share position as well?
Sure, Chris. This is Hassane. So if we look at the handset, we have 1 handset customer that we are a strategic supplier to that customer. So I'm -- we're not a good reference of the attach rate for Type-C and a lot of the mobile. Our exposure on mobile is very, very limited because of the strategic relationship. Our exposure to USB-C is in the broad market and the ecosystem, power, cable, docs, monitors, specifically automotive now. That's why we're doing Type-C. So a lot of our design and the sockets, the number of projects in production with Cypress USB-C, is really on the broad market. So attach rate on phone, I'm not a good proxy for it because that's not really -- we're not exposed to that. Now if you look at the growth rates of the rest of the market, we're still in the early innings. There's still a lot of the ecosystem that has not converted and that is the opportunity for us ahead. For market share, we expect to maintain our market share. We expect to maintain the #1 share, both in USB overall and in USB-C.
We regained that number one market share in overall USB in '18, we'll maintain that, driven, of course, by the USB-C. So that's where we see it. As far as ASPs, if you remember, I always talk about our USB-C angle is integration and programmability. The more integration we put, the ASPs will be either apples-to-apples will be up or slightly relative flat to the prior generation. And that's how we are able to maintain our position and maintain the gross margin trajectory that we need as a company. We don't -- we have multiple products for Type-C and the price ranges go from $0.25 all the way to over $1. So it's hard to talk about ASP for USB-C. I can tell you the margin has been holding on, meaning we've been introducing new products. We're offsetting the -- any pricing decline within a specific category, and we are fending off any competitor that is able to come in with a non-programmable product with our proprietary technology. So all of those dynamics are -- we are maintaining our #1, and I don't see that changing.
Great. And just maybe a quick follow-up there too. Your relationship with your big handset customer, does that preclude you from working with other handset OEMs? And then just outside of that, perhaps you can talk about, industrial seems like there was a little bit of strength during the quarter and consumer a little bit weak in the quarter. I think you mentioned Chinese consumer, what was going on there?
So just -- I'll comment on the first. So nothing precluded us from doing it, however, it is a strategic decision we have made not to go into mobile. We have been in mobile historically in the company, we've divested that business. Strategically, you hear me talk about industrial, automotive and the consumer and mobile is very limited. And just to remind everybody, that's a low single-digit percent for the company.
Our next question is from William Stein with SunTrust.
Two, if I can. Can you explain a comment you made earlier about building inventory in Q1 as you consolidate manufacturing footprint? I thought you were down to 1 fab. I'm just a little confused by that comment. And I have a follow-up, if I can.
Yes. Will, it's Thad. So as we've been working on our gross margins over the last several years, we've -- and I've said it many times, we've been looking at our manufacturing footprint. That's inside and outside. And as we go forward, we're making additional changes to some of the partners that we're dealing with and sometimes you got to build a little bit of inventory to manage through those transitions, and that's what you're seeing in Q1. It's more of what we've been doing.
Got it. Makes sense. That's helpful. One other. You talked about 0.77% book-to-bill, and I think, Hassane, you talked about the backlog not necessarily being as predictable and customers coming in very late and some concern about whether the backlog will be delivered or if customers will end up canceling and pushing out orders. Is it fair to say lead times are very short now, maybe almost quoting from stock? Is that the environment that we're looking at now? Any details there will help.
Yes. Well, this is Thad again. Not at all. I mean, so our lead times have been very stable really for probably a year now. They are in the ranges that we want to be in, and we continue to run in that range. So we see very little change to our lead times.
Our next question is from Craig Hettenbach with Morgan Stanley.
First question. Can you just provide the full year 2018 connectivity growth?
No. We're not breaking it up for the full year. I don't have it on me. But I did the second half of the year because that's the comment I made in Q3, where I said the second half of the year will be around the 16% to 17%, so I reported to that. But we're not breaking it up separately as a guide or as a backward looking.
Okay. Just for Q1, just relative to the sequential guidance, any context by kind of end market? So looking at, kind of, industrial, auto, consumer and enterprise, just what markets do you think would be, kind of, in line with your overall guide? What markets might be better or less?
Well, if you look at the three primary markets we're exposed to, the consumer will have the highest seasonality. But auto and industrial will be in line less the uncertainty that we see in the market. So a lot of the higher-than-seasonal guide for the first quarter for the midpoint of the first quarter is going to be primarily in the consumer. And regionally, primarily it's going to be driven in China.
Our next question is from Harlan Sur with JP Morgan.
Just kind of a follow-up on that, Hassane. If I look at the auto business, up strong, very strong double digits in Q4 and clearly, up strongly for the full year. You've got 90% revenue covered, so I think you have a good handle on what the auto business is going to look like? I understand your commentary about maybe seeing some slight weakness at the edges there, but is this a segment that can still be growing double digits year-over-year in Q1?
Automotive in Q -- I don't have the numbers specifically for automotive in Q1 from -- you're talking Q1 '17 to Q1 -- or Q1 '18 to Q1 '19?
Yes, I don't have that number. Maybe in a -- I'll try to find it. But I don't have it handy on me here. Because we usually -- we're not -- we usually don't guide specifically for an auto on a forward-looking quarter.
No, I understand. It's just that the business has been consistently growing double digits.
Yes, I mean, I look -- I've always said, I look at automotive just because of the nature of the business, I look at it more on an annual basis, that's why I always report the annual numbers at the end of the year primarily. Because a lot of it is, quarters come in and quarters go on the quarter boundary, that's not really an indication of the actual strength in the business. But I will reiterate my comment from earlier of automotive is going to grow, even if the units are flat or down. And that's on, call it, a 2019 outlook. Hopefully, maybe that helps.
No, that definitely helps. Let's just maybe look a little bit longer term. You talked about your full year design win pipeline being up 24%. As we think about the teams move to 50% gross margins once we get past this soft period, off the incremental design wins in 2018, what percentage of this mix roughly have gross margins above 50%?
Well, 37% of the funnel, as Hassane said in his prepared remarks, are new products. So you can think about those for sure as being above the corporate average and above the target. Now truth be told, there's a lot of other products that are in that funnel that are at/or above the products that have been out for a while. So as we focus forward, obviously new products coming out of R&D are at the targeted gross margin or higher and where our emphasis is designing out products that have low gross margin and swapping in for high gross margins. So you think about that funnel as being heavily focused on high gross margin products.
Yes. And we've maintained our new product development side, exactly what Thad mentioned two years ago, our focus on new products is products that are accretive and are at/or above our model. And as those start to turn from the funnel into revenue, but more importantly become a larger part of our revenue, those will start moving our margin on the trajectory towards our model.
Our next question is from Charlie Anderson with Dougherty & Company.
First one was on Traveo II. I know you mentioned the big design funnel there and then the higher margins. I wonder if you could maybe just remind us how large Traveo I is as a portion of the business or maybe just cluster, any commentary there would be helpful. And then I've got a follow-up.
Yes. I don't have the breakup of Traveo I. I don't think we've ever talked about Traveo I specifically. We've always talked about automotive overall, which Traveo I is inclusive of that. But as far as the funnel, it is I would say between Traveo, the body and cluster, which Traveo II covers both the body electronics, which is a new market for us and the cluster market which is an existing market. But it also expands our market in cluster because Traveo II adds a lot of the performance and more on the virtual clusters for us. So it's both a replacement for Traveo I, but also an expansion of the market, so go beyond.
Great. And then for a follow-up, you guys mentioned the leverage ratio down quite a bit in the last year. I wonder, if you maybe could just characterize your appetite for M&A right now or maybe the strategic importance that you see of M&A going forward.
Yes. Charlie, it's Thad. As I said, we're now at a point we have a lot of flexibility on the balance sheet. We've been issuing buyback, we obviously have the dividend. We're starting to build cash onto the balance sheet. We think that gives us flexibility in terms of fire power for M&A. We are always active and we're very selective, we're very disciplined. You've seen us do things in the past. But we continue to evaluate how we can expand our portfolio, but you will see us move in a very disciplined process and disciplined valuations if we were to move on something.
Our next question is from Harsh Kumar with Piper Jaffray.
First of all, congratulation, guys, on preserving the EPS in a really tough market. I'm sure the investors appreciate it. Hassane, I wanted to clarify something. I thought when you mentioned enterprise business, you mentioned 5G, if I'm not mistaken. I'm curious what kind of products you have there and any other color you might have around that segment?
Sure. Specifically on the enterprise and the 5G build-out and base station, it's our specialty NOR. And that's a -- because the value for those base stations or that 5G build-out and the infrastructure is very close to our strength in automotive. So they require high density, they require high reliability and they require longevity. Those 3 assets are what make our NOR very attractive, and that's the reason we are able to grow with that deployment. So that's our -- call it, our focus is primarily on the storage side of it.
Got it. And it's odd. The business you had the most grief on in the second half of last year actually held up the best, I'm talking about the NOR business. I'm curious if I can turn the question around and ask you what kind of hurdles do the Taiwanese have to be even -- to try to even catch up to you in densities or other metrics that you guys exhibit? And then also, if you could talk about the timing of JV, is that still on track for I think the June quarter, right?
Sure. So we'll be here a very long time to talk about barriers of entry, but let me try to summarize it a little bit. You have the technology barrier, we have a very good technology that is able to do high density at a very attractive cost structure, call it, from a die size perspective. But even if that were not the case, for example, our Semper NOR, our brand-new NOR, 45-nanometer, that we just introduced, has a M0 inside of it. M0 is doing a lot of system-level to do a reliability and system-level functionality that nobody else has today. Meaning, they don't even have a microcontroller in the -- under the same roof, let alone be able to do the software and all the stuff that is required. We have those. We are very strong at them. We combine the 2 that is, call it, years ahead of where a road map and organic road map can bring somebody else in. Those would be, I guess the -- and of course, it's a strategic decision from a company that a company has to do to go after a long-term business like we have done. Two years ago, I got even more grief when we said we're not going to run after the commodity business that was hard in the market, we're going to stick with long-term automotive, industrial and enterprise, and we're going to stick with high density when the world was on fire on low density because of OLED and because of all that constraints. We got a lot of grief for that. We never got the credit for that decision. I have always reminded everybody, wait till the market turned, this is where we are today. So on top of all the technical and all we can do on a road map and everything, it still remains a corporate decision and corporate strategy to focus on the right long term, and that we have done, and we're very good at it.
This concludes the question-and-answer portion of today's call. It would be my pleasure to turn the conference back over to Mr. Hassane El-Khoury for any closing comments.
All right. Thank you all for joining us today. I would like to take this opportunity to thank the Cypress team for stepping up and executing in 2018. During Q1, we will have our Analyst Day on March 13, at our headquarters in San Jose. We will also be at Embedded World in Nuremberg in February, and will be presenting at the 31st Annual ROTH Conference in March. We look forward to seeing many of you on the road. Goodnight.
Thank you for participating on today's Cypress Semiconductor conference call. You may go ahead and disconnect at this time.