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Cypress Semiconductor (CY) Q2 2017 Results – Earnings Call Transcript

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Cypress Semiconductor Corp. (NASDAQ:CY)

Q2 2017 Earnings Call

July 27, 2017 4:30 pm ET

Executives

Colin Born – Cypress Semiconductor Corp.

Hassane El-Khoury – Cypress Semiconductor Corp.

Thad Trent – Cypress Semiconductor Corp.

Michael Balow – Cypress Semiconductor Corp.

Analysts

Blayne Curtis – Barclays Capital, Inc.

John W. Pitzer – Credit Suisse Securities (NYSE:USA) LLC

John Vinh – KeyBanc Capital Markets, Inc.

Harsh V. Kumar – Stephens, Inc.

Adam Gonzalez – Bank of America Merrill Lynch

Suji Desilva – ROTH Capital Partners LLC

Charlie Lowell Anderson – Dougherty & Co. LLC

William Stein – SunTrust Robinson Humphrey, Inc.

Craig M. Hettenbach – Morgan Stanley & Co. LLC

Rajvindra S. Gill – Needham & Co. LLC

Operator

Good afternoon, and welcome to Cypress Semiconductor Second Quarter 2017 Earnings Release Conference Call. Today’s conference is being recorded. If you have any objections, you may disconnect at this time. I’d now like to turn the call over to Mr. Colin Born, Vice President and Corporate Development and Investor Relations. Sir, you may begin.

Colin Born – Cypress Semiconductor Corp.

Good afternoon, and thank you all for joining our Q2, 2017 earnings conference call. With me today are Hassane El-Khoury, CEO; Thad Trent, CFO; and Mike Balow, Executive Vice President of Sales and Applications. Hassane will make some introductory remarks, Thad will provide a financial overview, and then we’ll take your questions.

All information discussed in our press release and on this call is based on preliminary unaudited results, and we encourage you to review our 10-Q once filed. During the call, management will be making statements that should be considered forward looking and, as such, are subject to a number of risks and uncertainties that could cause actual results to differ materially from results anticipated by the forward-looking statements. Please refer to our earnings release, the Risk Factors in our 10-K filed with the SEC, and our other SEC filings for a more detailed discussion of these risks and uncertainties. All forward-looking statements are based on the information available to us as of today. We undertake no further obligations to update these statements.

Please note that the financial measures to be discussed by management today are non-GAAP measures unless they are specifically identified as GAAP measures. Reconciliations of non-GAAP measures to their most comparable GAAP measures and certain limitations of using non-GAAP financial measures are included in the earnings press release issued today.

I’ll now turn the call over to Hassane.

Hassane El-Khoury – Cypress Semiconductor Corp.

Thank you, Colin, and thank you all for joining us. Some of you may know Colin Born from his time at Atheros and Qualcomm or, more recently, GoPro. He recently joined us as VP of Corporate Development and Investor Relations and we’re glad to have him here. From where I’m sitting, he seems pretty excited to be here too and for good reason.

It’s a very exciting time for Cypress. It’s now been a year since we embarked on our Cypress 3.0 strategy of for focusing the company on selling innovative and differentiated, embedded solutions into markets that are growing faster than the overall semiconductor industry. The Cypress team has been executing well to this strategy, and we are beginning to see the benefits in the form of solid revenue, margin and earnings growth. In short, Cypress 3.0 is resonating well with both customers and partners, establishing Cypress as a premier provider of solutions for the rapidly growing world of connected things.

Our Q2 results reflect another record revenue quarter that exceeded our expectations, driven by strength across many markets and products, including automotive, wired and wireless connectivity, as well as favorable flash memory market dynamics. As you know, we exited the commodity memory business and have been capitalizing on strong demand at the higher end of the market. The and NAND and NOR flash markets continue to be supply constrained, allowing us to focus on revenue growth to drive incremental and sustainable earnings, while maintaining our growth (4:01) margin trajectory.

As we have discussed in the past, Cypress is focused on driving growth across three key vectors. Wireless connectivity, USB-C and automotive, and I’ll now discuss our progress in each of these focus areas. First, wireless connectivity, which we report as our IoT business unit. Let me start by saying we are the market leader in wireless connectivity solutions for the IoT market with the broadest customer footprint and product portfolio, and the results show it. It’s now been just over a year since we acquired the wireless IoT technology team and business from Broadcom. We have been very pleased with the team’s strong execution and the financial results over this past year.

Cypress’ strategic plan behind this acquisition is proving to be very powerful as the team tailors the acquired connectivity technology roadmap towards IoT at a platform-wide level, integrating our wireless connectivity with our microcontroller, PSoC, USB-C, and memory, hardware and software portfolio, and then driving this complete product portfolio through Cypress’ well-established automotive, industrial and consumer channels.

Cypress now has the most compelling and broad semiconductor and software product offering for the rapidly growing IoT industry and that is very exciting. However, continued execution is critical and that is why we are pleased that the integrated team recently achieved the significant milestone of sampling and introducing our first new combo chip as part of Cypress. This is our part that has completed its development cycle since the acquisition and there are more to come that will be in production by year-end with leading customers.

We continue to see broad applicability for our best-in-class wireless connectivity technology and solutions and have had good success in driving demand across a broad set of customers. We have doubled our customer count and increased our community users by over 40% since the acquisition. We are driving broader adoption of Cypress’ IoT wireless connectivity solutions with the recent introduction of our Quicksilver development platform in collaboration with Arrow Electronics, to leverage our WICED Studio SDK and Wi-Fi microcontroller, targeting designs in both the industrial and consumer end-markets.

We also updated WICED with enhanced Apple HomeKit, support for smart home applications, making it easier for our customers to design the solutions and leverage the expanding Apple ecosystem, including iCloud support for streamlined cloud connectivity. As a further proof of accelerating design activity, Cypress’ wireless connectivity, WICED SDK downloads were up by over 40% in the second quarter compared to the first quarter.

With another quarter of double-digit sequential revenue growth, the IoT wireless connectivity business has exceeded our expectations over the last year. Just today, our customer NETGEAR announced that their Arlo IP camera business more than doubled year-over-year in the second quarter.

As Cypress drive strong adoption of 802.11ac and Bluetooth into emerging IoT platforms, the business is well positioned for growth in the second half from a broad set of customers, including Nintendo. While we do expect Q3 to be a peak quarter for wireless connectivity due to holiday build, we’re increasing our annual IoT wireless connectivity growth target to between 35% and 40% from our pervious target of 23% to 27%. Just to be clear, this is only our wireless connectivity, incremental to all other revenue from solutions we ship into the same IoT end products and customers.

Next USB-C, the market is beginning to ramp as we expected. Customers are rapidly adopting USB-C to take advantage of the simplicity of a single, slim, easy-to-use connector for power, data, and video, while also benefiting from faster charging, high-speed data transfer and port consolidation. The ecosystem is rapidly developing and Cypress is driving this proliferation and fan out into PCs, tablets, mobile devices, cables, docks and other accessories. Beyond these more traditional markets, Cypress is also leading the charge in driving USB-C adoption at automotive and industrial customers. The number of customers in production with Cypress USB-C have grown by over 50% since last year as we started to see buying in Q2.

We recently introduced our newest controller, which includes support for Intel’s Thunderbolt connectivity to increase the ramp of USB-C into notebooks and desktop PCs, as well as docking stations. Additionally, a recent teardown of the iPad Pro 10.5 inch identified our CCG2 USB-C controller for power delivery, which cuts charging time by 50% using USB-C to Lightning. Further showcasing the flexibility of USB-C’s benefit even in existing ecosystems. We are starting to see strong customer traction for USB-C in automotive and have begun qualifying our USB-C solutions for top automotive OEMs.

USB-C provides faster and higher wattage charging of mobile devices in cars, including smartphones, tablets, notebook, PCs, game consoles and other electronic – personal electronics. These examples illustrate how we are expanding our reach and taking advantage of market adjacencies in USB-C with our solutions integration and programmability. As a reminder, USB-C is just starting to take off and is expected to be a multiyear transition. We are encouraged by the activity so far and looking ahead to the second half of 2017 and beyond.

Finally in automotive, where Cypress is the leading provider of embedded solutions, we continue to drive content growth in the Car of Tomorrow (10:59). In Q2, our automotive revenue grew 7% to another record for Cypress. And we are positioned to win as the market leader in instrument clusters, connected car, ADAS and infotainment, which are all growing faster than the overall automotive market.

As an example, our leading Traveo MCU and NOR flash memory are enabling a sophisticated graphic solution for DENSO instrument clusters in the 2017 Toyota Camry. We are at the forefront of the expanding market for autonomous driving solutions with our NOR flash as evidenced by our recently expanded collaboration with Bosch to provide critical functions to the ADAS platform.

Finally, we are now designed into all of the top eight worldwide automotive OEMs for Wi-Fi and Bluetooth connectivity in the car. We are pleased to report our most recent win, the new Audi A8. The A8 was recently launched on July 11 at the Audi Summit held in Barcelona and will appear on the German market in the late fall 2017. Cypress is enabling 802.11ac connectivity for content sharing, hotspot and rear-seat entertainment. This is the first European car model that offers this capability and is another example of the integrated Cypress team completing the production cycle for an IoT product in the first year since the acquisition.

In closing, I want to again acknowledge that these results would not have been possible without the strong execution by our worldwide team. Despite Thad and I spending a significant amount of our time on the proxy contest during the second quarter, we exceeded our revenue and earnings guidance and give credit to the strength of our team.

I’d like to thank our employees, customers and partners for their continued commitment and support.

Now, I’ll turn it over Thad to talk about our numbers.

Thad Trent – Cypress Semiconductor Corp.

Thanks, Hassane. I’m pleased to report another strong quarter that further underscores our execution of Cypress 3.0 and our results are reflecting the operating leverage in our model. Today, we’re reporting another quarter of record revenue in the post-SunPower era and the highest EPS since Q4 of 2011. Q2 revenue of $593.8 million, increased 12% sequentially, while we delivered $0.21 of EPS, an increase of 62% sequentially and 5 times faster than the revenue growth. I’ll walk you through each of the drivers as we step through the details for the quarter.

First, let me give some color on the demand environment. We believe the overall market remains healthy as we saw sequentially growth in all regions and all end market segments driven by content gains in connectivity, microcontrollers and memory. Our automotive business continues to be robust, achieving another record revenue levels growing 7% sequentially and 23% over Q2 of 2016. The consumer segment of our business also set a record revenue level, growing 15% sequentially, driven by strength across IoT wireless connectivity, microcontrollers and flash memory. And as a point of reference, auto and industrial segments represents 49% of total revenue, and consumer is 35% of our revenue.

During the quarter, we saw incremental demand due to limited supply in the flash memory market, allowing us to opportunistically engage with customers. Demand for our broad-based microcontroller and PSoC products also exceeded our expectations, with ramping of new end customer products in the consumer and communication segments.

And now, turning over to the divisions, MCD revenue was $361 million, up 13% from Q1, as we continue to see strength in our wireless connectivity business as well as microcontrollers. As I noted last quarter, we’re building inventory and adding capacity to support end customer demand in these areas, and we saw customers replenishing their inventory levels in the quarter.

Revenue in our IoT wireless connectivity business increased 17% over Q1, and non-auto microcontrollers increased 19%. We’re also beginning to see the ramp of USB-C as numerous design wins are starting to go into production. We expect more than 75 PC models to be in production by year-end, along with ramping mobile devices, power adapters and other accessories.

MPD revenue was $233 million, up 9% from Q1 and, as I mentioned, better than we expected due to strength in flash memory, which sequentially increased 9% on a dollar basis and 6% on a unit basis, as we brought on additional supply to meet this demand. We have seen a favorable pricing environment. But keep in mind, over half of our flash memory business is based on long-term contracts for our embedded customers. We are well positioned in the NOR market and will continue to drive incremental earnings and cash flow in this environment.

That brings me to gross margin. Our Q2 gross margin came in at 40.9%, the high end of our guidance, as we continue to execute on our margin improvement plan. The 40.9% is a 310 basis point improvement over Q2 of 2016. Ramps in both wired and IoT wireless connectivity, where margins are at or above corporate average, were offset by strength in legacy Fujitsu MCU automotive and certain flash products, where margins are below the corporate average.

Fab utilization was 75% and is expected to increase to approximately 80% by the end of the year. We expect Q3 margins to again improve to 41.5%, plus or minus, and we remain on track to achieve the 43% gross margin target for Q4.

Let me give you a few numbers for your models. Our operating expenses for Q2 were $151.5 million or 26% of revenue. This included $8.5 million of proxy-related expenses and there is an additional $3.5 million of settlement expenses, accounted for our GAAP-only results. Our OIE was $13.4 million, which reflects reduced interest expense from term loan refinancing and favorable foreign exchange impact.

Our tax expense in Q2 was $3.1 million. Our diluted share count for Q2 was 363.9 million shares. This includes 18.2 million shares for the in-the-money portion of the Spansion convertible, which increased by approximately 900,000 shares in Q2 due to our higher stock price. This resulted in net income of $74.7 million or $0.21 per share above our guidance range.

So turning to the balance sheet, cash and short-term investments totaled $108.8 million, and we had $223 million undrawn on our revolver. Cash from operations was $32.4 million. Accounts receivable at the end of second quarter was $337 million, resulting in DSO of 52 days.

Inventory decreased $13 million sequentially to $312 million with decreases in both MPD and MCD as we met increased demand in Q2. Our days of inventory decreased to 81 days as we focused on inventory. Our Q2 non-GAAP EBITDA was $107.2 million, another record level since the Spansion merger, and our debt was $1.28 billion. Our debt-to-EBITDA leverage is 3.4 times and we remain focused on driving this below (19:18) 3 times by the end of the year. Our CapEx was $15.6 million, depreciation of $16 million for the quarter.

So turning to guidance for the third quarter, again we entered the quarter over 90% booked, as our broad customer base and auto customers were providing better visibility. The book-to-bill was 1.2. Lead times extended within the quarter on our flash products requiring customers to layer in additional bookings. Adjusted for this lead time extension, our normalized book-to-bill is 1.09.

A quarter ago, we had expected slightly better-than-normal seasonal patterns for the second half of the year. Based on our first half results, the current market dynamics and ramping of our new products, our business is performing better-than-normal seasonal patterns. We’re expecting Q3 revenue of $585 million to $615 million, which at the midpoint is up 1% on the above-seasonal Q2 revenue and significantly above our expectations 90 days ago. Also, at the midpoint, our Q3 revenue will increase 13% over Q3 of 2016. This guidance also reflects the USB-C ramp we’ve been expecting in the second half and we’ll continue to be selective in the memory market, focusing on earnings growth over market share gains.

Our Q3 gross margins, as I stated, is expected to be 41.5%, plus or minus, and as always, margin will vary with utilization, products and customer mix. We expect Q3 operating expenses between $145 million and $147 million for the quarter. Our net OIE will be approximately $16 million. Tax expenses will be approximately $3 million. CapEx is estimated to be $20 million and depreciation of approximately $16 million. We anticipate the fully diluted share count to be 366 million shares. And as a result, earnings per share is expected to be in the range of $0.21 to $0.25 for the quarter.

So to wrap things up, Q2 was further evidence of our team’s strong execution of our Cypress 3.0 strategy. Our results and guidance, once again, demonstrates the leverage in our operating model as we deliver earnings at a faster pace than revenue growth.

With that, I’ll now turn the call back over to the operator to begin the Q&A.

Question-and-Answer Session

Operator

Thank you, sir. We will now begin the question-and-answer session. Our first question is coming from the line of Blayne Curtis of Barclays. Your line is open. You may begin.

Blayne Curtis – Barclays Capital, Inc.

Hey, guys. Thanks for taking my question, and a nice results. Thad or Hassane, maybe you can just talk about, as you look into September, you’re seeing a little bit of growth, obviously, off of a high June. Between the two segments, maybe you can just talk about, if you expect one to be up and the other down. I couldn’t figure out, on the memory side, the bookings in flash, but then you said you’re walking away for (22:35) some. So maybe you can just talk about the moving pieces within those two segments and in which directions they’re going into September?

Thad Trent – Cypress Semiconductor Corp.

Yeah, Blayne, this is Thad. So, we expect slight growth in the MCD division driven by obviously the IoT wireless connectivity, the microcontrollers for automotive. The memory side right now we’re projecting to be essentially kind of flat for the quarter. We’ll see how that plays out with the current market dynamics. But right now, as we brought on the capacity, we’re at full capacity to support that business. And depending on the mix, won’t necessarily have the ability to grow that revenue within the quarter much more than what we saw in Q2. So, the slight revenue growth we expect to be coming from MCD.

Blayne Curtis – Barclays Capital, Inc.

Got you. And then I just wanted to ask on USB-C, I think you said in the press release record revenue, but obviously small base. Can you just talk about the trajectory in the second half? What’s the right quarter that you’ll see a contribution there as you look at September and December, and if you can frame the magnitude of the opportunity there?

Hassane El-Khoury – Cypress Semiconductor Corp.

This is Hassane, Blayne. So, the second half of the year, as we’ve forecasted before, is going to be on the ramp. We started seeing the pull from the customers in Q2 in preparation for the ramp for the second half. So, all of that is kind of coming in exactly where we had expected it to be at the beginning of the year and in Analyst Day.

It’s going to come from ramping mobile and PC. We’re in a lot of PC models that are starting as well as mobile ramps that will be in the second half of the year. All that is already in our guide. But it’s following according to plan, according to our original forecast.

Blayne Curtis – Barclays Capital, Inc.

Perfect. Great job, guys. Thanks.

Thad Trent – Cypress Semiconductor Corp.

Thanks.

Operator

Thank you, sir. For our next question on queue, this will come from the line of John Pitzer of Credit Suisse. Your line is open. You may begin.

John W. Pitzer – Credit Suisse Securities (USA) LLC

Yeah. Good afternoon, guys. Thanks for letting me ask the questions. Congratulation on the strong results. Hassane, maybe just a follow-up to Blayne’s question on the USB Type-C. I’m wondering if you could talk a little bit about the competitive moats you have there. How durable are these sockets? As we see continued proliferation out into 2018, how are you guys thinking about your market share opportunity and/or sort of what the yearly price decline environment might be as this technology burns out?

Hassane El-Khoury – Cypress Semiconductor Corp.

Sure. So, obviously, just like any consumer or mobile and a hot market, competition is there. It’s been around. We’ve established a lead in market share, about 37%, 38% already just for being first to market. But obviously, there’s lot of new entrants and players in the market today. How that position is going to be affected in the second half, it’s all baked in. We’re very well positioned in second half. Everything is designed in. We’ll ramp according to plan. 2018, our design win pipeline is very strong. I’m very comfortable for the 2018, but we remain obviously competitive. We have a lot of new products coming out. We are targeting programmable and integration, which both make our sockets very sticky.

If you remember, during Analyst Day, I said, as soon as we start seeing commoditization in the low-end of that market, my forecast would be, first, the – potentially the cable, and 18 to 24 month, we will keep plan to maintain the margin. But for now, over the next 18 month, we have a very solid position and a very sticky position. I’m very comfortable with it.

John W. Pitzer – Credit Suisse Securities (USA) LLC

That’s helpful. Then maybe as my follow-up, for Thad. Personal observation, congratulations on good margin leverage, both sequentially and year-over-year. I think this is some of the best incremental margins you guys have kind of put up in a while. But I’m kind of curious, when I look at free cash flow, there still seems to be a pretty big gap between sort of net income and free cash flow. So, how are you thinking about closing that gap and what target could you share with us over time for free cash flow generation?

Thad Trent – Cypress Semiconductor Corp.

Yeah. I think what you’re seeing right now is you’re seeing a little bit of timing lag right now, right. As you noticed, we’ve put up a solid quarter of earnings, 12% growth. We built inventory last quarter in Q1, so if you think about it from a cash standpoint and the cash conversion, I think there is a lag to that. So, as we look forward into Q3, we see strong growth in cash flow – free cash flow. We manage the CapEx very tightly. We have been spending a little bit as we brought on the capacity. But as you know, most of our CapEx is maintenance, a little bit on bringing on this flash capacity.

But for the most part, if I look through Q3 and Q4, I think you’re going to see a nice earnings – sorry, cash flow growth through the second half of the year as the working capital kind of starts to come through and that cash conversion cycle closes.

John W. Pitzer – Credit Suisse Securities (USA) LLC

Any target as a percent of revenue you feel like sharing with us, Thad?

Thad Trent – Cypress Semiconductor Corp.

No, because again, I think, a lot of it’s the timing, right, and I think a lot of it depends on the market dynamics as well in terms of if additional capacity is needed.

John W. Pitzer – Credit Suisse Securities (USA) LLC

Perfect. Thanks, guys. Congratulations again.

Operator

Thank you, sir. Our next question will come from John Vinh of KeyBanc Capital Markets. Your line is open. You may begin.

John Vinh – KeyBanc Capital Markets, Inc.

Hey, guys. Thanks for taking my question. Just a follow-up question on USB-C. You’d mentioned that in the second half that there’s kind of two key areas that you expected to see a ramp, one in PCs and the other one in mobile. I was wondering if you could talk about how we should be thinking about your blended ASPs on each of those segments based on the design wins that you guys currently have going into the second half?

Hassane El-Khoury – Cypress Semiconductor Corp.

Hey, John, this is Hassan. There is a wide range of ASPs for that market. We talked about mobile as a segment. And I’ve said it in the past, within that segment, you have a device in the phone, device in the cable, device in the charger, and device in the dongle, et cetera. So even within those, the variation are anywhere from $0.25 to $0.80 or $1 depending on the integration and the level of power that is being delivered by these devices. So, it’s not really market dependent. It is device dependent and function dependent. So, the range is – like I said, it’s pretty broad.

John Vinh – KeyBanc Capital Markets, Inc.

Got it. Thank you. And then my follow-up question is for, Thad. Thad, you said Q3 guidance, 41.5% gross margins, and you’re on track to getting to 43% by the end of the year. With fab utilizations being at 75%, expected to go to 80%, it doesn’t seem like you’re going to get a lot of tailwinds on increased utilizations. Can you just maybe walk us through the bridge that remaining 150 basis points going from Q3 to Q4?

Thad Trent – Cypress Semiconductor Corp.

Yeah. Well, as we’ve said in the past, I mean, it’s literally (30:06) hundreds of line items, thousands of line items that we work on as a company. Obviously, we’re getting some favorable mix that – it helps on that. But more importantly is really the activities that we’ve been taking inside the company and utilization is one piece of it. You’ve seen that help us in the past and will be a little bit of a tailwind for us as we go forward. But we are also looking at the cost structure in our manufacturing sites, taking costs out there, which is part of the synergy that we’ve talked about over the years.

We’ve got channel consolidation that you’ve seen us do and that we’ll continue to be looking at in how we engage with our distribution partners around the world. We’ve got additional synergies from the Spansion merger that will start to hit through the rest of this year and we’ll get the full benefit of the synergies for the full year. And then, really, it starts to become a optimization of the manufacturing sites, right. As we out-production – today, we’re manufacturing about 35% of our products inside versus 65% outside. And it’s a matter of finding that right combination of which products go into which facility, to maximize gross margin. But there is a team here that is focused on this, that’s working on a lot more detail behind that, improving yields, taking cost out of our products. There’s, like I said, thousands of line items. And as we see it right now, we’ve got line of sight to that 43%.

John Vinh – KeyBanc Capital Markets, Inc.

Great. Thank you.

Operator

Thank you, sir. Our next question will come from Harsh Kumar of Stephens. Your line is open. You may begin.

Harsh V. Kumar – Stephens, Inc.

Yeah. Hey, guys. Congratulations on stellar execution also on raising the target for IoT. Hassane, question for you, you talked about 75-plus wins in the PC area for Type-C. I was curious if you could talk, maybe in terms of similar numbers or any numbers that you want to share, of how the design win traction is for USB-C in the back half of this year. And then, point two of that question is, do you think PCs will be bigger for you in USB-C exiting this year or you think handsets will be bigger in dollar terms?

Hassane El-Khoury – Cypress Semiconductor Corp.

It’s a very good triangulation question. So, I’ll give you a little bit of – some of the items I’ve talked about in the past. All the numbers that we have confidence and full visibility to are already in our guide. The mix and the rate at which each segment is going to grow, I’m not talking about those for one main reason is product ramp delays, product ramp slope. And those – it’s a brand new ecosystem, a lot of new products that are including Type-C in them. I’m just waiting for the shift-through to start happening, the sell-through at our customers to start happening before I can confidently start reporting to you outside of just my visibility from a forecasting side.

I’m very comfortable with the forecast and the guide we’ve given in general, and that’s based on strength that we’ve seen in Q2 as far as customer pulling in products. We need to – a few weeks from now, when customers start pushing out products on to shelves and sell through, that we start getting more confidence in the end product ramp. As we all know, some products will get delayed, some products won’t. Some products will make it, some won’t. I think our approach is very well balanced and it’s included in our guide.

Harsh V. Kumar – Stephens, Inc.

Okay. Thanks, Hassane. And then, as a follow-up, you talked about the combo chip and you talked about the first joint, I guess, in-house Cypress combo chip. I assume it’s a Wi-Fi plus Bluetooth combo chip. And so, I know that the business you acquired had these before. What’s so special about this particular one that you’re so excited about, or am I missing something here?

Hassane El-Khoury – Cypress Semiconductor Corp.

Sure. Well, the excitement is, first, the technology and what it provides as far as solution. But from where I’m sitting, a lot of people talk about achieving synergies is when you call integration complete, the team moving in the building is when you call integration complete. But when you have a high-tech acquisition and an integration, to me, when it’s done is when the team will tape out and introduce a very complex product in the new company. And that milestone was achieved in Q2, which is a very big deal of what that means for our future roadmap for our customers. We get a lot of questions about what did you get with the acquisition, do you have the roadmap, do you have the assets that you need. The Q2 milestone is very big, because it is a stake in the ground saying, yes, we do and we will keep contributing to the aggressive roadmap that we have acquired and we’ll keep delivering those products within Cypress.

Harsh V. Kumar – Stephens, Inc.

Understood. Congrats, again, guys.

Operator

Thank you, sir. Next question is from the Vivek Arya from Bank of America. Your line is open. You may begin.

Adam Gonzalez – Bank of America Merrill Lynch

Hi, guys. This is Adam Gonzalez on for Vivek. Thanks for taking my question. First, just wanted to touch on Q2 results, and I recognize you’re better – much better than what you’ve guided to. But Q3 guide seems to be a little bit below seasonal, which is 1% growth. I’m just wondering what are the puts and takes to that and should we expect Q4 to be above trend as well, or should we expect it to be seasonally down? Thanks.

Thad Trent – Cypress Semiconductor Corp.

Hi. So, this is Thad. So, as I stated, our business currently is not exhibiting normal seasonality. It hasn’t all year. I think we’ve outperformed every quarter. And if you look at the ramping of the new products, the underlying business may still have those seasonal patterns that you’ve got kind of businesses that are hitting in different quarters that are kind of causing that pattern to not look seasonal. So, obviously, we had big Q1 above seasonal, a big Q2 above seasonal, and we brought on additional capacity. We also saw customers replenishing their inventories that were struggling to get enough inventory from us in the past. And if you look forward, as I said earlier, we’ve got some products that we’re just constrained on, we’re not going to have more capacity, so you’re just not going to be able to get that incremental growth out of it. And it’ll come from our core business and ramping of these new products.

So, as I look forward, I think it’s a stellar Q3 and, like I said, much higher than what we predicted even 90 days ago. 90 days ago, I was saying it’d be slightly better than seasonal. If you take that, you do the math, this is exceptionally higher than what seasonality would have been for Q3. For Q4, I think what you’re going to see is a little bit of seasonality because some of the consumer products that will have a holiday build will roll off in Q4. So, I think you can think about, I’m not going to call it, a seasonal pattern, but I think you can see Q4 stepping down slightly from a Q3 baseline just because of some of the ramping products we have in Q3.

Adam Gonzalez – Bank of America Merrill Lynch

Got it. Thanks. Very helpful. My second question is on just the automotive market. Are you guys seeing any impact from the slowdown in U.S. auto sales? I understand Cypress is a global player, but just wanted to see if you’ve any take on that? Thanks.

Hassane El-Khoury – Cypress Semiconductor Corp.

This is Hassane. No, I mean, obviously, we’re monitoring, just like every other company, who has got 30% or a big exposure to automotive. But I remain confident that our content growth, which we reported last quarter, but more importantly this quarter with a – the maximum we’ve ever done in automotive, trumps any SAR (38:04) concern that there are in the market, specifically in North America. We are seeing growth across the board, focused on – in Europe, also where the impact on SAR (38:16) is actually positive. So, I remain confident in our projections and I’ll tell you, projections that I’ve given in Analyst Day, including our performance year-to-date. We’ll keep monitoring, but have no reason for concern. Automotive is healthy for us.

Operator

Thank you. Our next question is from Suji Desilva from ROTH Capital. Your line is open. You may begin.

Suji Desilva – ROTH Capital Partners LLC

Hi, Hassane. Hi, Thad. A nice job on execution here. Just want to circle back to the inventory. I think you’ve talked about this indirectly. But the level you’re at now, the 81 days, is that below still the target you guys have of 90-plus, and is it because of tightness? Or is this kind of more of a level you’d like to run at? Or are you below where you’d want to be? And what are just end (39:10) reason inventory is in that situation?

Thad Trent – Cypress Semiconductor Corp.

Yeah. Our target is to be below 81 days. We were at, I believe, 93 last quarter, so we worked it down to 81. Our target is to be closer to around 70 days long term. It will take us a while to get there. We’re still burning through some of that old inventory, it’s just a matter of having right mix and the customers. Where we’ve been supply constrained are products that we actually don’t have in our inventory. So, we’ll work through those – through that inventory. We’ll get down into those levels. Hopefully, mid next year, late next year, I think, we’ll get down into that, what I would call, a normal operating inventory level. But it is a focus for the company and you saw us build inventory last quarter and work it back down this quarter, which is what I predicted. And then, in terms of the -just the inventory, there’s about 7.1 weeks in the channel, increased from, I believe, about (40:08) 6.3 last quarter, that’s within our range of 6 to 8 weeks, and kind of at historical level. So, we don’t see anything ballooning there or anything that’s out of the norm, to be honest with you.

Suji Desilva – ROTH Capital Partners LLC

Okay. Good execution there. And then second question is on the MCD market, maybe kind of revisiting what you may have talked about at the Analyst Day. What’s the organic long-term growth rate we should think about here now that you’ve folded in the Broadcom acquisition? And if you give it by sub-segment that’ll be helpful, particularly since USB-C has been such a hot topic on this call?

Hassane El-Khoury – Cypress Semiconductor Corp.

Sure. So I’ll give you the – I’ll just reiterate the long-term projections. We have not changed them from Analyst Day. I think they’re pretty strong and we have confidence in them, more confidence now obviously with the results that we just posted. End market, we’re looking at auto, 8% to 12%; industrial, 3% to 5%; consumer, 10% to 15%. If you look at it by solution and division, we’re talking mid- to high-single-digit for MCD, And then MPD, we’ve always talked they’ll be slightly down, just because the memory market is slightly down and we’re offsetting the decline with share gains. We’re still behind that. Specifically, for connectivity, I’ll just reiterate, the 16% to 18% growth target long term. We’re still confident with that and our design win funnel supports that growth rate.

Suji Desilva – ROTH Capital Partners LLC

Okay. Thanks for reviewing that. Nice job, guys.

Thad Trent – Cypress Semiconductor Corp.

Thanks.

Operator

Thank you. Next question is from Charlie Anderson of Dougherty & Company. Your line is now open.

Charlie Lowell Anderson – Dougherty & Co. LLC

Yeah. Thanks for taking my questions and congrats on the strong results and guidance. I wanted to dig in a little bit flash. Maybe if you guys can just remind us on what portion of memory products is flash at this point. And then, if I think about the pricing environment, I think you said half the customers are long-term deals. So, should we think about that as maybe half is exposed to that favorable pricing? Then, as I think about it in the next quarter, are you assuming that favorable pricing keeps happening or, when you say flatter, you’re thinking the pricing levels off from the Q2 levels? Thanks.

Hassane El-Khoury – Cypress Semiconductor Corp.

So, if I take the two components of the pricing question, specifically, when we talk about contractual pricing, a lot – most of our exposure is auto and industrial. Those are all contractual. They’re multi-year contracts, which is the reason we like those markets, regardless of products going in to. Now, on the flip side of it, when I talk about being opportunistic, it’s on the markets that we have not been going after, or we have walked away from. And in our terms, walking away is you raise prices to where competition won’t be invited to participate. Those pricing, we still remain opportunistic, but it’s not just about the price and the margin. We want revenue sustainable earnings for that. Meaning, we will service customers that are potentially, not necessarily, started as focus flash customers, but we do cross-selling for microcontrollers or Wi-Fi or Bluetooth, and they need memory. We will support them with their memory demand at our price in order to generate more earnings.

So, our focus is maintaining our target and our path for the gross margin expansion. And if we are able to generate earnings, we will go after that business, while we maintain the gross margin trajectory. So, that’s kind of the balance that we do as far as being opportunistic about both pricing and supply. But the other side of the business, where the exposure is in auto and industrial, our focus is just to satisfy the customer demand per our original agreements.

Thad Trent – Cypress Semiconductor Corp.

Hey, Charlie, it’s Thad. So, the answer to your question about the flash component of MPD, it’s – there is give and takes every quarter, but on an average, it’s about two-thirds of the overall MPD revenue.

Charlie Lowell Anderson – Dougherty & Co. LLC

Perfect. That’s what I was thinking. And then a quick one on USB Type-C, in terms of the mobile design wins, and Hassane you mentioned, there is a lot of ways you can do that in terms of how much content, where you end up. I wonder the ones – the design wins that you do have, to what degree is there portions of that that you think are susceptible to integration or is everything that you want something that can sustain for two, three years, or is more of the burden on you to come up with new features to keep that same content level on those types of sockets? Thanks.

Hassane El-Khoury – Cypress Semiconductor Corp.

Yeah. I think where we are today, I can tell you, based on the design and the capability of our product, as far as what performance they do within the system at they’re in and the system, like I said, could be from a cable to a adaptor to a dongle, et cetera, I see a good, strong performance over the next couple of years. So, that’s why I mentioned earlier in the Q&A, I’m very comfortable with our position and the stickiness of our position, both on the designs that we’ll be ramping and the funnel that we have been winning.

Charlie Lowell Anderson – Dougherty & Co. LLC

Perfect. Thank you so much.

Operator

Thank you, sir. Next question is from William Stein of SunTrust. Your line is now open. You may begin.

William Stein – SunTrust Robinson Humphrey, Inc.

Great. Thanks for taking my questions. First, I’m hoping you can comment on the slightly longer term 48% op margin – pardon me, gross margin target by the end of next year relative to what you’re achieving so far this year and reiterating the near-term goals.

Thad Trent – Cypress Semiconductor Corp.

Yeah. It’s Thad. So, as we said, we’ve got 43% locked and loaded. We are comfortable there. I rattled off a number of items, talking about thousands of line items that we work on every day and that our team is executing on. Those don’t end in December of 2017. So those activities go through 2018. As we look forward, obviously, it will depend on the macro as well that we believe we’ve got some favorable mix coming our way as new products come out of R&D and start ramping. That gives us some nice favorable tailwind. And it’s something we’ll continue to work and execute on. So, we’re not changing that target.

Hassane El-Khoury – Cypress Semiconductor Corp.

Yeah. If you look at, we’re going to exit the year with 43%. We have line of sight to that. And that mix, where the growth is coming from, will continue in 2018. You see the new products coming up, which will sway the mix overall with a strong foundation that we have been working on, the thousands of line items for manufacturing getting cost out, which will continue, but that will become the baseline that we’ll build upon until – and exit 48%, which we are also maintaining.

William Stein – SunTrust Robinson Humphrey, Inc.

That’s very helpful. One follow-up, if I can. I saw in your product announcement or your new – I don’t know, if it’s new relationship, but you announced a new MCU and I think other product wind with DENSO for Toyota. It seemed remarkable to me, because I think DENSO has historically used Renaissance, and I think it’s probably very difficult customer for other microcontroller companies to penetrate. Is this is a new relationship and is this sort of important, potentially, to your business, as it seems, or am I overstating it?

Hassane El-Khoury – Cypress Semiconductor Corp.

Well, I’d give you two answers. One is, it’s not a new relationship with us and DENSO. We have a long relationship with DENSO. They’re one of our largest customers in the company today. What is new is what you started your question with, which is displacing Renaissance. That has been a trend, not just at DENSO, but across multiple other accounts. We’ve been gaining share and that’s in addition to just the new content that is being generated in the cars. Both those are what contributes to our confidence in our long-term targets and our current growth targets, specifically for automotive.

So, all of that. And if you notice on the DENSO design, it’s a microcontroller and a flash. So, that also plays into the cross-selling that we’ve been talking about since the merger. And those designs are starting to get to production based on just the design cycle latency that we see in automotive. So that now – we’ve talked about it at the merger time. I reported on it as far as progress and design wins, and now you’re starting to see those designs starting to generate revenue with multiple products and solutions from Cypress on the boards of our customers. So, you’ll see more of that coming out, not just in automotive, but across other markets.

William Stein – SunTrust Robinson Humphrey, Inc.

Great. Thanks.

Operator

Thank you. Next question is from Craig Hettenbach of Morgan Stanley. Your line is open. You may begin.

Craig M. Hettenbach – Morgan Stanley & Co. LLC

Yes. Thanks. I appreciate the context as you look out into Q4 in terms of seasonality and consumer. Anything else to add there in terms of USB, would that be another help if it extends into Q4 versus typical seasonality?

Thad Trent – Cypress Semiconductor Corp.

Craig, I think what I’ve said earlier, stepping back, I mean, that assumes that USB-C continues to ramp throughout the year, and that would offset some of the decline in the other consumer-oriented markets. So, that’s baked in kind of what Hassane calls a balanced forecast.

Craig M. Hettenbach – Morgan Stanley & Co. LLC

Got it. And then any other commentary, Thad, just around kind of the channel? You gave kind of the weeks of inventory. Just kind of how behavior was as you went through the quarter? I know you mentioned lead times there (50:11), but just looking for some context around kind of the cycle and what you’re seeing from both distributors and customers.

Michael Balow – Cypress Semiconductor Corp.

Yeah. So, Craig, this is Mike Balow. Our lead times did extend a bit through the quarter on a number of products. And distribution has tried to build a little bit of inventory to support some of (50:33) the longer lead times. As Thad mentioned earlier, with the lead times extending, it’s forced the customers to get more on the books. And I think, with the general tightness in the market, they’re trying to get inventory in place.

Thad Trent – Cypress Semiconductor Corp.

But yeah, Craig, I don’t think we saw – other than what Mike mentioned, I don’t think we saw anything outside the norm. Again, that inventory levels are right in our sweet spot, consistent with what we’ve seen in the past. We have seen them build some inventory on some of these products that we’ve been supply constrained on, but I think I wouldn’t say it’s anything outside of normal patterns.

Craig M. Hettenbach – Morgan Stanley & Co. LLC

Got it. Thanks.

Operator

Thank you. Next question is from Rajvindra Gill of Needham & Company. Your line is now open.

Rajvindra S. Gill – Needham & Co. LLC

Thank you and congrats as well. On the IoT business, I know, in the past, you kind of broke out the percentage from consumer, industrial and auto.

I was wondering if you can maybe talk a little bit about the split between those three sub-categories. Overall, you break out the business by the different end markets, so if we can get a sense of what’s going on, on the connectivity side. But just wondering if you have any insight on kind of a split of IoT between the consumer, industrial and auto?

Thad Trent – Cypress Semiconductor Corp.

Yeah. Yeah, the wireless connectivity breaks out to about 10% automotive, which is consistent with what we’ve been running in the past. About 20% comes kind of in this industrial category, and then 70% which is this broad consumer other, right. All these devices that are being connected kind of fall into that category. That can be things from gaming to toothbrushes to flashlights, whatever it may be that are getting connected, thermostats. But that’s essentially the breakout of the business as we see it.

Rajvindra S. Gill – Needham & Co. LLC

And the automotive business growing 7% sequentially and also growing well on a year-over-year basis, how are you specifically tied to the different progressions of ADAS systems from kind of a dollar content perspective?

Hassane El-Khoury – Cypress Semiconductor Corp.

Sure. So – this is Hassane. When we’ve outlined our new strategy, I mentioned our focus is enabling all ADAS system, basically, really agnostic of the level because we’re not providing the SoC or part of the SoC, or the periphery as far as in a microcontroller or a programmable fabric. But all of these, whatever level of autonomy and whatever level of periphery, they require a special type of memory. And that’s where our flash investment and our fresh flash products have been focused, which is providing all of the SoC vendors, and there are a few of them that are in the lead and gaining traction, do require external memory. It’s high-performance memory, it is secured memory. Obviously, you can’t have any potential for a hack or a disturbance being external. So, we are focusing our investment on these products that provide low power, high performance and security.

Those are what our play is in ADAS today, along with all SoC vendors. Our engagement with the OEMs and with the Tier 1 is at that level. We announced a partnership with Bosch in the quarter, where Bosch selected the Cypress flash memory, the NOR flash memory, specifically, as their memory platform for their ADAS platform. So as you see those products and those systems deploy and ramp, we will start engaging and ramping those memories with them. So, that’s been our – so, basically, it doesn’t matter what level accelerates, whether level two, three, four, five, we will be in as soon as ADAS, in general, starts ramping at any level.

Rajvindra S. Gill – Needham & Co. LLC

Great. Just last question for me. You break out the revenue by end market, auto, industrial, consumer and then you also break it out by solution, memory, microcontroller, connectivity, mixed signal. So, if I did the numbers right, I mean it seems like the connectivity grew 21% sequentially, followed by 9% sequential growth in memory and 8% in microcontroller. Were those product segment increases driven across evenly through the different end markets or was there one end market with respect to one different product line where you saw more growth versus the others.

Hassane El-Khoury – Cypress Semiconductor Corp.

Yeah. I mean if you look just at our end market composition, the industrial and automotive is about 49% and it’s been – in the last few quarters, it’s been 52%. So, that tells you that a lot of the growth in the quarter was from the consumer. Basically, everything grew, but consumer grew a little bit faster across the board. And that put the total revenue more on the consumer side as a percent, but everything grew, like you highlighted.

Rajvindra S. Gill – Needham & Co. LLC

Great. Thank you very much.

Thad Trent – Cypress Semiconductor Corp.

Thanks, Rajvi.

Operator

Thank you, sir. That will be our last question on queue. I’ll now hand it back to Hassane El-Khoury for some closing remarks.

Hassane El-Khoury – Cypress Semiconductor Corp.

All right. Thank you all for joining us today. We’re looking forward to an exciting second half of the year as we focus on our key growth markets and continue to execute on our exciting vision for Cypress 3.0. We look forward to seeing many of you soon at conferences and on the road. As a reminder, we’ll be presenting at the KeyBanc Capital Markets Global Technology Leadership Forum in Vail, Colorado on August 7th and the Deutsche Bank’s 2017 Technology Conference in Las Vegas on September 12th. Good night.

Operator

Thank you, everyone, for participating on today’s Cypress Semiconductor conference call. You may now disconnect.

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