Intel Corp (INTC) — Q2 2019 Earnings Call Transcript

Thank you, operator. And welcome everyone to Intel's second quarter earnings conference call. By now you should have received a copy of our earnings release and the earnings presentation. If you've not received both documents, they're available on our investor website intc.com. The earnings presentation is also available in the webcast window for those joining us online. I'm joined today by our CEO, Bob Swan; and our CFO, George Davis. In a moment, we'll hear brief remarks from both of them followed by Q&A. Before we begin, let me remind everyone that today's discussion contains forward-looking statements based on the environment as we currently see it and as such does include risks and uncertainties. Please refer to our press release for more information on the specific risk factors that could cause actual results to differ materially. A brief reminder that this quarter, we have provided both GAAP and non-GAAP financial measures. Today, we will be speaking to the non-GAAP financial measures when describing our consolidated results. The earnings presentation and earnings release available on intc.com include the full GAAP and non-GAAP reconciliations. With that, let me hand it over to Bob.

Thanks, Mark. The second quarter was significantly stronger than we forecasted in April and our results demonstrated our customer's preference to the performance of Intel XPUs as workloads grow, diversify, and become increasingly complex. That leads for performance manifested in strong mix in ASPs across the business. Our Q2 results are proof points for the megatrends that underpin our strategy. The world's insatiable appetite for data is driving demand for solutions to process, store and move it faster and better. Customers want to work with partners who can deliver performance and platforms to address their most important technology challenges. Our data-centric businesses overall performed roughly in line with our April expectations. Data center and IoTG customers chose our highest-performing products leading to strong mix in ASPs. While our cloud customers absorb capacity they put in place over the last year, we continue to expect cloud demand to improve in the second half. Enterprise and government spending remains weak however, particularly in China. PC demand continued to improve particularly in the commercial segment. We now expect the PC TAM to be up slightly for the full year. Strong demand for our highest-performing products and the productivity and TCO gains they deliver continues. Mix was stronger than we anticipated. While small core supply improved we were not able to fully satisfy customer demand for these SKUs in the second quarter. Tariffs and trade uncertainties created anxiety across our customers' supply chain and drove a pull-in of client CPU orders into the second quarter. We also halted shipments to certain customers in response to the U.S. government's revised entity list. After a thorough review, we were able to resume shipments of some products in compliance with regulations and the net impact on the second quarter was limited. While we hope and expect trade issues to be resolved, further tightening of export restrictions would come with revenue risk to our business. As a result, we entered the second half of the year a little more cautious than we were 90 days ago. We met with many of you in May at our investor meeting, where we outlined three major thrusts of our game plan to transform our company and grow. First, we're pursuing the largest opportunity in our company's history a nearly $300 billion TAM comprised not just of CPUs for PCs and servers, but of XPUs and adjacent technologies for an incredibly wide range of workloads and devices. Second, we're strengthening our product leadership by accelerating the rate of innovation. And third, we're evolving our culture and improving our execution so that we can play an even greater role in our customers' growth and success. I'll take a few minutes to share some of the progress we're making. I'll start with expanding our opportunity and expanding our TAM. Over the last few years, we have dramatically expanded our served market, while the PC market was declining. Our served market now is more than five times larger and growing faster and we have reallocated spending to expand our capabilities in higher growth areas. We are evolving Intel Inside from a CPU inside a PC to XPUs inside everything that processes stores and moves data. Big bets in 5G, AI, and autonomous systems are an important part of this transformation. In May, I outlined a disciplined framework for investing in and evaluating big bets as we expand into new markets. First, we'll invest where we have an opportunity to lead major technology inflections. Second, our investments should allow us to play a larger role in our customers' success. And finally, they must show a clear path to profitability and attractive returns. Network infrastructure, which is transforming as the industry transitions to 5G, is one of our most important areas of investment and we are laser-focused on this opportunity. This business is growing at a 40% CAGR since 2014 from just over $1 billion in revenue to more than $4 billion last year. The network cloudification that comes with 5G expands our opportunity in the core network and at the edge, as more data moves closer to where it is created. We expect to be in production on Snow Ridge, Intel's 10-nanometer system-on-chip technology for 5G base stations early next year. We've already announced that two large telecom equipment manufacturers have committed to this architecture and we're on track to 40% share in this market segment by 2022. While the 5G network opportunity meets each of our investment criteria, the 5G smartphone opportunity does not. This is why we decided to exit the 5G smartphone modem business and conduct an analysis of our options for the remaining parts of that portfolio. Today, we announced the sale of the majority of our 5G smartphone modem business to Apple. This deal preserves Intel's access to critical IP we have developed. It enables us to focus on the more profitable 5G network opportunity where we are growing and winning share. Another growth market we're gaining share is the Internet of Things. We are using our architecture, accelerators, and software assets, combined with unmatched scale and partners to develop one of the industry's fastest-growing IoT portfolios. Taken together, the IoTG and Mobileye businesses grew at 22% over last year after adjusting for the sale of Wind River. More intelligence is moving to the edge, and more industries want to harness the power of data to create business value, innovate and grow. Devices and systems are becoming more autonomous. This is a trend IoTG is shaping and capitalizing on. Our team's work is producing outstanding results. In the second quarter, we grew at roughly 3x the market rate and are positioned to significantly outgrow the market over time. Here again, we saw demand for performance and strength across all verticals we served, with computer vision being an especially critical workload. Mobileye is positioned to lead another huge opportunity, autonomous driving. This business has grown at more than 30% CAGR since we acquired them in 2017. Our market leadership continues to build momentum with 20 new design wins this year, representing 11 million lifetime units. Nissan's ProPILOT 2.0 and NIO's pilot vehicles have begun production featuring Mobileye base L2+ system for hands-free assisted driving technology. I visited the Mobileye team in Israel last month and was treated to an autonomous ride through the streets of Jerusalem. The progress we are making in Level four and Level five autonomy is extraordinary. Our mobility as a service joint venture with VW for deploying a commercial robotaxi service in Tel Aviv by 2022 is on track. Global coverage of REM or Road Experience Management mobilized real-time crowdsourced mapping capability is expanding rapidly. Several major auto OEMs, most recently Ford, are adopting this breakthrough data-centric capability. To understand the power of this data consider this; 1.5 million kilometers are sent to the cloud daily for BMW production vehicles. With the data collected from just the last four weeks, Mobileye was able to automatically map 94% of the German Autobahn and motorway network. And the commercial opportunity for REM extends beyond real-time maps for vehicles. Since announcing the agreement earlier this year, Mobileye and Ordnance Survey have jointly launched a service that delivers high-precision road network location data to companies across multiple sectors. Artificial intelligence is a $10 billion data center silicon opportunity by 2023. And today it's fueling cloud customer demand for solutions that accelerate demand in AI workloads. This is evidenced by the fact that key cloud customers, most recently Baidu, are collaborating on our Nervana Neural Network Processor for Training or NNP-T. NNP-T will sample to customers later this year expanding our already diverse AI portfolio which spans multiple architectures including ASICs like NNPI, TPUs, GPUs, and FPGAs, all unified by a single programming model, One API. The second major element of our game plan is extending product leadership by accelerating the rate of innovation. The future of computing will require a solution-oriented mindset building on six pillars of innovation. Over the last 50 years, Intel has delivered breakthrough-after-breakthrough in computing performance that has propelled technology and society forward. We are far from finished as our product and customer announcements over the last quarter demonstrate. Our Data Center Group just announced a very important strategic partnership with SAP to optimize Intel's platforms including Xeon Scalable processors and Optane DC persistent memory for SAP's end-to-end enterprise software applications including SAP S/4HANA. For over a decade, we have worked closely with SAP in developing differentiated breakthrough technologies that make organizations run more efficiently. The broadening of our strategic partnership with SAP will allow our mutual customers to accelerate the organization's digital transformation by deploying SAP business applications optimized for Intel-based infrastructure in the cloud, on-premises, and in hybrid environments. Our ecosystem partners have already received Icelake server samples. We are making good progress on Icelake server and are now planning to start production wafers in the first half of 2020 with the volume ramp in the second half of the year. Both yield and defect density are ahead of schedule for our 10-nanometer data center products. Cascade Lake, which is ramping now, is on track to be one of our fastest ramping products ever and we have a great solution for our customers in the first half of 2020 with Cooper Lake in the same platform as Icelake. We are working more deeply with our customers to understand their needs and become the partner that they rely on to innovate and grow their businesses. They challenge us. It's producing results and it's making us better. For example in the second quarter, we announced a strategic partnership with Google to collaborate on Anthos, a new reference design based on the second-generation Xeon Scalable processor and an optimized Kubernetes software stack that will deliver increased workload portability to customers who want to take advantage of hybrid cloud environments. These deep customer engagements are frankly one of my favorite parts of the role. We are constantly thinking about how we can help our data center customers harness the potential of data by processing, storing, and moving it more efficiently. And a central part of the equation is interconnect technology, which is why we recently announced our intention to acquire Barefoot Networks. Barefoot Networks is an emerging leader in Ethernet switch silicon software with the programmability and flexibility necessary to meet the performance needs of the hyperscale cloud. We closed the transaction this week and we are excited to have the Barefoot team as part of the Intel family. Our client computing customers can look forward to exciting new Intel products this year. In the second quarter, we launched a special edition of the world's best gaming processor the Core i9-9900KS. We also launched our new 10th Gen Core product family codenamed Ice Lake which integrates Wi-Fi 6, Gen11 graphics and AI acceleration. While we are delivering on the present we are also creating the future. Intel Labs is researching completely new architectures like quantum and neuromorphic computing that promise incredible leaps in performance and power efficiency. Neuromorphic computing strives to emulate the neural structure and operation of the human brain, which could deliver big advancements in artificial intelligence by allowing computers to sense, learn and behave more naturally and efficiently. Just this month, we announced an eight million neuron neuromorphic system comprising 64 Intel Loihi research chips that's now available to the broader research community. Finally, we are evolving our culture and improving execution because our customers are counting on us. Our process technology roadmap continues to improve and we're making excellent progress on 10-nanometer. We began shipping Ice Lake clients in the second quarter supporting systems on the shelf for the holiday selling season and expect to ship Agilex, our first 10-nanometer FPGA later this year. We now have two factories in full production on 10-nanometer. We are also on track to launch 7-nanometer in 2021. With a roughly 2x improvement in density over 10-nanometer, our 7-nanometer process, which will be comparable to competitors' 5-nanometer nodes, will put us on pace with historical Moore's Law scaling. We're also making steady progress increasing CPU supply. Through our investments, focused execution, and tighter customer collaboration, we expect our PC CPU supply will be up mid single digits this year, while we expect the PC TAM to grow slightly. We'll continue to work with our customers to meet their required product mix and ramp additional capacity to ensure we are not a constraint on their growth. A final point of pride in the second quarter that speaks to Intel's values is the release of our annual Corporate Responsibility Report, which highlights the progress made over the last year toward our 2020 goals around environmental sustainability, supply chain responsibility, diversity and inclusion, and social impact. We achieved a number of our 2020 goals ahead of schedule: energy conservation, non-hazardous waste recycling, workforce diversity, and technology empowerment. Being responsible stewards of the communities in which we operate is central to our culture and it is helping us transform and deliver the results you expect of us. I'm proud of what our team has accomplished over the last quarter and look forward to sharing more proof points of our progress with you in the coming months. With that, I'll hand off to George, who will take you through the financial details.

Thanks, Bob, and good afternoon everyone. We had a solid Q2 with revenue coming in at $16.5 billion, down 3% year-on-year and higher by $900 million compared to our guide. Data-centric revenue was $7.7 billion, down 7%. And PC-centric revenue was $8.8 billion, up 1% year-on-year. Our Q2 operating margin was 31%, down two points as client ASP strength was more than offset by platform volume declines and continued NAND pricing degradation. Q2 earnings per share came in at $1.06, up 2% year-on-year and $0.17 over our guide for the quarter. Year-to-date, we have generated $5.7 billion of free cash flow, returned $8.4 billion to shareholders, paid dividends of $2.8 billion, and repurchased approximately 117 million shares. As mentioned last quarter, we anticipated a more challenging year in 2019 coming off a large build-out of capacity in 2018 by DCG customers as well as the pricing dynamics in memory, which is largely playing out as expected. In light of these factors, I'm pleased with our results and operating performance for the quarter. Non-GAAP EPS was up 2% year-over-year driven by strength in our platform ASPs, lower 10-nanometer startup costs, lower operating expenses, as well as lower shares outstanding and a McAfee dividend. Offsetting factors were data-centric demand softness, continued NAND pricing pressure, and PC supply constraints, impacting our ability to fulfill low-end PC demand. Our non-GAAP tax rate came in at around 12%, in line with last year. Let's now turn to segment performance. Our Data Center Group ended the quarter with revenue at $5 billion, down 10% from the prior year and up 2% sequentially. This was slightly ahead of our expectations with platform ASPs, up 2% year-on-year. Xeon ASPs were up double digits year-on-year on mix as our customers continue to select high-performance products. Against the tough year-over-year compare platform units were down 12%. Cloud revenue was down 1% year-over-year as cloud service providers absorbed capacity after growing demand 40% in 2018. Enterprise and government revenue declined by 31% with particular weakness in China while communication service providers' revenue increased 3% year-over-year. We see comms service provider demand still in the early phase of a meaningful 5G-related build-out. Overall, our other data-centric businesses were down 1% year-over-year or up 2% excluding Wind River on strength in our Internet of Things businesses, partially offset by ASP weakness in our memory business. Our Internet of Things businesses, which include IOTG and Mobileye continue to show growth and delivered record revenue, up 22% excluding Wind River. IOTG showed strength across all segments with revenue growth of 23% year-over-year excluding Wind River and operating income growth of 21% on strong demand for higher-performance products in the quarter. We believe a portion of the revenue outperformance in IOTG is from tariff-related pull-ins. Our Mobileye revenue and operating margin were up year-over-year 16% and 20%, respectively on continued ADAS penetration. Our memory business revenue was down 13% as the industry supply surplus continues to feed a deteriorating NAND pricing environment. NSG operating income weakened by approximately $220 million year-over-year. PSG revenue declined 5% year-over-year as softness in cloud and enterprise demand more than offset growth in 5G wireless. Advanced products, which includes those manufactured on 28-nanometer through 14-nanometer process nodes grew 15% year-on-year. PSG operating margin was down 49% year-over-year on lower revenue, product mix and 10-nanometer road map investments. The Client Computing Group demonstrated strong execution this quarter with revenue up 1% year-over-year on mix driven ASP strength, strong demand in commercial PCs and modems and $200 million to $300 million in revenue from order pull-ins due to trade and tariff concerns. We believe the PC TAM grew slightly in Q2, led by our commercial PC demand. Our PC units were down 5% as our small core supply was constrained and we cannot fulfill all of our customer demand. We have made significant progress against our supply challenges and we expect supply and demand to return to balance in the second half. That said, demand has been stronger than expected and product mix will continue to be a challenge in the third quarter as our teams work to align available supply with demand. We saw strong ASPs in the quarter with notebook ASPs, up 3% year-over-year and desktop ASPs, up 5%. Operating margin for our client group was 42%, up five points year-on-year on strong revenue and mix and lower cost of sales post qualification of our 10-nanometer Icelake client product. For the first two quarters, we generated $12.5 billion in operating cash flow. And we invested $6.9 billion in capital to ramp 10-nanometer capacity and for 7-nanometer product development. We also spent $5.6 billion to repurchase 117 million shares to date. Buyback was accelerated in the second quarter, where our average purchase price was $46.78 per share. We have $11.7 billion remaining on our Board authorization. Now let's talk about the full year outlook. For the full year, the market dynamics reflected in our April guide remain largely in place, although, memory has continued to weaken relative to our expectations. Although we have seen a weaker first half in our data center business, we expect a better second half as demand from cloud and comms service providers, improves and our second Gen, Xeon Scalable continues to ramp. We are increasing our revenue outlook for the full year by $500 million to $69.5 billion to reflect the outperformance in the second quarter, somewhat offset by the effect of trade-related pull-ins and a weaker memory environment. We continue to expect revenue from our data-centric businesses to be down low single digits for the full year. Our guidance for full year PC-centric business growth remains a low single-digit decline for the year, reflecting share loss in small core applications, where we have been short supply longer than expected and demand has remained healthy. We expect to have additional small core forward supply in the second half which should allow us to regain some of that lost share. Operating margin for the year is expected to be 32%, flat to our previous guide. Full year expectations for gross margin are unchanged at approximately 60%. We expect Q3 gross margins to be roughly line with Q2, on strong flow-through of higher revenue offset by increased 10-nanometer cost as we ramp production. The cost increase in Q3 will be tempered, as we will be selling through some of the previously reserved 10-nanometer in the quarter. And we see the benefit of a grant related to our NAND factory in China. We expect Q4 gross margin to be down 3 points to 3.5 points sequentially, as we continue to ramp 10-nanometer. And will have sold through the previously reserved inventory. And will also not see the benefits of the NAND grant. We are making great progress on 10-nanometer. And expect to see continued yield improvement as we move into 2020 and work through the cost curve. Full year spending is expected to be down almost $1 billion year-on-year, in line with our prior outlook, adjusted for cost related to our acquisition of Barefoot Networks. We are now expecting 2019 savings from our modem exit to rise to approximately $400 million to $500 million from our earlier estimates of $200 million to $300 million. The increased savings are being offset by higher spending on 10-nanometer and 7-nanometer processes and product R&D. Earnings per share for the year, is now expected to be $4.40, up $0.05 from our April guide, reflecting higher Q2 earnings offset somewhat by the impact of tariff pull-ins on the second half, weaker memory and a slightly higher full year tax rate. We now expect the non-GAAP tax rate for Q3 and Q4 to be approximately 13% up slightly from our April guide as we anticipate a higher mix of lower pre-tax income in the second half and higher tax demands. Turning to Q3 outlook, we expect revenue of $18 billion, up 9% sequentially, which is within our normal seasonal range after adjusting for trade-related pull-ins in Q2. Our data-centric and PC-centric businesses will be down mid-single digits year-over-year in Q3 against very challenging compares. We expect Q3 operating margin of 35% and non-GAAP EPS of $1.24, on higher sequential revenue particularly in PC, data center, and IoT. I will conclude here. And turn the call back to Mark.

All right. Thank you, George. Moving on now to the Q&A. Operator, please go and introduce our first caller.

Hey! Thanks guys. Just a question on share expectations, I know in the Analyst Day you expected the competitive environment to get a little more competitive, although it doesn't seem happening in Q2. And maybe you can talk about how you expect your share to trend over the next four to six quarters in light of the competitor coming out with 7-nanometer and then you guys introducing 10-nanometer later on. Do you think you'll maybe lose share over the next three to four quarters and then gain it back? Or how should we think about things are going to play out?

Hey, Chris, it's Bob. First, I would say that during the course of this year as George mentioned in his prepared comments, we lost a little bit of share in the second quarter, particularly in CSG at the low and small core, primarily due to supply constraints. And our expectation is that we'll begin to work our way back in the second half of the year given the capacity we put in place to have more supply and meet our customers' demand. But stepping back and just looking at the macro environment over the next several years and particularly in the second half of the year on the data center side, what we've indicated is it will be a much more competitive environment. Our intentions are with a not a 90% share position, but more like a 23% share position that we have significant prospects for growth across multiple aspects of our business. And our intentions are over that time frame to continue to grow our data-centric collection of businesses at or above market rates to grow. So that's consistent with what we said back in January. We reiterated it again at our May Investor Day and nothing's really changed from that standpoint. Thanks, Chris.

Okay. So a two-part question on the Data Center Group. I guess first and foremost, could you just discuss a little bit about the differences between the subsegments? The cloud side was impressively strong in the quarter and it sounds like you think it's going to continue. But the enterprise and government side, I know you said that was China specific, but that was exceedingly weak. Any more color on what's going on and that enterprise side in the current quarter and probably of equal if not greater importance the second half looks like you still expect a really big ramp and potentially better than seasonal. What gives you the confidence in the second half ramp in DCG?

Sure. Overall, regarding growth, cloud has been relatively weak in the first half of the year as the cloud providers are still adjusting. We anticipate that cloud will become somewhat stronger as we move into the second half. As George mentioned, the communications sector has seen low single-digit growth as our customers start preparing for the transition to 5G, so we expect that growth to start picking up more in the latter part of this year, and we believe it will be more significant in 2020. The enterprise and government sector has been particularly challenging during the first six months of the year. Q1 was quite weak and Q2 was even weaker. Although we are not pleased with this performance, it aligns with our expectations for both the first and second halves of the year. Last year was exceptionally strong for enterprise and government, with growth far exceeding our expectations, largely due to increased digital transformation efforts by CIOs and a favorable tax reform environment that gave them more spending capacity. We greatly benefited from that last year. This year, the comparisons are tougher for both the first and second halves, and we sense that CIOs are approaching the second half with more caution. Additionally, the situation in China is even more challenging. Therefore, our outlook for the enterprise and government sector in the first half and moving into the second half is that it likely won't see a significant improvement. However, we expect cloud and communications to show some improvement within the context of our overall guidance for the full year.

Yes. I would just add that we saw enterprise and government down 31% year-over-year. This was perhaps a bit weaker than our forecasts, which were already predicting disappointing performance in that group. But overall, I won't add anything further to what Bob said.

Thanks a lot.

Hi, guys. Thanks for taking my question. So we have gross margins coming down into Q4, you're probably in the low to mid-58%. And I know at the Analyst Day, you sort of gave an indication for gross margins in like the 2021 timeframe to be around 57% on a $77 billion number. I guess how do I think about the trajectory from where we're exiting this year to the gross margin profile in 2021? Does that imply that 2020 gross margins should be down from obviously 2019, and 2021 should be down from 2020? And then what happens if you actually don't hit your revenue guidance of $77 billion in 2021, because the margins impact is mostly fixed? Does that imply margins come down even more in that case?

I think it's George. We mentioned that we expect to bottom out at 57% in 2021. While we didn't provide specific guidance for 2020, we implied it would be closer to the 60% range. As we consider 2019 to 2020, two main factors will likely help us. First, we'll begin to see the benefits from moving up the yield curve in 10-nanometer technology, which is currently challenging and is reflected in the fourth quarter gross margin. Additionally, we’re experiencing a significant impact from memory in the fourth quarter, influenced by a grant we had in the third quarter. This will lead to a sequential drop due to the absence of that grant, highlighting how much memory has affected the gross margin for the DC-centric group. If we can see improvements in memory in 2020, there are signs of firming in ASPs, though it's still early to determine that. This could also play a role. Furthermore, we are seeing growth in our adjacent businesses, which have good margins and are expected to continue growing into 2020. Overall, I believe that the benefits from the 10-nanometer yield curve, potential improvement in memory, and growth in adjacent businesses will contribute positively beyond our current Q4 situation.

Hi, thanks. I had a question for George. So George, I'm just trying to figure out the incremental accretion from the sale of the modem business. It doesn't seem like a lot of it’s dropping through to op margin, because you're investing more in 7 and 10-nanometer. So I'm just wondering why that would be the case if yields are on track. Thanks, George.

One of the things we discussed, Tim, was the importance of integrating both the 10-nanometer and 7-nanometer roadmaps, as we believe the economics justify the investment. The current investments are aimed at making this happen. We anticipate that this deal will yield noticeable benefits next year, particularly with a significant reduction in operational expenses associated with the segment that will conclude at the end of this year. This year, we expect those expenses to be around $400 million to $500 million, but for next year, that figure could potentially double, which we believe will positively impact total spending. The key question is whether we need to maintain the higher expense rates we are currently experiencing to fully support this acceleration into next year. There might be opportunities in that area as well. However, we are prioritizing investments in areas that we believe will enhance yield in the 10-nanometer process and improve product performance in both the 10 and 7-nanometer technologies.

Good afternoon. Thanks for taking my question. Maybe just again to kind of step back from the data-centric businesses. On the revised full year outlook, you're still guiding data-centric to be down low single-digits year-over-year. Previously within data-centric you guys were looking for DCG specifically to be down mid-single digits year-over-year which implies about 20% growth in DCG second half versus first half. Is that still how the team sees DCG for the full year?

I would say we're still roughly in that ballpark. We haven't really changed our view of the full year to maybe a little bit that slipped into the first half relative to our original second half expectations on the pull-ins even though it's more of an impact on the PC side that we saw a little bit of that in DCG. So now we're looking to a strong second half for DCG.

Great. Thank you.

Thanks for taking my question. On inventory they were up about 12% sequentially in terms of dollars. And now when I look at your second half sales, you're forecasting them to grow 13% to 14% half over half so it kind of makes sense. But just inventory in terms of historical levels they're still quite elevated given the macro conditions. So is this all 10-nanometer-related inventory? Just what's driving this? How do you see it trending in the second half? And will there be any impact on the gross margins from any utilization changes that might be needed?

Sure. That's a great question. We're closely monitoring our inventory. The significant increase this quarter, as you suspected, was primarily due to the addition of 10-nanometer products in our finished goods. This has resulted in some gross margin benefits, which we began to observe this quarter and will continue into next quarter as previously reserved inventory moves into the marketplace, positively impacting CCG margins. Typically, we expect to see an uptick as we head into the seasonally strong third and fourth quarters. Overall, we believe the inventory adjustments related to 10-nanometer products are valid. However, we do feel that our inventory levels in the memory sector are higher than we would prefer, and we plan to reduce those over time. It's a challenging market to achieve this while maintaining confidence. We will keep a close eye on it, as inventory levels have contributed to pressure on our free cash flow, particularly due to working capital concerns.

To George's point, while we're not big fans of growing inventory we feel great about qualifying the Icelake product in the second quarter. And that qualification is the single biggest reason for the step function and inventory from Q1 to Q2. So we knew if we executed on our plans of the Icelake client qualifications we'd have a step-function inventory and we feel good about getting that qualification done and behind us. The implications of that is the higher balance in Q2 versus Q1.

Yeah, good afternoon, guys. Congratulations on the solid results. Maybe if I can go back to the gross margin from the Q4 level, I'm just kind of curious given that CapEx has been running significantly ahead of depreciation I'm kind of curious if there's anything going on the depreciation schedule which is impacting the calendar fourth quarter gross margins. And George to the extent in the previous question, you talked about maybe some tailwinds relative to the fourth quarter run rate next year in 2020 how do we think about the bridge from sort of the Q4 guide of kind of 58.5 to the Analyst Day guide for 2021 of 57. Is that all just the impact of 7-nanometer coming on in that year? Or is there some price consideration? How should we conceptually think about that?

Okay, John. That's a great three-part question. There's nothing unusual going on in depreciation in the fourth quarter. As I said most of the impact is really related to we'll have gotten through all of the previously reserved 10-nanometer products. So you're going to see more pressure on gross margin from the products that are coming into the marketplace while we're still at the low end of the yield curve on 10-nanometer, which is where we are today. In 2020, how I think about 2020, I think we as I said earlier we think we'll see a benefit from moving up the yield curve on 10-nanometer. We're pleased with our process work that's going on there now. And also we would expect that memory which has been a significant drag on gross margin this year will help us a little bit overall. So, no real change. Probably the easiest thing would have just to go back and say no real change in our outlook that we gave at Analyst Day in terms of the gross margin trajectory over the next few years.

Hey, George, I want to mention that there’s nothing particularly unusual regarding depreciation. Over the coming months, two significant factors will impact our situation. First, we have an increasing amount of fully depreciated 14-nanometer equipment, which has been a core part of our operations. This is a positive development. Conversely, we've been ramping up two fabs, and many of our assets under construction aren't being depreciated yet. Therefore, while we're seeing a decline in the lifespan of the 14-nanometer equipment, we're also integrating some of the previously purchased 10-nanometer equipment. Overall, while there aren't any significant changes at the macro level, these two factors are crucial in understanding the composition of our equipment and the balance between fully depreciated assets and those coming into operation.

Thank you. You mentioned being more cautious about the second half compared to 90 days ago, but your guidance for the second half hasn't changed significantly since then. How are you approaching this in relation to the forecast? Additionally, when you refer to pull-ins, I'm surprised to hear about them occurring alongside shortages. Could you elaborate on the factors that are contributing to revenue being pulled into Q2?

For the second half of the year, we continue to see it as we discussed 90 days ago. The main difference has been the strong demand for PCs, which led to increased sales in the second quarter. We are passing some of that strength through, except for the pull-ins affecting the full year. I don't want to imply that we won't experience the typical seasonal balance, and we anticipate a strong second half for the company. We expect significant improvement in the Data Center Group as they manage through capacity issues, and we believe demand for PCs will remain robust. In contrast to our earlier forecast, I might be slightly challenging the notion of a weaker second half. However, demand for memory has been somewhat lower than expected, and average selling prices have decreased significantly, which we expect will cause some challenges. While some demand was pulled into the second quarter, the overall year is unfolding largely as we anticipated, with some positive developments in the PC total addressable market.

I would add that compared to where we were in April, looking toward the second half of the year, we still face the potential rise in tariffs on goods from China and the uncertainty surrounding the entity list and the speed at which license applications will be handled. In the recent quarter, we performed about $900 million better than expected, while the year is off by $500 million, with approximately $400 million attributed to pull-ins. As we approach the second half, there are still uncertainties regarding the situation in China, which is a vital market for us, and that makes me somewhat anxious.

Yes, good afternoon. Thank you, George and perhaps Bob as well. We've been hearing discussions about your plans to be price aggressive in certain sectors to protect market share, as you've mentioned at the Analyst Day and other forums. Could you share your strategic thoughts on this approach in your notebook business where you're launching a 10-nanometer product compared to your desktop business, which may still be using 14-nanometer technology for a while longer? Thank you.

I want to highlight that we are looking at a total addressable market of $300 billion, which is the largest in our company's history. We believe we have a low market share with a significant opportunity to grow, although we recognize that the data-centric landscape is becoming increasingly competitive. Our goal remains to protect our market share while continuing to explore new growth opportunities. Over the past few years, particularly since early 2017, we have worked to maintain our position in the PC market by moving customers to higher-performance products that yield better average selling prices. We see this vast market as an opportunity to expand and protect our segments, though we are more cautious in certain areas, especially when supply is limited. Overall, we know the competition will intensify and we factor that into our outlook for the second half of the year and beyond.

Thanks, Matt. And operator, I think we have time for just one more question and then we’ll turn the call back over to Bob to wrap things up.

Thanks very much. I would like to clarify your comments regarding the restrictions on shipments to various entities in China. Can you confirm that the net effect was minor in the second quarter? Do you anticipate any significant impact on DCG revenues from the restrictions and shipments in the third quarter, or will that also be minimal?

In the second quarter, the situation was more favorable, likely resulting in a net positive due to activities that accelerated shipments. When comparing the items we were not allowed to ship with those that were approved, we found that concerns about potential tightened restrictions contributed positively in the second quarter. We anticipate that this trend will continue in the latter half of the year. It remains to be seen how many of the demand issues were addressed in the second quarter, but our forecast is aligned with the current activity level. As Bob mentioned, we are still cautious about potential policy changes before the year ends.

Thanks David. And we'll hand the call back over to Bob to wrap things up.

Thanks, Mark, and thank you everyone for joining us. I want to reiterate that the quarter turned out significantly better than we anticipated. Revenue, gross margins, and earnings exceeded our expectations, while spending remained on track. As a result, we are raising our full year outlook and feel positive about our performance halfway through the year. Additionally, we are actively managing our supply chain to ensure that we do not hinder our customers' growth. We have made solid progress in the first half and are in a stronger position as we move into the second half, although there is still work to be done. We are working closely with our customers and are optimistic about supply as we enter the latter half of the year. Furthermore, our advancements in 10-nanometer technology and our confidence in transitioning to 7-nanometer technology are increasing due to our execution. We view this as the second milestone in our three-year outlook, consisting of 12 key checkpoints, and we are satisfied with our current standing. We look forward to providing another update in 90 days regarding our ongoing progress and momentum in this long-term journey. Thank you for joining us, and we look forward to speaking with you again in 90 days.

Thanks, Bob, and thank you all for joining us today. Operator, can you please go ahead and wrap up the call?