Jalene Hoover - Head-Investor Relations John C. Hollister - Chief Financial Officer & Senior Vice President George Tyson Tuttle - President, Chief Executive Officer & Director.

Craig A. Ellis - B. Riley & Co. LLC Tore Svanberg - Stifel, Nicolaus & Co., Inc. Blayne Curtis - Barclays Capital, Inc. Matthew D. Ramsay - Canaccord Genuity, Inc. Anil Kumar Doradla - William Blair & Co. LLC Cody Acree - Drexel Hamilton LLC Ian L. Ing - MKM Partners LLC Harsh V. Kumar - Stephens, Inc. Rajvindra S.

Gill - Needham & Company, LLC Suji De Silva - ROTH Capital Partners, LLC.

Good morning. My name is Shannon and I will be your conference operator today. At this time I'd like to welcome everyone to Silicon Labs Second Quarter 2016 Earnings Conference Call. All lines have been placed on mute to prevent any background noise. After the speakers' remarks, there will be a question-and-answer session.

I would now like to turn the call over to Ms. Jalene Hoover. Ms. Hoover, you may begin your conference..

Thank you, Shannon. Good morning, everyone. Thank you for taking the time to dial in. Tyson Tuttle, Chief Executive Officer, and John Hollister, Chief Financial Officer, are on today's call. We will discuss our financial performance and review our business activities for the second quarter. After our prepared comments, we will take questions.

Our earnings press release and the accompanying financial tables are available on the Investor Relations section of our website at www.silabs.com. This call is also being webcast and a replay will be available for four weeks. Our comments today will include forward-looking statements or projections that involve substantial risks and uncertainties.

We base these forward-looking statements on information available to us as of the date of this conference call and that information will likely change over time.

By discussing our current perception of our markets, the future performance of Silicon Labs and our products with you today, we are not undertaking an obligation to provide updates in the future.

There are a variety of factors that we may not accurately predict or control that could have a material adverse effect on our business, operating results, and financial condition.

We encourage you to review our SEC filings which identify important factors that could cause actual results to differ materially from those contained in any forward-looking statements. In addition, it is not our intent that the non-GAAP financial measures discussed today replace the presentation of Silicon Labs GAAP financial results.

We are providing this information to enable investors to perform more meaningful comparisons of operating results and more clearly highlight the results of core ongoing operations. I would now like to turn the call over to Silicon Labs Chief Financial Officer, John Hollister..

Thank you, Jalene. I'm pleased to announce outstanding financial results for the second quarter. We achieved record revenue of $175 million which exceeded the high end of our guidance range. As indicated on our April call, second quarter revenue includes $5 million related to the sale of certain non-strategic patents.

Excluding patent sale revenue, our total product revenue grew 5% sequentially to $170 million, also establishing a new record. Non-GAAP earnings for the quarter finished at $.75 per share above the high end of our guidance range.

Underlying our strong second quarter revenue performance, IoT set a new record of $77 million, up 8% sequentially and 11% year-on-year. We saw particularly strong performance in mesh networking, ICs and modules, Bluetooth smart modules and 8-bit microcontrollers. IoT represented 45% of our Q2 product revenue.

Total infrastructure revenue, including our timing and isolation products, was $36 million or 21% of our second quarter product revenue, up 13% sequentially and 18% year-on-year.

Our timing products achieved record revenue in Q2 and will continue to benefit from a number of megatrends, including the shift from enterprise to cloud computing in data centers and increasing bandwidth demand, which is driving 100-gig adoption in data center, interconnect and metro area networks.

Cisco is forecasting IP traffic to triple in the next five years. Our isolation products delivered record revenue for the sixth consecutive quarter with growth significantly outpacing the market.

We are taking share from our digital isolation competitors as well as incumbent optocoupler suppliers by offering higher performance, longer lifetimes and 10 times the reliability of optical-based solutions.

Our market opportunity is expanding as our isolators gain traction in a wide range of applications, including power supplies, electric and hybrid electric vehicles, solar inverters and motor controllers.

Broadcast finished the quarter better than expected at roughly flat performance to Q1 with record automotive revenue offsetting an expected decline in consumer. Total broadcast revenue ended at $38 million or 22% of second-quarter product revenue. Access revenue declined as expected to $19 million or 12% of Q2 product revenue.

We saw sequential growth in all geographies in the second quarter with particular strength in Europe. Looking at end markets, we saw the largest increase in industrial, fueled by the ZigBee smart metering ramp in Great Britain and increased sales of our isolation products.

Revenue from industrial end markets has grown nearly 20% year-on-year and we expect the momentum to continue. Strong performance in our broadcast automotive products drove a sequential increase in automotive end-market revenue. And lower TV tuner sales drove a slight decline in revenue from consumer end markets.

Worldwide distribution revenue increased over $10 million or 10% sequentially to approximately 69% of second-quarter product revenue. We are on track to expand our customer base by 20% this year, demonstrating the effectiveness of our broad-based approach to the market, including our Simplicity Studio development tools.

Non-GAAP gross margin in Q2 was above the high end of our target model range at 62.3%, which includes a 110 basis-point benefit from the patent sale. Product gross margin finished strong, primarily due to mix with growth in infrastructure and broadcast automotive products. Non-GAAP operating expenses were in line with guidance at $73 million.

Second-quarter R&D expenses increased slightly to $41 million with an expected increase in tape-out costs as we continue to expand our IoT portfolio. SG&A expenses declined marginally to $32 million, with reductions in legal and payroll taxes offsetting increases in variable cost on higher profitability.

Non-GAAP operating income increased by more than $10 million in the second quarter to $36 million or 20.5% of total revenue. We are pleased with the degree of operating leverage we were able to drive for the quarter.

Due to strong revenue performance, superior gross margins and inline OpEx, we achieved $0.75 per share non-GAAP EPS, exceeding the top end of our guidance range by $0.08. These results reflect an approximate $0.09 after-tax benefit from the patent sale, consistent with guidance.

Our non-GAAP effective tax rate was better than we expected at approximately 10.6% due to the geographical mix of income for the quarter. On a GAAP basis, Q2 gross margin was 61.9%. R&D expenses were $52 million and SG&A expenses were $39 million.

For the quarter, stock compensation expense was $11 million and amortization of acquired intangible assets was $7 million, both consistent with expectations. GAAP operating income for the quarter was $18 million or 10.1% of total revenue. Second quarter GAAP diluted earnings per share ended at $0.37, which was above our guidance range.

Turning now to the balance sheet, we ended the quarter with cash and investments of $251 million. Year-to-date cash flow from operations was healthy at $60 million and we continue to see only modest levels of CapEx required in the business at $6 million for the six-month period.

Second quarter year-to-date, we have completed over $38 million in share repurchases with an additional $62 million remaining authorized in the current program. The diluted share count for the quarter increased only slightly to 42.3 million shares which is near a record low.

Accounts receivable declined to $72 million on days sales outstanding improvement to 37 days. Net inventory grew to $56 million, with turns declining to 4.7 times. This is in line with our internal target as we continue to position the company for growth by maintaining adequate inventory levels. I will now cover third-quarter guidance.

We expect third-quarter revenue to be in the range of $171 million to $176 million with growth in IoT, a seasonal peak in broadcast, flat infrastructure and a decline in access. We anticipate that Q3 gross margins will be approximately 59% due to strong performance from our broadcast consumer and IoT wireless module products.

Additionally, given expected continued growth in our IoT module revenue, we are lowering our gross margin target 100 basis points to a range of 58% to 60%.

We are maintaining our non-GAAP operating income model of 20% to 25% We have made progress this year toward achieving our target model and we anticipate this trend to continue with revenue growth into 2017. We estimate Q3 non-GAAP OpEx to decline to $72 million with lower take-out costs and continued judicious expense control.

We expect our Q3 non-GAAP effective tax rate to be approximately 11%. We anticipate that our non-GAAP EPS will be in the range of $0.61 to $0.67 and our GAAP EPS to be in the range of $0.27 to $0.33. I will now turn the call over to Tyson..

Thanks, John. We are pleased to report exceptional second-quarter financial performance, fueled by records in all of our strategic growth products including IoT, infrastructure and broadcast automotive, which now represent more than 70% of total product revenue. IoT is approaching half of our total product revenue.

A large and diverse market, the IoT presents a decades-long trend to connect everything in the world with end applications requiring wireless connectivity, integrated processing, ultra low power and small footprints. The underlying challenge is how to best address this broad market efficiently and with a sustainable strategy.

Historically, we have offered highly differentiated components into larger systems with the goal of sustaining our market success with superior performance, coupled with barriers to integration and market diversity.

The IoT represents a new paradigm for Silicon Labs, where we can provide the complete system and control the integration path and add additional layers of differentiation in stacks, software, tools and simplicity. We have created general-purpose hardware and software platforms addressing the full range of applications that represent the IoT market.

Our platforms include standards-based and proprietary wireless connectivity, highly integrated SoC devices and world-class software tools that make it easier for developers to add connectivity to their end products while optimizing for ultra low power and long battery life.

During the quarter, we expanded our Wireless Gecko SoC portfolio to include multiband as well as multiprotocol capability, an industry first for the IoT.

This flexible platform enables developers to work with one set of software tools while supporting proprietary stacks as well as standards-based protocols such as ZigBee, Thread and Bluetooth low-energy.

For example, connected device-makers can now embed a combination of protocols such as Bluetooth to commission and configure devices with a smartphone and sub-gigahertz protocols to communicate over long-range or legacy proprietary networks. Customers benefit from simplified designs, reduced cost and complexity and accelerated time to market.

We believe our Wireless Gecko SoC portfolio positions Silicon Labs as the leading provider of silicon, software and solutions for our target IoT markets. Our platform-based strategy allows us to quickly optimize for specific markets while serving a broad range of applications through simplicity and state-of-the-art software tools.

To meet the needs of a world that is increasingly software driven and to add value and differentiation to our products, we have directed the majority of our incremental R&D investments and M&A over the last five years toward the development of our software capabilities.

Building on our software strength, we recently released our Connect wireless networking protocol, which enables developers to upgrade legacy proprietary systems with an easier-to-use full-featured protocol stack, supporting sub-gigahertz and 2.4 gigahertz frequency bands.

Connect runs on top of our radio abstraction interface layer, or RAIL software, which simplifies RF configuration and enables developers to easily migrate application code to new ICs, essentially helping to future-proof proprietary development.

Further leveraging our software expertise, we've launched a new development kit that helps IoT developers and makers race ahead in creating cloud-connected things for the IoT.

Our ThunderBoard-React kit includes a demo board packed with temperature, humidity, optical and hall-effect sensors, acceleration and Bluetooth low-energy technology for connectivity.

ThunderBoard-React comes with a mini smart car that measures performance of the car, transmits data to the cloud through mobile devices and displays it in real time for data analytics. The kit includes all mobile apps, firmware and open-source code for designers to start developing cloud-connected applications right away.

Smart metering was one of the earliest areas of traction for our full portfolio of low-power devices. These products incorporated our 8- and 32-bit MCUs in wireless devices, supporting both ZigBee and sub-gigahertz connectivity.

Our momentum in the smart metering market continues as government agencies have mandated utility companies to offer advanced metering infrastructure systems as part of larger smart grid initiatives.

For example, by the end of 2020, households and businesses across Great Britain will install around 53 million smart meters, with approximately 30 million homes also requiring an in-home display and a communications hub, for a total of 113 million units. And we expect to win most of that business. ZigBee technology is ideal for smart metering.

The protocol's simple, scalable, self-configuring and self-healing mesh networking capabilities offer utility and metering OEMs a mature, proven standard they can count on. It is also low power, which allows metering products to last up to 15 years.

During the quarter, we also introduced a complete hardware and software reference design that reduces the cost and complexity of developing USB type C cables and adapters. The next leap forward in USB technology, USB type C, supports higher data speeds, faster charging, greater flexibility and smaller form factors than previous USB connectors.

For those reasons, USB type C is poised to become the connector standard of choice for mobile devices, PCs, docking stations, monitors and other consumer electronics products, with an estimated 2 billion USB C enabled devices deployed by 2019 according to IHS. In August, we will celebrate our 20th anniversary.

We have a long history of leveraging our mixed-signal and RF design expertise to deliver highly integrated solutions.

From our groundbreaking DAA to the world's first CMOS RF synthesizer, advanced timing solutions, radio and TV tuners, digital isolators, microcontrollers and wireless SoCs for the IoT, we have consistently demonstrated our ability to pioneer innovation and achieve market leadership.

Our vision is to connect people devices and data across multiple markets and applications. We are beginning a new chapter in the creation of a more-connected world, where the intersection of cloud computing and the proliferation of connected devices will transform our lives and economy in dramatic ways, and Silicon Labs is at the heart of it.

We are executing on an aggressive roadmap to leverage the potential of these trends. Our strong second quarter results and third-quarter guide are evidence of our progress and position us well for growth. Thank you for your time and attention. Before we take your questions, I'd like to turn the call back to Jalene. Jalene..

Thank you, Tyson.

Before we open the call for the question-and-answer session, I would like to announce several conferences that we will participate in during the third quarter, including Pacific Crest's 18th Annual Global Technology Leadership Forum in Vail on August 8, Citi's Global Technology Conference in New York on September 7, and Drexel Hamilton's Telecom Media and Technology Conference, also in New York on September 8.

We would now like to open the call up for your questions. To accommodate as many people as possible before the market opens, we ask that you please limit your questions to one with one follow-up.

Shannon?.

Your first question comes from the line of Craig Ellis from B. Riley. Your line is open, please go ahead..

Thanks for taking the question and congratulations on the operating margin performance in the quarter. I just wanted to follow up on the comments about isolation share gain from both digital and optocoupler competitors.

Can you go into more detail there and provide us with some more color on how you see isolation playing out as we look over the intermediate term, say, through the 2017 time period?.

Craig, this is Tyson. Our isolation products are the evolution of a technology that we've been developing for 20 years. It started with our DAA technology where it was proven out with all sorts of lightning and real-world application examples.

And so, we've developed a very robust isolation technology that then for the last decade we have been applying towards the replacement of optocouplers in systems that require higher levels of performance, higher levels of isolation voltage, higher levels of reliability and faster speed.

So it offers a wide range of advantages over traditional technology. And we've had superior specs and parameters than the competing solutions from TI and ADI, in particular.

We also – it's a silicon-based solution and we are able to integrate additional circuitry around the isolation barrier to solve specific problems around motor control, power supplies, inverters, and – so that has given us a really strong position in the market and so we've won a lot of business in data centers, in hydroelectric vehicles, in solar energy and a lot of different other applications.

It's a broad – it's actually one of our broadest businesses. We have a large number – rich penetration into the distribution channel and very good traction in the market. We've been growing that business; it's actually one of our faster-growing businesses. It's a subcategory of infrastructure, but in the 30-plus% range.

Over multiple years, we've done six consecutive record quarters now and we expect that type of momentum in isolation to continue to play out as we go into 2017..

That's very helpful color, I appreciate it, Tyson. The follow-up is tying together some comments around the IoT segment and then John's comments on the gross margin range. So within IoT we have modules which are growing, but I believe a lower-margin business.

We've got the launch of SoCs which is a very unique capability and which small revenues now, but likely growing and then there are more discrete solutions.

What I'm hoping you can do is provide some color around how you see those different types of businesses evolving over time? And what the gives and takes are relative to gross margins and the gross margin range that John talked about?.

Sure, Craig, this is John. We've seen strong performance in our module product lines this year and see that trend continuing which is really the primary emphasis to the adjustment in the gross margin target model that we provided this morning. Overtime, we are very well positioned to continue to cost down and remain very competitive in the market.

And we think with the advent of the SoC strategy, we're very well positioned competitively from that perspective. So the module content is really the primary driver on the module margin adjustment..

Yeah, this is Tyson. Just to remind you, the module business came from our two acquisitions last year of Bluegiga, which brought in Bluetooth smart technology and then also Telegesis, which had a number of ZigBee modules into the market. And we had made the decision to bring that in through M&A.

They have leading positions in the market and we've seen very good traction with that. The rationale for that move was so that – the modules are actually very appropriate for selling into the channel. It makes the RF performance is guaranteed. The antenna is integrated. You have pre-certification.

So it makes it easy to support and gain scale and leverage across the broad market. In addition, with the – now our SoCs are inside of the majority of the modules and that share is increasing as we go forward.

And it allows us for high volume accounts to put the SoCs directly on the board and make the software scalable from both the module into an onboard design. And so that left us – optimized both the support side as well as the margins going forward. So we thought it was very important to get into the module business.

We did know that there was additional content in the modules. So it's not – it's less silicon content, so the margins are a little bit lower. But overall, we think it is a very constructive and healthy piece of our business and we're seeing good success in the market as evidence of that..

Thanks, guys..

Your next question comes from the line of Tore Svanberg from Stifel. Your line is open, please go ahead..

Yes, thank you. Nice quarter. I guess a follow-up to that last question on the SoCs and the gross margin.

So is it my understanding that as SoCs become a higher percentage of the revenue that there could be some potential upside to gross margin? Or is this sort of the new norm going forward?.

Yeah, Tore, this is John. New norm is a healthy way to view this. The SoCs would be higher margin than the module contents over time. We'll see how the IoT margins play out, but bear in mind also we have infrastructure products operating at above our corporate average margin and we do expect that to continue to grow as well.

So there's puts and takes even within IoT, across the various product lines. We thought it judicious to go ahead and update the model, given the trends that we're seeing. And our goal is to drive revenue growth and generate higher operating leverage with judicious expense control as we move through the course of 2017..

Understood. Thank you.

And as my follow-up, could you elaborate a little bit on your comments about Q3 broadcast, I think you said that a peaking of broadcast? And maybe you could also elaborate a little bit on the TV tuner business, sort of, what the dynamics are now, especially as it relates to pricing and as this business now become small enough where it's becoming less and less of a headwind for the broadcast business? Thank you..

Sure, Tore, this is John again. So as we've indicated earlier this year, we had some tough year-on-year comparisons in the first half of 2016, given the particularly strong performance in broadcast, particularly in the video business in the first half of 2015.

We're seeing our way through that phenomenon now and actually seeing some upside in third quarter in the video business.

That's the result of a couple of factors, one being regain of share, some of which was impacted by the Cresta lawsuit issue and just overall better penetration of the China market, and as well as the Olympics in Rio this year driving some degree of additional demand.

We do see that as a seasonal peak in third quarter and would expect that to tail off some in the fourth quarter just due to seasonality. So overall, once we're past the first half comparisons, we're seeing a reasonably healthy video market here now, more stable..

Great. Thank you..

Your next question comes from the line of Blayne Curtis of Barclays. Your line is open, please go ahead..

Thanks for taking my question and nice job on the quarter. I just want to all follow back on the gross margin. So you're guiding to the midpoint of that range. I would assume that IoT is going to continue to outgrow your overall business.

So just curious when you say that's the ongoing range here, what are the other offsets? Are you able to improve the margins on the module side? Or is it really infrastructure that helps in the mix? So what are the moving pieces that keep you in midpoint of that range?.

Yeah, it's both of those, Blayne; this is John again. IoT now is a bit below the corporate average with the higher module content, so and clearly, we have ongoing cost improvements around the modules themselves.

We have ongoing cost improvements around the underlying chips and strength in infrastructure as some of the major factors affecting that landscape..

Okay. And then just another clarity on the last question, so you're saying broadcast is up in Q3, but that's a peak and then should decline in Q4? I just wanted to understand what peaking meant, because I originally thought it was down. And then as you look to December, just any color on just overall seasonality would be helpful..

Sure. So when we say peak, we mean sequentially....

Yeah..

...for the year, for this calendar year. And it's really just driven by seasonal demand on the consumer market. That's really the primary factor from annual seasonality. We'll be able to give some additional color, of course, on the next call, as how things shake out for the fourth quarter..

Okay. Thanks..

Your next question comes from the line of Matt Ramsay from Canaccord Genuity. Your line is open, please go ahead..

Yes. Thank you very much for taking my questions. Good morning.

I guess going back to the IoT business and an earlier question did a good job of talking about the different drivers going forward, maybe, Tyson, you could give us a little bit of an update with the ramping module business of what we should think about as a target growth rate for revenue in the IoT business going forward? I mean, it's always hard to guide that stuff too far.

But if the margins are a hair lower, it would seem like the addition of the module business could drive some elastic demand in the channel, so just trying to get an update on the top line. Thanks..

So in terms of the drivers for IoT, we've got a broad range of applications. We've got a number of high-volume applications as well as success in the channel, with the modules being very appropriate for the channel.

If you look at the module margins and the quantity of revenue that's coming from that and the fact that we have moved our gross margin target model down, it was 60% to 62% and now it's 58% to 60%. That 2-point up is entirely attributable to the lower gross margin out of the module business.

So the change in model does reflect the additional module content. We do have cost reductions in place to continue to make those products more competitive in the market and to continue to drive success with those. The modules are especially important in the channel. It makes the products more attractive to sell, very easy to sell.

There's no RF support for antennas and compliance required with the modules, so it's a very popular product – set of products and it's an important part of our strategy going forward. So while it does come at a lower gross margin percent. Actually when you sell a module to gross margin dollars are higher.

So as we have more growth in the modules, it will provide a little bit of a lower overall gross margin, but the gross margin dollars is an accretive number there.

And we believe it will drive significant success, both in the channel with the broad customers, but also as those customers move into high volume, our ability to move those onto SoC type designs..

Got it, got it. I think the last point about gross margin dollars is what I was really trying to get at. And then as a follow-up, I thought it interesting your quite bullish commentary in your prepared remarks about the UK rollout of the smart meter platform.

How are you thinking about that in the context of the Brexit decision? Is it impacted one way another? I'm just kind of unclear on what that impact might be for domestic investment in the UK. Thanks..

The UK smart metering rollout is something that we've been working on for three to four years. This has been a program with the UK government and the utilities and, actually, as a result of Brexit, if you believe that there would be some additional stimulus into the economy, it might be something that they accelerate.

But I certainly do not see any reduction in ordering patterns or any hesitation to continue with that rollout. It's something that's driven by the government and by mandates and we believe that it has got a lot of momentum in place. That rollout will happen over the course of four or five years as it deploys across the UK.

So it's an exciting opportunity. I think if you just look overall at the impact of the Brexit and the stronger dollar, it does also drive a bit of favorability with foreign exchange in terms of our operating expenses, but overall, we think that the impact is minimal, if not somewhat positive..

Great. Thanks. Good to see the nice results..

Your next question comes from the line of Anil Doradla from William Blair. Your line is open, please go ahead..

Congrats from my side, too. So couple of questions, now on the $5 million patent sales, obviously, you talked about it a little bit last quarter.

Tyson, can you give us a little bit of color, and going forward, I mean, is there like a patent strategy in terms of maybe divesting some of your patents, given the amount of IP you guys have developed over the years?.

So, the $5 million patent sale came – it was in our infrastructure product area. We haven't talked specifically about what patents, but these were some patents that were non-strategic in a product area that we have deemphasized. They were valuable patents and were able to sell those at a favorable price. We continue to view IP sales as opportunistic.

It's part of a strategy that if it makes sense, we will do it, but it's not something that we plan on an ongoing basis. I would add that we have a very strong IP position. We have over 1,500 patents pending and issued and continue to file new IP at a fairly rapid clip as we develop new products and technologies over time.

So it is an important component of the value of the company and in terms of the competitive positioning of the company. But in terms of monetization, it is something that we treat opportunistically..

And on the timing front, clearly things are improving there.

Can you share some insights on what's going on perhaps on the wireless side, on the wireline side, any kind of incremental color in terms of the demand environment, especially from Asia, China versus North America?.

So, we did hit a record quarter in timing, passed a very nice milestone there. And saw good strength in our core data communication customers, so this is wireline, optical networking, high performance where our traditional business has been.

We are seeing some uptake in the data center and in wireless, but that is still a smaller portion of revenue and actually represents a good growth opportunity for us for that set of products, and we are optimizing our portfolio somewhat for those specific market segments. So, we see the growth in that business continuing to layer on.

We believe that 2017 should be a good year for timing as well. But I think that as we're coming into the second half we're seeing maybe more kind of nominal demand out of the timing customers. And so, we think that in terms of timing, in Q3 it will be a smaller portion of the product revenue mix.

And so, that does provide a bit of a headwind on the overall corporate gross margin. But in terms of the competitive positioning and the strength of the end markets and our product developments, we think that that is solid and actually increasing as we go forward into next year..

And, Tyson, one final one, I remember like two, two-and-a-half years ago you guys introduced kind of a high-volume, more consumer-oriented – using some MEMS technology and all that stuff.

Can you share some – how that's playing out and how much did that contribute in your results?.

The consumer portion of the timing business has been deemphasized. And in particular the Siemens products, we believe that that was not coming in as an attractive business for us.

So we have emphasized the high-end and higher performance aspects of our timing products, where we believe we can drive profitable growth and have a significant competitive differentiation and advantage..

Fantastic, thank you..

Your next question comes from the line of Cody Acree from Drexel Hamilton. Your line is open, please go ahead..

Thanks, guys, for taking my questions and congratulations on the progress.

Tyson, on the module strategy in IoT and the change in the gross margin target, is there a way to quantify the trade-off that you think you're getting in growth rate for taking a lower gross margin? And then as you look at the operating margin of that business, I would think that you're able to maybe get better leverage for your R&D across multiple players, so while you're lowering gross margins are you able to actually either improve or keep stable operating margins on those same products?.

Hey, Cody. This is John. I'll start out here. We don't have specific numbers to quantify the trade-off precisely in that way, but I would just start by pointing out that we believe the market itself will be addressed with a high percentage of module content.

We've seen industry estimates that up to 50% of the Bluetooth market would be addressed in the form of modules and roughly 20% of the mesh networking market would be addressed in modules. So this really is important incremental business, and it's important for our customers to get an effective on-ramp to the IoT.

And yes, I mean, we agree with the thesis of what you're saying, we should generate more operating leverage with those module sales..

about how do you make money; and how do you drive good profitability out of a broad market? And it requires leverage across multiple applications. Our SoC platforms need to be general-purpose enough to be used in a lot of general applications, but also competitive in terms of cost and highly differentiated in lot of the vertical applications.

And the modules are an important piece of that general-purpose strategy. And you also need to get leverage out at the channel and out of customer support. We're growing our customer count by 20% per year. And we're certainly not adding 20% to our sales force in our applications engineering or R&D per year.

And so got getting that leverage and having this whole mindset of simplicity and making these products easy-to-use, out-of-the-box, so the customers can just pick them up and run with them I think provides a significant advantage for us in the market and it's something that we've been focused on for quite some time and I think we're getting better and better as time goes forward..

And, Tyson, you mentioned that increasing customers I guess, if you're not able to maybe quantify an increase in maybe an IoT growth rate, are you at least seeing a tangible enough increase in design win activity that's obviously causing you to make structural changes in your gross margin expectations, so that whether it's ready to translate to revenue there is already some tangible numeric increase in your design traction that's causing this change?.

Well, we have now significant portion of our wireless business going through modules and that's responsible for the lower overall gross margin because we're carrying additional components within the modules that we don't mark up as much as we would mark up the SoC. The gross margin dollars are higher. Last year, we grew our IoT business by 26%.

In the first half of this year, it was a little bit less than that, but we should notch in close to 20% for the year. And it's continuing to see strong design win traction around a lot of the vertical applications within IoT such as smart home, security, you've got wearables, you've got lighting.

There's a lot of industrial applications around metering, certainly we talked about the UK smart energy ramp, but there's a broad set of applications.

But the design win traction that we're seeing continues to support these strong double-digit growth rates in the business and I think also validates our investment strategy around modules, around incremental R&D investments, around IoT and having moved out of the more areas such as broadcast and access.

And now having 70% of our revenues coming out of these growth products, positions us well going forward.

I think we've gone through this transition from a component based company to more of a system company, driving close to 50% of our revenue now out of IoT and the market traction we're seeing we're quite pleased with where we are positioned strategically..

Perfect. Thank you, guys, and congrats..

Thank you..

Your next question comes from the line of Ian Ing from MKM Partners. Your line is open, please go ahead..

Thanks for taking my question. First one's for John. For Q3, I've got OpEx down slightly to get to the EPS range. And then as you look at December, do you think you have the potential to go below the 5% OpEx growth target growth you've laid out for the full year? And could you talk more about the cost reduction opportunities available? Thanks..

Yeah, Ian, that's right. We guided Q3 at $72 million, which would be $1 million below where we landed Q3. The guide on the total year from the beginning of the year was around 5%. I would hold that. It could come in slightly favorable to that, but it's roughly at the 5% level, perhaps slightly below..

Perhaps slightly below, okay. Great. And then, could you talk about perhaps the weighting of IoT versus broadcast in terms of driving the revised gross margin range? It sounds like broadcast peaking right now, perhaps more of a contributor that could fall over time.

IoT and the channel business that sounds like it has a lot of runway, perhaps the current weighting and how that weighting plays out over time?.

Yeah. So, the general trend would be broadcast consumer would be declining over time, with growth in broadcast automotive, so there's a bit of a change underway within the broadcast portfolio itself. But overall, the IoT in terms of dollar growth, in particular, is where we see the highest contribution to our overall dollar growth in the future..

Okay. Thank you very much..

Your next question comes from the line of Harsh Kumar from Stephens. Your line is open, please go ahead..

Thanks for letting me ask a question.

Real quickly, Tyson, what exactly are you guys selling in the smart metering products at UK? Is it just the ZigBee or the mass solution? Or are there other things that you can tack on such as microcontroller and other stuff?.

The primary product that we're selling into the UK smart energy market is a ZigBee SoC. It does include the microcontroller functionality. But it is a ZigBee SoC and in most of the cases, it is a module..

I got you. And a lot of questions on your gross margin going forward, I'm curious if there are things you can do, if there are aspects of cost that you can cut out or perhaps even scale? I know modules get a lot lower gross margin, but you do have significant software capability that you perhaps able to layer on.

Are there aspects such as scale or software tack-ons that could offset in the future perhaps this shift towards module and the gross margin there and that's happening to you – your business?.

So, there are significant cost improvements that we can drive into the module market. Actually, there's significant differentiation that we can drive into the module market because we have control of the silicon and in designing the silicon we can keep the module and the cost of the module in mind.

In my view the package or the module just looks like another package for the part, although it does greatly simplify the RF design and support requirements. So, we can drive size improvements. We can drive cost improvements with the modules because we also control the silicons.

And the software if you're looking at in terms of monetization of software, that's something that has been traditionally difficult for silicon companies to achieve, is to be able to charge for software, although you can think of the software and the differentiation of the software further differentiating the product.

But we are trying to understand how to value and how to potentially charge for software over time. I think that that's a significant opportunity as you integrate security into the devices, as you can individually address them, as those devices get connected, as the devices have general functionality that can be enabled in the field.

There are ways to continue to differentiate and potentially monetize software. Today, that's a small part of our business, but it's something that I think it's a significant opportunity, in particular, in the IoT area as you've got those different functionalities and demands from the customers.

I'd also think that just on the margins, you've got – there's a mix both within IoT and the different applications, different flavors of wireless, between 8-bit, 32-bit, so that mix does drive a little bit of the gross margin within IoT. And then you've got the mix at the corporate level.

You've got broadcast consumer at a somewhat lower margin than the corporate average; that is declining. You've got broadcast automotive above the corporate average; that is growing. Timing and isolation both above the corporate average; those are growing very nicely.

So you've got, again, mix that as quarters come and go, we will have a little bit of variation, but there is no denying the fact that a) the module is a larger fraction of our content and that has essentially provided a drag of about 200 basis points on the overall gross margin. It is also I think giving us a lot of leverage in terms of the growth.

And I'd also say that we have a leading portfolio of products. They are market leading in terms of competitiveness and we have taken no prisoners in terms of gaining market share in strategic markets. And that volume will drive growth. It will drive further cost improvements with volume and we see that playing out over time.

But it's our goal to be leaders in the segments in which we're competing, in particular around IoT and infrastructure..

Understood, Tyson. Thank you very much..

Your next question comes from the line of Rajvindra Gill from Needham & Company. Your line is open, please go ahead..

Yes, thank you for taking my questions. I appreciate it. Just kind of a big picture question on the competitive landscape, specifically in IoT, wanted to get your thoughts on that? Clearly, there's been consolidation that's been going on in IoT, both larger companies acquiring others as well as some companies buying carve-outs of larger entities.

So, I wanted to see what's your thought process on the competitive landscape in IoT? And what do you think are going to be the kind of the key differentiators to win in this market?.

I believe our competitive positioning has never been better, both because of our progress and our internal developments in getting out our SoC platforms and building that portfolio of products and software. But also, as a result of the consolidation we've seen Atmel being acquired by Microchip. We saw the merger of NXP and Freescale.

We saw the sale of the Broadcom IoT assets to Cyprus. And I think that, each one of these provides an opportunity for us to gain share as those companies integrate. And I think that it's one thing to say that you're putting two things together.

It's another – there's a lot of devil in the details of how that comes together in terms of culture, in terms of roadmap, in terms of which process technology things are on. And I think that that provided a lot of distraction for the competition and provides an opportunity for us to gain share.

I think that the vertically oriented companies just compared to a year ago, I think that certainly we've seen Broadcom exit in the sale on that set of assets to Cyprus, I think that's certainly makes that less of a competitive threat to us over time.

I think that in the case of Qualcomm and their focus on cellular and I think less emphasis on the markets that we're going after takes them out of – they are not really on the radar as much.

And I think the overall reduction in the number of competitors, in the broad market, the microcontroller companies is also an advantage and coupled with the distraction that those companies are seeing as they're integrating together. So, I believe that overall our competitive position, we remain very focused.

And focused in the market, focused with customers and see this as a position of strength for us..

On the IoT, in terms of the different connectivity standards, there are multiple standards, I wanted to get a sense from you, if you could maybe talk about what applications are going to require which standards? And how you're positioned in each of those applications from a connectivity portfolio perspective?.

So our traditional strength has been in both sub-gigahertz connectivity, which is mainly used in a lot of industrial markets, and we have continued to strengthen our position there with – we talked about our radio abstraction interface layer that we introduced to help customers port their stacks onto our new SoC platforms and to make that easy.

And that's really the result of a decade of work on understanding the requirements and developing chips, and that functionality is now integrated into our SoCs. We also have had a long history in mesh networking ICs. So this is ZigBee and Thread that – the UK smart meter rollout for instance is on ZigBee.

That set of standards is good for robustness, for low energy, for command-and-control type networks.

You've got home automation, security, metering, lighting being very significant markets for the mesh networking technology, where a lot of the devices are either battery-operated or need to have a robustness and a scalability and a range that is uniquely addressed by the mesh networking technology.

And we're seeing significant growth in adoption of those in end devices as well as within gateways, in the operators and in commercial gateways integrating IoT functionality as part of the internet access that goes into the home and into businesses. So that's a very positive trend.

And I think that the need for that low-power mesh networking is unique and is not served by the other ones, which are – you've got Bluetooth, which is primarily used today for connection between an end device and a smartphone. So it's not really a networking technology.

It's trying to move towards being a networking technology, but it's traditionally been used for audio, and with the advent of Bluetooth low energy, which is where we have focused our efforts, into a wide variety of connected device applications outside of audio with wearables, for instance, being a particular use case for Bluetooth.

So that's an important part of the portfolio. Again, our multi-protocol SoC can speak proprietary sub-gigahertz. It can speak mesh networking, and it can speak the Bluetooth low energy.

So our silicon platform and the software can support multiple protocols in the same device and that makes it very scalable across – it's efficient from our R&D perspective, but it's also scalable across a lot of applications. And combining them in a lot of applications is a key piece of differentiation for us.

So those are – the primary focus for us have been on the low power type of standards. You've also got Wi-Fi technology, where we have some modules and have some experience. Those are typically in higher data rate applications, and then you've got some of the wide area networking technologies like LTE.

You've got SIGFOX; you've got LoRa, and those are used to talk directly to wide area networks, and we have not traditionally played in those areas. So we have focused on the low power, lower data rate applications, which are really the sweet spot for a lot of these IoT applications..

Great. Thank you. That's very helpful..

Your next question comes from the line of Suji De Silva from ROTH Capital. Your line is open, please go ahead..

Hi, Tyson. Hi, John. You talked about the modules – the smart meter business being modules.

I'm wondering which end markets tend to be more module-centric versus chip-centric, and what percent of IoT you think will be modules two to three years out?.

Can you repeat the last part of your question? It was mumbled..

Sure.

What percentage of the IoT business would be more modules in two to three years, would you say?.

Okay. So if you look at – the modules are going after a lot of broad applications. So metering, for instance, is – they have integrated modules. You've got a lot of the Bluetooth applications outside of the space-constrained ones. So anything that's a lower volume (58:59), like, say,100,000 units and below, is going to tend to go towards modules.

And it's not specific to a market, it's really in terms of the size and sophistication of a customer and how much R&D capability they have versus spending a little bit more on a module and being able to avoid that R&D expense.

So for the highest volume applications like lighting you could see that going down on the board, for very space-constrained wearables, high-volume applications, you could see that going down on the board. But I believe that modules are going to continue to be an important fraction of the IoT wireless business.

We don't break that out separately in terms of the mix. But I believe that the fraction of our IoT business going through modules is going to continue to increase over time, although I'd never see it becoming a majority of the wireless piece of the IoT business.

So we've got a mix of microcontrollers and wireless, and then you also have modules as an important component there. But you're going to continue to see significant growth on modules as well as those other areas within IoT..

Okay. And then on the multiprotocol wireless products, what combinations of wireless protocols are you seeing near-term traction for most? Thanks..

A lot of the ZigBee applications, like in terms of provisioning, in terms of getting that device onto the network, it makes it easier to have Bluetooth capability integrated into the same device.

So, when you first pair the device with the network it goes into Bluetooth mode, talks to a smartphone, you get it set up and then it switches over to ZigBee. You can also see those applications being used for things like beacons, or continuing to talk to a smartphone directly as well as the network. So that combo is quite popular.

We also see a lot of customers in the industrial space wanting to do the same thing. So a lot of the proprietary sub-gigahertz customers being able to speak Bluetooth as well as proprietary; that is attractive.

We have a number of customers wanting to talk to both a ZigBee and a Thread network or even you can do ZigBee and a sub-gigahertz network; there's some customers there.

So it really just provides a nice Swiss Army knife for the customers to mix and mash the protocols for the use cases and to add additional functionality to the devices to make them easier to use and more differentiated out into the market. And I think that that set of capabilities is an important part of our connectivity strategy going forward.

It's very attractive to the customers..

Thanks, Tyson..

Thank you. I would now hand the call back over to Jalene Hoover..

Thank you, Shannon. And thanks to everyone for joining us this morning. This concludes today's call..

This concludes today's conference call. You may now disconnect..