Intel Corp (INTC) — Q3 2019 Earnings Call Transcript

Thank you, operator, and welcome everyone to Intel's third 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, Trey. Q3, 2019 was the best quarter in our company's history. We generated $19.2 billion in revenue and $1.42 in non-GAAP EPS, exceeding our guidance by $1.2 billion and $0.18, respectively. We've achieved record revenue both overall and in our data centric businesses while making continued progress on our strategic priorities. Simply put, our ambitions have never been greater. We are growing share in a large and expanding $300 billion market opportunity fueled by the exponential growth of data, which is reshaping computing. I want to start with a recap of our May Analyst Day and our three priorities; accelerating growth, improving execution, and deploying capital for attractive returns. First, growth. It starts with the core belief. We are at a key inflection point with the exponential growth of data creating massive demand for semiconductors. Cloud workloads are diversifying, networks are transforming, and more computing performance is moving to the edge. We've been on a multi-year journey to reposition the company's portfolio to take advantage of this industry catalyst. Today we have the product and technology leadership that uniquely positions us to capitalize on these trends and we're investing in the IP required to help our customers win the inflections of the future. The opportunity is massive. As we told you in May, we expect to generate $85 billion in revenue and $6 in EPS in three to four years. But that doesn't happen just by saying it. Achieving this goal means delivering on our operational and financial priorities every 90 days. Growth starts with our core business for our workload optimized platforms are winning in a highly competitive marketplace. It's now been nine quarters since the first Xeon Scalable processor launched and we're proud to have delivered over 23 million units as customers rely on Xeon to power their data-centric workloads. In the third quarter, leading cloud customers ramped our second-generation Xeon Scalable processors with AWS, Google, and Alibaba deploying instances based on Cascade Lake. Customers including BP and TU Darmstadt selected our highest performance Xeon Scalable platform, the 9200 series for their most demanding workloads. One key reason customers are choosing Xeon Scalable is the platform's built-in workload acceleration for AI. With the combination of Intel deep learning boost and AVX-512 technologies, we're seeing advantages of up to 9x in AI influence versus competitors' CPUs. We also see cloud and enterprise momentum building for our breakthrough memory technology, Intel Optane. This quarter we announced a strategic collaboration with Oracle. Oracle is incorporating the high performance capabilities of Intel Optane, DC persistent memory into its next generation Exadata platform, which powers high performance database infrastructure at most of the world's leading banks, telecoms, and retailers. And in Client Computing, we're excited that all our major PC OEM customers have Ice Lake designs with 18 already shipping out of a total 30 expected to launch this year. We recently announced the next generation of Intel Xeon W- and X-series processors for high-end desktops. These platforms lead the industry in bringing Intel deep learning boost powered AI acceleration into high-end PCs and mainstream workstations for the first time. Available soon, these products deliver performance and value that give enthusiasts and creators more reasons to keep choosing Intel. We've also embarked on a multi-year program called Project Athena that charts a course for the PC ecosystem to raise the bar on laptop innovation. Amazing devices like the Dell XPS 13, two-in-one, and the HP Elite Dragonfly, that meet the Project Athena spec are already available. Our PC and server franchises are vital, but our ambitions are even greater. We're extending our product leadership to power, and increasing the 5G and AI enabled world. We have multi-billion dollar networking and IoT edge businesses, delivering double-digit growth, and AI is driving significant revenue across our product portfolio. We began investing 10 years ago in network, IT, SOC capabilities, and software, so that we could drive workload convergence on Intel's silicon. Today, we achieved number one share in the network and silicon market, with expected 2019 revenue of more than $5 billion growing at 12% this year. We're also well positioned for 5G deployments in 2020 and expect to grow our market segment share and wireless base stations to 40% by 2022. And we're ready for the next market inflection as 5G enabled significant new IoT and edge growth opportunities that extend from in-network and on-premise edge equipment to smart connected endpoints. Winning here means blending the right compute performance per watt with the emerging killer apps of the edge. Computer vision and AI inference acceleration, these are the differentiating capabilities that have propelled our IOTG and Mobileye businesses to leadership share and a combined annual revenues approaching $5 billion. The businesses are also growing quickly, up 18% year-to-date excluding Wind River. We're only at the bend of the curve in the edge opportunity, and we're investing to lead. Finally, Artificial Intelligence. AI is becoming a pervasive use case. According to IDC, 75% of enterprise applications will use AI by 2021, and that's why we're infusing AI in everything we build. But this isn't just about the future. We are driving meaningful AI revenue inside Intel now. With products spanning from the Data Center to the Edge, we expect to generate more than $3.5 billion in AI driven data-centric revenue in 2019, up more than 20% year-over-year. We're confident in our growth, but we also need to improve our execution on multiple fronts. First, supply, we've increased our output in response to stronger-than-expected demand. We've invested record levels of CapEx the last two years to expand our capacity and support our customers' growth. With that investment, we've increased our 14-nanometer capacity 25% this year, while also ramping 10-nanometer production. We expect our second-half PC client supply will be up double-digits compared to the first-half, and we expect to further increase our PC client supply by mid-to-high single-digits in 2020, but that growth hasn't been sufficient. We're letting our customers down, and they're expecting more from us. PC demand has exceeded our expectations and surpassed third-party forecasts. We now think the market is stronger than we forecasted back in Q2, which has made building inventory buffers difficult. We are working hard to regain supply demand balance, but we expect to continue to be challenged in the fourth quarter. Our manufacturing process node execution is also improving. We have Fabs and Oregon in Israel and volume production on 10-nanometer and will soon start 10-nanometer production in Arizona. Yields are improving ahead of expectations for both client and data center products. The Intel 10-nanometer product era has begun and our new 10th Gen Core Ice Lake processors are leading the way. In Q3, we also shipped our first 10-nanometer Agilex FPGAs. And in 2020, we'll continue to expand our 10-nanometer portfolio with exciting new products including an AI inference accelerator, 5G base station SoC, Xeon CPUs for server storage and network and a discrete GPU. This quarter we've achieved power on exit for our first discrete GPU DG1 an important milestone. As we discussed at the May Investor Meeting, we are accelerating the pace of process node introductions and moving back to a two to two-and-a-half year cadence. Our process technology and design engineering teams are working closely to ease process design complexity and balance schedule, performance, power and cost. We are on track to launch our first 7-nanometer based products, a data center focused discrete GPU in 2021 two years after the launch of 10-nanometer. We are also well down the engineering path on 5-nanometer. Last, a few thoughts on our capital deployment priorities. We are confident in our future and our Board has approved an additional $20 billion share buyback authorization. We have an excellent balance sheet generate strong free cash flow and continue to invest in R&D and CapEx to grow. We've also returned 100% free cash flow to shareholders over the last 10 years. At the same time we're making trade-offs. While we've increased R&D spending by more than $1 billion since 2015, we have reduced our total spending by nine points over the same period. Additionally, we have established clear criteria for our big bets like Mobileye, 5G and memory and storage. Our ambitions are to play a larger role in our customers' success and generate attractive returns for our shareholders. And if we can't do both, we'll take swift action. We are making great progress with our Mobileye acquisition. We've now shipped over 12 million IQ devices this year, up more than 40% over the same period last year. And in the third quarter, we delivered record revenue and secured six major new design wins totaling nearly 10 million lifetime units. We've increased our investment in 5G, but we've also announced our 5G smartphone modem exit and the sale of the IMFT fab to Micron. We expect those to close in the fourth quarter and we continue to take steps to improve 3D NAND profitability and reduce memory CapEx investments, while evaluating a variety of partnership options that can accelerate the path to profitability and improve returns. We are confident in our multi-year business plan and consistent with that we are increasing our buyback commitment. We expect to repurchase approximately 20 billion shares over the next 15 months to 18 months. We will fund the buyback from proceeds we generate from partnerships and/or non-core asset dispositions and by returning approximately 100% of 2020 free cash flow to investors. In summary, our energies are focused on accelerating our growth, improving our execution and allocating our capital wisely. Thanks to the team for a great quarter. And now, I'll hand the call over to George for more details on our Q3 results and business outlook.

Thanks Bob, and good afternoon everyone. We had an outstanding Q3, with record revenue of $19.2 billion approximately flat year-on-year, and $1.2 billion higher than guide. We saw a record data-centric revenue of $9.5 billion, representing just under 50% of our total revenue an all-time high. DCG, IOTG, NSG and Mobileye, all individually achieved record revenue in the quarter. PC-centric revenue was down 5% year-on-year on a very tough compare. Q3 operating margin was approximately 36%, one point ahead of our guide on revenue strength and spending leverage. Gross margin for the quarter was 60.4%, modestly below expectations as strong flow through of higher DCG revenue was more than offset by mix effects of higher than expected NAND revenues and one-time impacts in NSG including the absence of an expected grant associated with our NAND factory. Q3 EPS was $1.42 $0.18 above our guide. The results demonstrate strong top line performance, expense discipline, increased share buybacks as well as non-operational factors like lower tax rate offset by the one-time items in our NSG business. Year-to-date, we have generated $11.7 billion of free cash flow and returned $14.3 billion to shareholders. Operating margin of 36% in the quarter was down approximately four points versus last year as ASP strength in our server and client businesses and lower spending were more than offset by NAND pricing degradation, changes in modem reserves, platform volume declines and higher cost as we ramp our 10-nanometer client products. EPS was up 1% or $0.02 year-over-year as lower operating margin was offset by lower share count, the absence of one-time impairments related to the IMFT joint venture and a lower tax rate. Our non-GAAP tax rate in Q3 was approximately 11%, down one point versus last year and below our 13% guide. As we reported a better than expected tax benefit related to our non-U.S. sales on our recently filed 2018 U.S. tax return as well as for the 2019 tax year. Let's move to segment performance. Our Data Center Group had record revenue at $6.4 billion, up 4% from the prior year on our recently filed 2018 U.S. tax return as well as for the 2019 tax year. Let's move to segment performance. Our Data Center Group had record revenue at $6.4 billion, up 4% from the prior year and up 28% sequentially. These results beat our expectations with platform ASPs up 9% year-over-year on strong adoption of our highest performance second-gen Xeon Scalable products. Against the tough year-over-year compare, platform units were down 6% while DCG adjacencies achieved 12% revenue growth driven by our connectivity solutions. DCG growth segments, cloud and comms, now represent over two-thirds of total DCG revenue. Cloud revenue was up 3% year-over-year. Returning to growth after a historic 2018 platform refresh as cloud service providers exited a three quarter passivity absorption cycle. Enterprise and government revenue came in ahead of expectations growing 1% on strong mix and better China demand while communication service provider’s revenue increased 11% on continued adoption and share gains of IA-based solutions. We estimate in Q3 that the enterprise and government and communications service provider segment benefited from trade-related demand pull-ins of approximately $200 million in revenue from Q4. As a result of the strong top line performance, DCG achieved record quarterly operating income and operating margin of 49% was up 13 points sequentially. Our other data-centric businesses were up 13% year-over-year, and Q3 marked IOTG's first $1 billion revenue quarter, up 9% year-over-year, underscoring Intel's expanding opportunity at the edge. IOTG operating income was down 4% year-over-year due to lower benefits from inventory reserves and a mix shift to lower margin products. Mobileye revenue and operating income were up year-over-year 20% and 29%, respectively on continued ADAS penetration and new program launches. NSG revenue returned to growth, up 19% on continued bit growth, partially offset by year-over-year pricing declines. These pricing declines along with the one-time impacts discussed earlier contributed to NSG's operating loss of approximately $500 million. PSG revenue grew 2% year-over-year on continued strength in wireless, partially offset by softness in Cloud and Enterprise. And operating income was down 13% on segment product mix. DCG revenue was $9.7 billion, down 5% year-over-year as ASP strength, partially offset lower platform volume. PC unit volumes were down 10% versus Q3 2018, where we benefited from drawing down internal inventory to satisfy demand. We continue to be supply constrained in Q3, particularly at the value end of the market as higher than expected PC demand strength continues to outpace our supply despite the capacity additions that Bob discussed earlier. Adjacencies grew 10% year-over-year, driven by strong demand for modems and connectivity solutions. Operating margin was 44% flat year-on-year as lower revenue was offset by lower spending driven by the 5G smartphone modem exit. Year-to-date, we have generated $23.3 billion in operating cash flow and invested $11.5 billion in CapEx. We also returned 122% of free cash flow to shareholders through dividends and buybacks. During the quarter, we ramped buybacks purchasing 92 million shares at an average price of $48.78 per share. Now moving to the full-year outlook. As a result of our strong Q3 operating performance and momentum into Q4, we are increasing our revenue outlook for 2019 by $1.5 billion to $71 billion. We expect revenue from our data-centric businesses to be flat to slightly up for the full year and expect our PC-centric business to be flat to slightly down both improving versus prior guidance. Operating margin for the year is expected to be approximately 32.5%, up 0.5 point from our prior guide. Full year expectations for gross margin are unchanged at approximately 60%. We expect Q4 gross margin to be down two to 2.5 points sequentially as we continue to ramp 10-nanometer and will have sold through the previously reserved inventory consistent with prior expectations. Expectations for full year spending are unchanged, down approximately $900 million year-on-year. As a result, non-GAAP EPS for the year is now expected to be $4.60, up $0.20 from our July guide on the strong top line performance and tight expense control. We are raising gross CapEx by $0.5 billion to $16 billion, as a result of increased 10-nanometer and 7-nanometer investments. And we are raising our free cash flow guide by $1 billion to $16 billion. Let's turn to Q4. After adjusting for the impact of trade related pull-ins in DCG, we expect Q4 revenue of $19.2 billion, up 3% year-over-year and flat sequentially. Data-centric businesses are expected to be up 6% to 8% year-over-year on continued cloud recovery and sequential NAND pricing growth. Our PC-centric business is expected to be flat to slightly down year-over-year. We expect Q4 operating margin of approximately 33.5% and a tax rate of 13.5%. EPS is expected to be $1.24, down sequentially on lower gross margin, lower below the line non-operational benefits, and a higher tax rate. In summary, we are very pleased with the Company's strong operating performance and we will be very focused over the quarter on delivering a record year.

All right. Thank you, George. Moving on now to the Q&A, as is our normal practice, we would ask each participant to ask just one question. Operator, please go ahead and introduce our first caller.

Yeah. Good afternoon and thank you for taking the question. I guess a question on the data center side, it's just it's – to square up the numbers, it looks like you're suggesting DCG, up maybe 5% year-on-year. So, can you speak to the accuracy of that, and then I guess bigger picture the comm service provider side clearly a very large source of strength for you guys, up 11% year-on-year and now representing more than 40% of the mix. So, curious if you can kind of speak to the most important drivers of that business and how you're thinking about growth over the next one, two, three years? Thank you.

Yeah. Thanks, CJ. First, you're – we gave a DC centric guide of 6% to 8%, and yeah, I would – we didn't get DCG specifically, but I would say it's a little bit lower than our 6% to 8% data center growth. So, you're in the ballpark. On comm service, the comms has been an extremely important aspect of the business for a number of years now where we've seen the programmability at the network with NFV and software defined networks, an opportunity for us to migrate the networking environment to IA architecture. So, we've been doing this for a number of years, it's been a source of growth for us over time. And in the quarter, the 11% growth was significant in and of itself, but remember last year's third quarter was also up in the mid-to-high 20s. So, we continue to make great progress. What we see going forward in this business is really a big opportunity in 5G so next year you're going to see – yeah, our good progress has been on 3G and 4G, next year we see real design wins that we've achieved real growth as we go into it a 5G world where we continue to see what we characterize as cloudification of the network. More and more compute moving from the cloud and data centers out to a network in edge and that's been an opportunity for us that we've been invested in over the past, and we expect to be a big source of growth for us going forward. Thanks CJ.

Yeah. Hi. Good afternoon guys. Congratulations on the solid results. I want to stick with DCG Bob. If you look impressive that ASPs were up 9% year-over-year, especially as the mix shifted toward the comms business, which I believe tends to be lower ASPs. It's also happening in the quarter, where you're seeing your competitor ramping their next generation chips. So, I guess I'm trying to understand, what's the power of the Xeon Scalable upgrade cycle you referred to in your prepared comments, what innings are we in, in your mind, how much of an ASP lift can that give you, and do you anticipate any unusual pricing action as competition heats up in this market?

Boy, was that your one question, John? Yeah. Okay. So first I'd say in our – yeah, obviously we're well into Skylake, but the transition now is in the Cascade Lake and that's a higher performance SKU. In the quarter, the high ASPs were really driven by particularly cloud customers really move into the highest-end product within the Cascade Lake family. So, we're seeing the transition from Skylake to Cascade Lake and within Cascade Lake a real high performance SKU, that's our highest, highest performance ASP. So, that mix dynamic in Q3, I don't expect that to stay where it is. I think we'll go to more of a balance as we get into Q4 next year. And in terms of competitive dynamics, I would just say that we've got a great lineup of products. We got Skylake to Cascade Lake; first half of next year, we're looking at Cooper Lake. As we talked before, we're really excited about Ice Lake server coming out in the second half of next year, and we realize that it will be a more competitive environment and we've tried to capture in essence on how we think about 2020's both demand – demand equation, but also the margins that we flagged a little bit on the – on our Q2 call or back at Analyst Day, I think. So good, good quarter, good momentum first half to second half, high performance SKUs driving real high ASPs even though you're right. The ASPs with comms have a tendency to be a little bit lower. I think that's...

Great. Thank you. I wonder if you could talk to the shortages a little bit more. And, I guess, in the context of how much you said you brought 14-nanometer capacity up. And I realize demand is better, but it seems like it’s a few points better and yet the shortages are intensifying. Can you just talk a little bit about that and when do you think we'll be in a position where you don't have those tensions in your business anymore?

Yeah. Thanks. Thanks, Joe. First, I'd just kind of try to put it into context. Over the course of the last three years, I guess, we've grown the business by about 20%, so $13 billion in revenue over the last three years, and the practical reality is we didn't anticipate that kind of explosive growth three years ago, so we didn't have the capacity in place to deal with it, and we've been working our tails off for the last 12 months to ensure for our customers that we wouldn't be a constraint on their growth. From the last two years, I think, as you know, we've spent over $30 billion in CapEx to both, have more capacity for 14, while we also begin to ramp 10. In my prepared comments I said, we added 25% wafer start capacity 2018 to 2019. Our first half to second half unit volume will be up double-digits. So we're making good progress throughout the course of the year, but our expectations were in the second half, we would be back in a supply/demand equilibrium. And the fact of the matter is we're not there, because the demand profile that's resulted in our $1.5 billion higher revenue is just higher than we had anticipated. So we have more work to do to meet our customers' demands in the fourth quarter and going into 2020. As we see fourth quarter, we're still going to be a constraint in our customers' growth, which is absolutely where we do not want to be. But with the higher demand, we will be constraining their growth in the fourth quarter. But as we go into 2020, our expectations are, we'll add another 25% capacity both for 14 and 10 and that we will have particularly for PC client we expect to be able to do a mid-to-high single-digit unit volume growth next year and that we don't expect the market to grow that fast. But we got to have just more inventory buffers, so we're there when our customers need it. So Q4 will be a little challenging and 2020, we expect to be able to rectify things.

Thank you.

Thanks, Joe.

Hi, thank you very much. Bob, I wanted to discuss the triarchy and the cadence you mentioned about returning to a two to two-and-a-half year schedule. My understanding was that there were fundamental physical constraints that were causing the cadence to extend. What issues have the engineers and process teams resolved, or is this limitation confined to the 7-nanometer process? Will you revisit this again? Thank you.

That's a great question. During our Analyst Day, we went into detail about our lessons learned from the challenges we faced with 10-nanometer and how we are applying those lessons as we plan for the next two generations. Currently, our main focus is on scaling 10-nanometer, and we feel very confident about the capacity we've established, the products in development, and the improvements in yields we've seen almost weekly over the past six months. Regarding 7-nanometer, we were less aggressive with our density goals. Looking back on our experience transitioning from 14 to 10-nanometer, we realize that trying to scale at a 2.7 factor led to too many complex innovations for our manufacturing processes, and we learned that such ambitious targets are difficult to achieve, especially as conditions become more challenging. We have taken many lessons from our 10-nanometer transition and applied them to 7, where we have simplified the design rules. For the past couple of years, we've been working with EUV technology, which has posed challenges, but we plan to utilize EUV as we scale to 7-nanometer. Our first 7-nanometer product is expected to launch in the fourth quarter of 2021, and we anticipate returning to a two-year cadence for 7 and future nodes. Overall, we've gained valuable insights from the 10-nanometer experience, and we expect to maintain a two to two-and-a-half year cadence for at least the next few nodes.

Thank you.

Thanks a lot.

Thank you for taking my question. I'll ask one question, but maybe you have some technical difficulties.

Pierre, you are breaking up.

My question is about the changes in your competitive landscape over the past three months. Are things aligning with your expectations from our discussion over the summer? Also, what percentage of your data center footprint do you think could be impacted by competition?

Pierre, let me reframe that. I believe you're referring to competition and our perspective on it, particularly regarding both the PC and data center segments. I'll focus on the PC side, as there might be some concern about the year-over-year comparison for Q3. It's important to note that in Q3 of last year, we significantly reduced our inventory, which then entered the channel. Hence, when comparing year-over-year for Q3, it might seem a bit lacking in demand. Over the past 90 days, we haven't noticed any changes in our view of competitive dynamics. We are notably affected at the lower end of the market, which presents a supply challenge for us. This is one of the reasons we are increasing our production capacity into 2024, as we believe it provides us with the chance to compete for those units again next year. Bob, would you like to add anything regarding the data center segment?

I’ll give it a shot even though I'm not completely certain I understood the question. In terms of competitiveness, it is indeed a more competitive environment. We've just increased our full year outlook by $1.5 billion and raised our operating margins. I believe that nothing significant has changed competitively in the past three to nine months compared to our expectations. The primary change has been our performance. Looking ahead to next year, we know we need to significantly enhance our contribution to our customers' success. We're expanding our product offerings, architectures, packaging technologies, process capabilities, and the software we develop. This way, we can continue to improve product performance for our customers. Overall, we are feeling positive about our current position, but we are certainly not complacent as we face an increasingly competitive landscape heading into 2020.

Hi, everyone. Thank you for taking my question. I would like to know how much of the enterprise cloud and communications business in DCG for the quarter was influenced by China. Also, regarding the $200 million pull forward you mentioned across enterprise and cloud, was the boost in enterprise more or less than $200 million relative to your expectations?

Yes, Stacy, your figures are accurate. The $200 million was related to the enterprise, government, and communications sectors, and I would say that once we consider that $200 million, it was generally in line with our expectations. We anticipated a slight increase, and the year-over-year growth exceeded our expectations.

So, by more than $200 million?

That was a fairly big number for us relative to our expectations.

So, how much of enterprise was China then?

In terms of our data center business composition, around two-thirds is represented by cloud and communications, while roughly one-third comes from enterprise and government. This distribution has significantly shifted over the years as we’ve expanded our cloud presence and gained market share in communications. Currently, we are in a two-thirds to one-third situation, and enterprise and government saw significant performance across the board in DCG this quarter, exceeding our expectations from July. We experienced acceleration from the first half to the second half of the year, and the increase was greater than we had anticipated. Notably, we observed strong performance overall. However, regarding EMG growth specifically, we are trying to assess what factors are influencing early pulls versus what we can reliably project moving forward. Our estimate indicates that of the $1.2 billion in stronger performance, approximately $200 million was particularly associated with enterprise and government, especially from China. Thank you, Stacy.

Thank you.

Thanks so much. Bob it sounds like for 10-nanometer, it sounds like Ice Lake is still on track for the second half of next year and it sounds like the 7-nanometer GPGPU is still on track for 2021. You did talk about for the first time about 5-nanometer. So, can you talk a little bit about how you think of make versus outsource? And really what I'm after is sort of anything sacred or if go into a foundry partner to make CPU or maybe even like a chiplet strategy. If that would eliminate a significant piece of your competitive disadvantage, would you consider that or is that sort of off the table for now? Thanks.

We have no new updates regarding our process since our Analyst Day. We're working on ramping up production every two years for our 7-nanometer technology, and we expect to continue at a pace of two to two and a half years. Currently, our focus is on our 10-nanometer and 7-nanometer products for the fourth quarter. We are committed to regaining our leadership in process technology, but we are also open to exploring all options to ensure we create the best products and optimize where we manufacture them. Other foundries have contributed to our capacity over the years, and we will continue to assess opportunities that can better support our growth and meet our customers' increasing demand across our diverse product lineup.

Thanks Bob.

Hi, guys. I wanted to ask on gross margin. A year ago on your third quarter call, Bob you gave some directional commentary on what you thought for the out-year for 2019. Today, as we look into 2020. You have a lot of moving parts with two nodes ramping 10-nanometer, 7-nanometer yields competition lots of moving parts admittedly. But I was hoping at least versus maybe the fourth quarter exit rate this year that you could give some puts and takes on how you're feeling about next year's gross margin?

Hey, Ross. This is George. Maybe I'll take that. Actually, there is – with respect to 2020. There is no material change to my characterization on the last call, where we were talking about a 58% outlook for Q4 and 57% in 2021. And the question was well should that – are those good proxies for 2020, and my point was now we think we'll be closer to 60% than to those numbers. But, if you want to think about tailwinds and headwinds going into 2020 that we look at, as we think about that number. So tailwinds will be obviously we're going to have lower modem in the mix next year. Memory is starting to come out of that deep down ASP period, and we think volumes are going to be up as we get a little better supply and demand situation. The headwinds that we're very mindful of is obviously 10-nanometer ramping is – it can be a little bit of a headwind on margins, and also competitive impacts on ASPs. So, those are the – those are the things that we'll continue to look at, but as we look at those today no material change at all from my previous comments.

I would probably just, I guess echo. In all the complexity and all the moving parts – George kind of flagged the – where I'd characterize the four things that we're really dialing in on. One, going into next year mix is going to be better as our modem volume will be lower and our NSG profitability will be better. So, mix is going to have a – mix has been a drag on 2019's gross margin, and it will be a big contributor as we go into 2020. And secondly, on the first half of 2019, we had a lot of the – on cost of sales related to pre-PRQ 10-nanometer products. So that will not repeat itself. So those two things are good favorable things. The third thing is just George flagged this I just simplified. There's no transition and for us no transition next year is going to be 14-nanometer, we'll be a little better in terms of its profitability. Yields won't be dramatically different because we're extremely mature. But depreciation levels will be lower, because a lot of these tools have been fully depreciated, there because we've been on that node for so long. So, for the node transition 14 will be a little bit better. Our expectation is 10-nanometer yields will continue to improve, but at the same time the mix of 10 versus 14 will be a little bit of a wait. So, no transition will work against us. And we also - we've tried the best we can take into account competitive dynamics as we exit this year and going into next year in our quest to play a bigger role in our customers' success. We're going to compete to protect our position and expand the role we play. So those are the four things and lots of complexity and lots of moving parts, but we – a year ago we dialed in 2019 pretty well. Now, we've got to dial in 2020 as well.

Thanks for all the detail.

Operator, I think we'll have time for two more calls.

Thanks for taking my question. Bob, you mentioned you're still facing some capacity shortages. I wanted to understand how you are planning capacity for next year. What proportion will be 14? What will be 10? And will that mix require a higher or similar level of capital intensity as we saw this year?

Our goal for next year is to ensure we do not hinder our customers' growth. To support this, we plan to increase our capacity by 25%, maintaining the same level as this year. We are confident that our data center is in good shape, but for our client output, we aim for a mid to high single-digit unit output. This will help us meet anticipated customer demand and allow us to rebuild our inventory buffers to manage any fluctuations. We are focused on establishing the necessary capacity to align with customer needs and restore our inventory levels, which have seen depletion over the past nine months. Regarding capital, we will provide more details in January, but as George mentioned back in May, we expect a multi-year capital plan with no significant changes from our current position, though it will depend on growth.

I would just remind everyone that in 2019 we made a significant change by shifting our capital from the memory sector to expanding our 10-nanometer and 14-nanometer capabilities. We are continuing to increase capacity in 14-nanometer and have also started adding capacity at 7-nanometer. Our focus is on establishing the capacity necessary to eliminate shortages from our quarterly discussions.

Very good. Thank you.

Good afternoon and great job on the quarterly execution. Last time we had a cloud and enterprise spending digestion pause was first half of 2017. It's kind of the same setup as is passed by similar to 2017. DCG had strong second half growth, and in fact back in 2017 it kicked off what was a four or five quarter period of strong spending by your cloud customers. Do you guys get a sense in discussions with your customers that the spending reacceleration is sustainable for the next few quarters? I mean if I look at things like compute workload growth that continues at a strong pace. Workload themselves are getting more complex and so, just wanted to get your views on sustainability of this strong growth profile in DCG into next year.

The macro trends we see, particularly the growing demand for data creation and the need to process, store, and manage that data, have not diminished. These trends have been very attractive for some time, and we anticipate they will continue. However, our experience with cloud providers shows that they undergo significant buying cycles followed by extended periods of adjustment. Last year was particularly strong for them, but it has been three quarters leading into the third quarter where we observed a period of adjustment. In the third quarter, especially in high performance computing, we noticed that they began to re-enter the market to increase their purchases. The duration of this cycle will depend on several factors, but demand from the end market appears to remain robust, indicating a need to add capacity. We believe we will align our capacity with their ongoing demand, especially given their absence from the market for nearly three quarters up to Q3.

Thank you.

Thanks Harlan. And we're going to hand the call back over to Bob for some closing comments.

Thank you for joining us. We feel great about the quarter and are raising our outlook for the full year. The market trends we observe are stronger than ever, and we are focused on delivering for our customers. We are ramping up a variety of products in the 10-nanometer area and have increased confidence in the 5-nanometer process. We are working towards getting back to a two-and-a-half-year cadence for the seven and five nanometer technologies. Our confidence in the future remains strong. In the first nine months of the year and with our increased share buyback, we are putting your investment to work and addressing the disconnect between the intrinsic values we shared in May and our current trading. We are utilizing our balance sheet to take advantage of this situation. Thank you for your engagement and questions. We'll talk to you soon.

Thanks Bob and George. And thank you everyone for joining the call today. Operator, could you please go ahead and wrap-up the call?