NXP Semiconductors NV (NXPI) — Q3 2016 Earnings Call Transcript

Great, thank you, Skyler, and good morning to everyone. Welcome to the NXP Semiconductors' third quarter 2016 earnings call. With me on the call today is Rick Clemmer, NXP's President and CEO, and Dan Durn, our CFO. If you have not obtained a copy of our third quarter 2016 earnings press release, it can be found on our company website under the Investor Relations section at nxp.com. As most of you have likely seen the Qualcomm and NXP press release this morning, we appreciate your patience and waiting for our earnings call to begin. During our earnings call today, we plan to keep our prepared remarks to the key points so we can quickly get to your questions. This call is being recorded and will be available for replay from our corporate website. Our call today will include forward-looking statements that involve risks and uncertainties that could cause NXP's results to differ materially from management's current expectations. Please be reminded that NXP undertakes no obligation to revise or update publicly any forward-looking statements. For full disclosure on forward-looking statements, please refer to our press release. Additionally, during the call today, we will refer to non-GAAP financial measures. Pursuant to Regulation G, NXP has provided reconciliations of the non-GAAP financial measures to the most directly comparable GAAP measures in our third quarter 2016 press release, which will be furnished to the SEC on Form 6-K and will be available on the NXP website. I'd like to now turn the call over to Rick.

Thanks, Jeff. And welcome, everyone, to our earnings call today. As Jeff mentioned, we're very excited about the transaction we announced this morning. In lieu of time, we want to provide a summary of our Q3 results and guidance for Q4. We'll keep our comments brief, but we're prepared to address any questions you may have concerning the quarterly performance throughout the day. NXP finished Q3 with very good performance. Revenue was up just over 4% sequentially, with all business lines delivering results in line with our guidance. We drove strong non-GAAP operating margins due to a combination of solid execution by the business and operations teams, which drove better-than-planned non-GAAP gross margin, when combined with strong operating expense control. Taken together, this resulted in very strong non-GAAP free cash flow. Looking at the specifics, revenue in Q3 was $2.47 billion, an increase of just over 4% versus the prior quarter, and up 62% versus the year-ago period. Looking at the HPMS segment, revenue was $2.1 billion, an increase of just over 4% from the prior quarter, and up 80% from Q3 2015. From an operating segment perspective, the results are as follows. Automotive, revenue was $853 million, down 1% quarter-on-quarter, but up 177% from the year-ago period. In terms of product line trends, Auto MCU advanced Analog and Sensors were all slightly better than planned, with infotainment down modestly. In Secure Connected Devices, revenue was $592 million, up 15% sequentially and up 87% year-on-year. With our mobile transaction group, we experienced strong seasonal improvements as a result of both our largest smartphone customer, as well as good traction on new models with Korean and Chinese OEMs. Progress with deploying our mobile mass transit solution in China is going very well. Mobile transit or mass mobile payments, or mass transit, is a perfect intersection of secure payments and high throughput mass transit, all delivered on a mobile device. Six out of China's ten initial largest cities are up and running with our mobile transit solutions, and eight OEMs have launched this solution. Initial activation rates are very good, and post-activation top-offs are showing promising trends. In the MCU group, revenue was up sequentially as we saw very good demand for 32-bit ARM-based MCUs and solid demand for our i.MX apps processors that was offset by the roll-off of legacy MCUs. Lastly, we experienced solid demand in our mobile audio business as new products have gained solid traction with Chinese Android handset OEMs. Within SI&I our Interface and Communications Infrastructure Group, revenue was $476 million, up 8% sequentially and up 76% year-on-year. In the Interface Group, demand was strong and slightly ahead of plan due to the seasonal handset trends, similar to what we saw in the mobile transactions group. In the RF Power group, revenue declined sequentially as anticipated. At this stage, we believe the wireless base station markets will continue to be relatively soft over the intermediate term. Given the supply chain model in the base station market, we continue to have difficulties determining accurate in-market demand trends. In the Digital Networking market, we experienced flattish demand as anticipated, and believe the business has begun to bottom-out. We are somewhat encouraged, as we are seeing composite trends in terms of design wins, and particularly in the enterprise wireless access and switching space. Within SIS, revenue was $178 million, down 11% sequentially, and down 34% from the year-ago. This was essentially in line with our expectations at the beginning of the quarter. We do not see growth in this business in the near-term, as China banking continues to be weak and there is no incremental benefit to NXP from the U.S. contact EMD market based on the current market and competitive dynamics that we’ve mentioned in the past. At this point in time, the trends within the e-gabbing transit and access in the market, with some improvements, are not sufficient to offset the decline in the banking revenue. As our fourth quarter guidance reflects, we’re guiding for a further stepdown in this business. We think over the intermediate term, revenue will hover around $150 million per quarter, although Q1s are typically seasonally weak, and our Q1 could be this time. Turning now to the Standard Products segment, revenue was $320 million, slightly better than our expectations, reflecting an increase of 6% from the prior quarter and down 2% from the year-ago period. Turning to our distribution channel performance, the total months of inventory in the distribution channel held steady at 2.5, with absolute dollars of the inventory increasing $45 million on a sequential basis. In summary, Q3 was a solid quarter with strong financial performance, a positive reflection on the progress towards our committed goal. We view the overall stemming market as being next. In certain end markets, like auto and SBD, business trends are very encouraging. However, the market trends in the SIS, RF Power, and digital networking continue to create headwinds for the overall business. We believe we have found a bottom in both SIS and digital networking, the two most challenged businesses in our portfolio. Now, I'd like to pass the call to Dan for a review of our financial performance.

Thanks, Rick, and good morning to everyone on today's call. To get your questions as quickly as possible, I’m going to read an abbreviated version of my script today, highlighting what we believe are the key points. We delivered strong financial performance in Q3 with key highlights being: we delivered revenue that was above the midpoint of guidance; our strong operational execution drove non-GAAP gross margins above the plan; we tightly controlled our operating expenses, resulting in better fall-through and stronger non-GAAP operating margin; we generated excellent cash flow in the quarter and deployed over $0.5 billion in share repurchases; specifically, we delivered revenue of $2.47 billion in Q3, up 4% sequentially, with the non-GAAP gross margin toward the high end of our guidance at 50.5%. Total NXP non-GAAP operating margin in Q3 was at the high end of our guidance at 28%, which is up 240 basis points sequentially and up 470 basis points in the last two quarters alone. This strong margin improvement demonstrates great progress in driving synergy capture well ahead of plan. As we have said in the past, the best way to measure our success in capturing merger synergies is to look at the progression of our non-GAAP operating margin. Since the merger closed, we have successfully driven 54 basis points of non-GAAP operating margin expansion. On a $10 billion revenue run rate, this 540 basis points of margin improvement suggests that we have already exceeded the $500 million synergy run-rate target within the first three quarters post close and more than a full year ahead of the schedule communicated at the time we announced the merger. In terms of capital allocation, during the quarter, we repurchased 6.5 million shares at a cost of approximately $555 million or $86.3 per share. This brings our total year-to-date share repurchases to just over $1.2 billion or 14.9 million shares at an average price of $81.62 per share. I would now like to provide our outlook for the fourth quarter. We currently anticipate Q4 revenue will be in the range of $2.4 billion to $2.5 billion. At the midpoint, we expect revenue to be about $2.44 billion in Q4. We expect the following trends in the business during that quarter. Auto is expected to be flat, which is well ahead of normal seasonality and much better than Q4 from the year-ago period. Secure Connected Devices is expected to be down modestly in the low single-digit range. Secure Interface & Infrastructure is expected to be down modestly in the low single-digit range. Secure Identification Solutions is expected to be down in the mid-teens percentage range sequentially. Standard Products is expected to be flat sequentially. We anticipate revenue from manufacturing, corporate, and other to be approximately $52 million. At the midpoint, we expect non-GAAP gross margin to be 50.7% and non-GAAP operating margin to be 28.3%. Lastly, our Q4 guidance contemplates about $12 million of IP license revenue. It is unclear how the pending acquisition will impact our IP revenue pipeline going forward. Lastly, I'd like to take a moment to discuss the status of the Standard Products divestiture. We've received all the regulatory approvals associated with the divestiture. The disentanglement process is going very well, and we're on track to close the divestiture in Q1 of 2017. From a financial model perspective, post the divestiture, NXP will drive top-line growth in the range of 5% to 7% CAGR over the 2016 to 2019 timeframe. Post-divestiture, NXP will have a superior profit margin profile with our long-term non-GAAP gross margin in the range of 53% to 57%. We will tightly control our non-GAAP OpEx spend envelope into a range of 14% to 16% for R&D, and 6% to 8% for SG&A. Taken together, we anticipate our long-term non-GAAP operating margin to be in the range of 31% to 34% for NXP. From a timing perspective, as we discussed in our Analyst Day earlier this year, we believe we can enter the lower band of our long-term margin ranges exiting 2017. This means total company non-GAAP gross margin should be about 53%, and non-GAAP operating margin should be about 31% as we exit 2017. To be clear, this is an exit rate, not a full-year 2017 number. Our long-term margin progression guidance assumes we continue strong execution on synergy capture, and we minimize the impact from stranded costs from the divestiture throughout 2017. In terms of the use of proceeds, NXP will net $2.3 billion from the divestitures. We will use the proceeds to reduce our gross debt and achieve our 2-times net leverage target. We plan to redeem three tranches of debt. First, we will redeem the $390 million term loan due in 2017. Second, we will redeem the $500 million, 5.75% senior notes due in 2021. And lastly, we will pay down approximately $1 billion of the term loans due in 2020. Post-redemptions, gross debt will be approximately $7.5 billion with a weighted cost of debt at 3.6%, and an annual interest expense of approximately $275 million. Putting this together with the Q4 cash balance and adjusted EBITDA, that is consistent with Q3 where we saw net leverage of 2-times. The ultimate amount of pay-down of the 2020 term loans may vary up or down depending on what is required to achieve the 2-times net leverage target. Lastly, we anticipate that our cash taxes in 2017 will be about $30 million to $35 million per quarter. With that, I would now like to turn the call back to the operator for your questions.

I just want to go back to the channel inventory. It looks like it was up sequentially in the September quarter. What do you think drove that? And as you are looking cautiously at your December quarter guidance, what would you expect channel inventory to look like exiting the December quarter?

So to be clear John, it was up. I think it was $34 million. So it was up in terms of dollar level, but it was still at 2.5 months of inventory. So we’ve continued to be around that level. To be clear, as we go forward, we’re not planning on it changing significantly, but we want to be opportunistic. There are a lot of interesting things developing in the channel market with one of our competitors, and we want to ensure that we’re playing that opportunistically to have an impact from a top-line revenue growth basis.

And then, Dan, I just want to make sure I understand some of the up margin, you’re taking about exiting 2017. I guess, first, does that include or exclude the standard product divestiture? I apologize if I missed that. And just given the announcement this morning, would there be an opportunity to try to accelerate some of the organic synergy gains at NXP ahead of the merger? Or how should we think about that?

So, John, a couple of things. First, the guidance we gave just provides clarity on how the Company will profile post-divestiture. It’s very consistent with what we said at the Analyst Day, and very consistent with what was said at the time we announced the divestiture of Standard Products. Exiting the year, on a run-rate, we’ll close to the low-end of our margin guidelines. It will not be a full-year 2017 number. In terms of pre-close synergy capture opportunities, we have to be absolutely clear on this. While we can plan for integration as a company, strong execution post-close is a function of really staying on granular detailed bottoms-up planning. It is just that planning. So there will be no change to the decisions we or Qualcomm made as independent companies in the deal pendency period. And we will continue to execute against the plan we just communicated. Post-close of the Qualcomm transaction, that is when you'll start to see decision making reflecting the combination of the two entities and economic impact associated with it.

And maybe just one thing I'd like to point out, John. We talked about that our Q4 outlook includes $12 of intellectual property revenue. There could be an impact from the decision that we announced this morning associated with that. So, we want to be clear. That's included in our guidance, and we'll have to ensure that we fully understand that as we better understand the implications of the announcement today.

I guess, the first question is on the deal with Qualcomm. How, in your perspective, either Dan or Rick, do you reconcile the earnings power that the Company described at Analyst Meeting earlier this year with the price that Qualcomm is paying and you're accepting that price? Any framework in how you view valuation will be helpful?

I think, Ross, it's really important to realize that the pre-rumour price represents a 34% premium. So for a transaction of this size, it's a pretty sizeable premium. That being said, as we looked at the opportunity that we have on connected devices, we’ve been talking about this. Ultimately, we needed to have a better connectivity portfolio to drive the leadership that we wanted to achieve. Specifically, autonomous driving has become more obvious over the last few quarters that we needed increased computing horsepower to do machine learning and be able to take advantage of the complete ad hoc solution as opposed to the areas where we clearly identified the leadership that can drive. So, we think that's very complementary. Although we have a good connectivity platform for our current portfolio as we look out over the next few years, we've clearly had to expand our connectivity capability to be in the leadership position we wanted on the Internet of Things. The combination brings together very nicely; our Board went through this and approved this based on their view associated with the price. I think the other thing that we shouldn't lose sight of is there's a lot of broker laps between the shareholders of both companies. There is clearly an opportunity for both shareholders who view the value creation opportunity as significant as we do for them to participate by actually buying Qualcomm shares.

And I guess as my follow-up. Dan and Rick, you could answer this too, if you wish. But you did a great job of running us through where the margin structure will be as we think about the next 12 months or so. From the revenue side of the equation, at that same Analyst Meeting earlier this year, you talked about a 5% to 7% growth rate over-time. I realize that doesn't imply to any given single year. But how are you thinking about that as you look into 2017? Automotive is doing better than people feared, and you're growing well on SBD. But areas like SIS and maybe the high-power RF might be disappointing versus what you might have expected in May?

My answer will probably leave you a little unsatisfied. The revenue CAGR we gave you is exactly that: a CAGR over a three-year window. I think we have a portfolio of businesses. And like you pointed out and like Rick said in his comments, we’ve got some businesses that are performing really well. We've got some businesses that are performing in line, and then we’ve got a couple of businesses that are living in a difficult neighborhood right now. Rather than getting into extra sizing our guidance one year out, we just want to stick to the three-year CAGR. We understand the markets we participate in, and understand the core franchises we have, and the leadership positions we have within those respective end markets and the performance profile of those businesses. That should give us a pretty good idea of how to profile next year, but we won’t get into the extra sizing of guiding the year out.

I think the only thing that we could add is when you look at our outlook for Q4, the guidance we set that we talked about 2016 will be a transition for us, and Q4 not being down as you would typically expect on a seasonal basis; it’s actually a little better than the environment. So, I think it actually portrays a leading indicator. But as Dan said, we’ve really only guided established that on a three-year compounded growth rate; it’s just not in the individual units period.

Thanks for taking my question. And then I’ll add my congratulations to the deal this morning. I have two questions if I can. First, Dan, you highlighted that the Company has already achieved its $500 million cost savings run-rate quite a bit earlier than expected. I wonder how much you see as left. Now that you’ve achieved that, do you think there’s more to go as the Company progresses?

I think I will use the goal posts. Where we’re today and where we will exit 2017. At the time of the announcement, we talked about this being a synergy capture window. With those goal posts in place and the trajectory implied by those goal posts, you can quickly come up to what that is rather than going out with a specific number. The goal posts get you where you need to be.

And the next question is about the seasonally strong growth in autos for Q4. I think seasonally that’s a down quarter, but you’re guiding up. Should we interpret this as a content growth opportunity? Is this the initial ramp of V2X, is that a meaningful part of the separation? Or is there something else going on there? Any update on other V2X design wins in general would be much appreciated.

Well, it’s broad-based. So I think the key is it’s not V2X. V2X is not a significant revenue contributor in Q4 this year. There are some shipments taking place, obviously, on the design wins that we’ve talked about. But as far as being a significant contributor to revenue, it’s not in V2X. It's pretty broad-based, but really focused on MCUs, and beginning to ramp some of the design wins that had been achieved over the last few years as those begin to be realized and shipped into the customer.

I want to go back to the deal dynamics. I understand I think the need to achieve a better connectivity portfolio to achieve your goals. But if that’s the case, why is selling for $110 to somebody else absolutely the best way to get that needed connectivity? I mean, if I just look at the stocks right now, in the pre-market, Qualcomm is up something like 4% or more. You guys are up barely 2%, which suggests right now shareholders of Qualcomm are happier with the deal than shareholders of NXP. So, why is this the best way to get what you need in order to achieve your growth goal?

Stacy, it's important to remember that any value is determined by the negotiation between two parties. We should not overlook that there was a 34% premium over the pre-disclosure, pre-rumor period. In considering a transaction of this scale, a 34% premium is, as we've been advised, nearing the upper limits. When we assess the benefits of merging the two companies to create a leading platform in the industry, the significance is too high to disregard. Our Board has reviewed this and believes that the price is fair and reasonable for our shareholders. Shareholders have the option to invest in Qualcomm shares themselves if they perceive the opportunity in the same way we do. We believe this reflects a fair value, and the 34% premium over the pre-rumor price is an important consideration.

Stacy, I just want to say one thing. Overall, I do think this is a terrific deal. You’re right in pointing out that Qualcomm shareholders are very pleased. The improvements in our stock price versus an unaffected price are substantial. I’m not a finance expert, but I think our stock will trade on discounts to close, but I do think this is a terrific deal.

And just to follow-up on that. I mean, why wouldn't you guys be willing to put in the work over the next few years to achieve a higher stock price on your own? I mean this thing isn’t going to close for over a year anyway. What makes you think you couldn't get the stock price above $110 on your own by the end of 2017? It seems, given the margin targets you talked about and the growth goals mentioned at the Analyst Day, something that should be achievable with more upside beyond that. So, why wouldn't you try to get it now rather than selling out at $110 today?

So, Stacy, I think the key is we're comfortable with the performance we've laid out. We're very comfortable with the portfolio we have. The opportunity to have a more complete ubiquitous platform addressing the market opportunities we see, we just thought it was too significant a chance to forgo. We feel that it’s extremely compelling. We believe our shareholders can achieve reasonable value from this transaction. Again, if they believe as strongly as we do in the opportunity, they can participate in it through Qualcomm shares. This has nothing to do with us not believing in what we've laid out. We still feel positive about that. If you look at our trading over the last couple of years, we typically have traded at a discount to our peers. To achieve this with a very significant premium for a very large deal is something we are pleased with.

As Rick said, this is about creating a powerhouse. This is just a fantastic opportunity to create a powerhouse company.

Operator, we’ll take one last call here this morning. We want to keep this abbreviated today.

Rick, you mentioned the Secure ID business is bottoming. I think you said that for two quarters now, but it is expected to be down again sequentially in the double-digits for the December quarter. What are some of the milestones that we should look out for that business finally stabilizing?

That’s a really good question. I think that we shouldn’t lose sight that this business is really the technology that gives us the ability to provide security on a broad base set of solutions. Now, we have product shipments that take place associated with it. Clearly, we’ve had the benefit of the stocking of the contact with bank cards in China, which we were moving toward. Now, it’s going to be more of a replenishment cycle, which is not going to offer the same kind of volumes that we’ve had in the past. With some of the competitive practices and activities we see associated with the contacts base, we’re being very selective in our participation. That’s why that business is not performing as we would have liked. We’re down to a point where we think it's going to level out, but we’ve been at this point in the past. We did mention that there is seasonality to that business which is typically down in Q1, so even if we’re at this bottom, there could be quarters below that. As a percentage of the total volume, the trends in ticketing and e-gab become a larger share of the total. We do see a number of design wins there, but as we’ve talked about before, that tends to be fairly lumpy. We do feel positive about the business. The key is to drive security technology across many applications for the total company, especially considering a combined basis.

And as my follow-up, you mentioned the wireless base station market seems to still be soft and will remain soft. What are some of the data points to support that? Is there any visibility as to when that market may potentially start growing again? Thank you.

The data points that support that revenue continue to be difficult to predict based on the supply chain. When considering the fundamental assumptions, we are going to continue to see an expansion of data over wireless networks. You should see the ability for base stations to grow. However, it’s virtually impossible for us to project when that will take place. We continue to be a leader in that space, which is a very positive opportunity for us. It’s a profitable business. As we see the industry moving toward more content across wireless networks, we believe there are opportunities for the early implementation of 5G and massive MIMO that could play a role in increasing revenue in the upcoming quarters. But it's certainly not going to be a factor in the next few quarters. So, we expect that business to remain hard to predict, but it maintains very nice profitability, and we continue to be a leader.

Fair enough. Thank you.

Thanks.

Well, everyone, thank you very much for attending our call today. We realized it was an abbreviated call, but given the announcement first thing this morning, we want to allow you to get back to news and notes. We really appreciate all your support. With that, we'd like to end the call today. Thank you very much.