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Operator
Good day, ladies and gentlemen, and welcome to the ON Semiconductor third-quarter 2016 earnings conference call.
(Operator Instructions)
As a reminder, this conference is being recorded.
I would like to introduce your host for today's conference, Parag Agarwal, VP of Corporate Development and Investor Relations.
Sir, you may begin.
- VP of Corporate Development & IR
Thank you, Terence.
Good morning and thank you for joining ON Semiconductor Corporation third-quarter 2016 quarterly results conference call.
I'm joined today by Keith Jackson, our President and CEO, and Bernard Gutmann, our CFO.
This call is being webcast on the investor relations section of our website at www.onsemi.com.
A replay will be available on our website approximately one hour following this live broadcast, and will continue to be available for approximately 30 days following this conference call, along with our earnings release for the third quarter of 2016.
The script for today's call and additional information related to our end markets, business segments, geographies, channels, and share count are also posted on our website.
Our earnings release and this presentation include certain non-GAAP financial measures.
Reconciliation of these non-GAAP financial measures to most directly comparable measures under GAAP are in our earnings release, which is posted separately on our website in the investor relations section.
During the course of this conference call, we will make projections or other forward-looking statements regarding future events or future financial performance of the Company.
The words believe, estimate, project, anticipate, intend, may, expect, will, plan, should or similar expressions are intended to identify forward-looking statements.
We wish to caution that such statements are subject to risks and uncertainties that could cause actual events or results to differ materially from projections.
Important factors which can affect our Business, including factors that could cause actual results to differ from our forward-looking statements are described in our Form 10-Ks, Form 10-Qs, and other filings with the Securities and Exchange Commission.
Additional factors are described in our earnings release for the third quarter of 2016.
Our estimates may change, and the Company assumes no obligation to update forward-looking statements to reflect actual results, changed assumptions, or other factors, except as required by law.
We will be holding our 2017 analyst day on March 10 in Scottsdale, Arizona.
And we will be sending out invitations and additional details of the event in coming days.
During the fourth quarter, we will be attending the Credit Suisse Technology, Media and Telecom conference on November 30.
Now, let me turn it over to Bernard Gutmann who will provide an overview of third-quarter 2016 results.
Bernard?
- CFO
Thank you, Parag, and thank you, everyone, for joining us today.
Let me start by updating you on recent directives from the Securities and Exchange Commission on disclosure of non-GAAP financial measures.
Due to new and revised compliance and disclosure interpretations on the use of non-GAAP financial metrics by US listed companies from the US Securities and Exchange Commission, we are revising our practices with respect to guidance and use of non-GAAP measures.
Please see the earnings release for additional information.
Now let me provide you details on our third-quarter 2016 results.
ON Semiconductor today announced that total revenue for the third quarter of 2016 was approximately $951 million, an increase of approximately 8% as compared to the second quarter of 2016.
Third-quarter revenue included the contribution of approximately $53 million from our acquisition of Fairchild Semiconductor, which closed on September 19, 2016.
The incremental contribution from Fairchild was partially offset by approximately $5 million of revenue we didn't see this quarter as a result of the divestiture of our Ignition IGBT, TVS diodes, and Thyristor product lines.
GAAP net income for the third quarter was $0.02 per diluted share.
GAAP income before income tax for the third quarter was approximately $87.3 million.
Non-GAAP income before income tax for the third quarter was approximately $107.3 million.
Net cash paid for taxes in the third quarter was approximately $6.5 million and diluted shares outstanding were approximately 420 million.
GAAP gross margin for the third quarter was 34.6%.
And non-GAAP gross margin for the third quarter was 35.9%.
GAAP and non-GAAP gross margin for the second quarter of 2016 was 35.1%.
GAAP operating margin for the third quarter of 2016 was approximately 4.9% as compared to approximately 8.6% in the prior quarter.
Our non-GAAP operating margin for the third quarter was 12.9%, as compared to 12.3% in the prior quarter.
GAAP operating expenses for the third quarter were approximately $282 million, as compared to approximately $233 million for the second quarter of 2016.
Non-GAAP operating expenses for the third quarter were approximately $218 million, as compared to approximately $200 million in the second quarter.
The sequential increase in operating expenses was driven by the inclusion of Fairchild in our third-quarter results, annual merit increases which become effective in the third quarter of every year, costs related to Fairchild integration, and increases in legal and tax consulting fees.
We had strong operating cash flow performance in the third quarter.
I am very excited about the cash flow potential of ON Semiconductor, and with the addition of Fairchild, we should see meaningfully improved cash flow performance in 2017.
Operating cash flow for the third quarter was approximately $133 million, as compared to approximately $104 million in the second quarter.
Operating cash flow for the third quarter was negatively impacted by approximately $26 million related to the modification of our term loan B financing.
During the third quarter, we spent approximately $36 million of cash for the purchase of capital equipment, and we obtained approximately $104 million from the divestiture of our ignition IGBT, TVS diodes, and Thyristor product lines.
We exited the third quarter of 2016 with cash, cash equivalents, and short-term investments of approximately $880 million, as compared to approximately $588 million in the second quarter.
At the end of the third quarter of 2016, days of inventory on hand, adjusted for 11 days of revenue contribution from Fairchild and the fair market value step-up, were 113 days.
ON Semiconductor days of inventory in the second quarter were 120 days.
In the third quarter of 2016, distribution inventory days increased marginally as compared to the second quarter, primarily due to the inclusion of Fairchild.
For the third quarter of 2016, our lead times were up quarter over quarter.
Our global factory utilization for the third quarter was slightly up sequentially.
Now let me provide you an update on the performance of our business units, starting with the Power Solutions Group, or PSG.
Revenue for PSG was approximately $408 million.
Revenue for our Analog Product Group for third quarter of 2016 was approximately $363 million.
Revenue for the Image Sensor Group was approximately $180 million.
Now I would like to turn the call over to Keith Jackson for additional comments on the business environment.
Keith?
- President & CEO
Thanks, Bernard.
I will start with update on progress we have made thus far on integration of Fairchild, and then I will provide commentary on current business trends and on various end markets.
We are pleased with our acquisition of Fairchild and also with the progress we have made thus far in the integration process.
As of now, we are tracking significantly ahead of where our announced synergy targets.
Recall that at the close of transaction, we announced that we were targeting to achieve annual synergy run rate of $75 million, six months after the close of the transaction.
We already have exceeded our six-months post-close target, and we plan to implement further actions in the current quarter to realize additional synergies.
We expect to start to see the impact of these measures on our operating costs in early next year.
Let me now provide additional detail on the action we have taken to realize synergies in various functional areas.
On the R&D front, we've identified redundant or uneconomical programs, and are in a process of eliminating many of these programs.
A sizable portion of R&D program rationalization will likely be achieved in the current quarter.
As we previously mentioned, although ON Semiconductor and Fairchild had very complementary product portfolios, both companies were investing to grow in similar areas.
In sales and marketing, we took actions on the first day after close of the transaction to effectively integrate the sales team.
Redundancies in account management were eliminated and customer accounts were allocated immediately after close of the transaction.
Based on inputs from our customers, we retained the best talent between the sales forces of the two companies.
With addition of Fairchild's portfolio, ON Semiconductor has significantly improved its presence in the distribution channel.
We intend to leverage our expanded presence to drive higher stales through the distribution channel.
In general and administrative, we are rationalizing corporate functions such as finance, IT, legal, and human resources.
As we integrate the systems of the two companies, we should see meaningful savings on the G&A front.
The departure of Fairchild management team has contributed to savings on the G&A front.
On the operations front, planning is well under way, and we're beginning to execute on synergies.
Our initial assessment indicates that Fairchild's facilities are in good condition, and we intend to increase loading at most of these facilities through insourcing and production transfers to drive higher margins.
Fairchild's operations planning systems are very similar to ours, and we expect a seamless integration of operations of the two companies.
Our initial assessment fully validates our financial and strategic rationale behind the acquisition.
The acquisition is highly complementary, and overlap and redundancies in products and customers of the two companies are lower than previously expected.
Fairchild has a very strong product portfolio, and with our scale and execution rigor, we're confident that we can generate significant value from Fairchild's portfolio.
As we have indicated earlier, Fairchild's expertise in mid- and high-voltage power management is highly complementary to our strength in low-voltage power management.
Customer reception to the transaction has been very positive.
Customers realize the combined strength of the two companies, and they're willing to engage with this in an even more meaningful manner than before.
We have seen increased interest from automotive, industrial, and communication customers in our combined portfolio.
Fairchild has also added a list of marquee customers in the network and industrial end markets, and we are pleased to be working with these customers.
As we had indicated earlier, the combination of ON Semiconductor and Fairchild creates a new leader in discrete power management market.
Giving our scale, execution history, and relationships, customers now have a very credible alternative to traditional market players for discrete power management solutions.
Customers across end markets and geographies intensify their engagement with us for mid- to high-voltage power management solutions.
We will provide further updates on the financial and strategic impact of the acquisition at our analyst day on March 10, 2017.
Let me now comment on the business trends in the third quarter.
During the third quarter, demand trends were stable, and the bookings were generally steady across most end markets and geographies.
End-market trends were generally in line with expectations.
Recent commentary from customers points to a steady demand environment.
Despite a stable macro environment and generally benign demand environment, we continue to manage our Business in a prudent manner.
We continue to execute on our strategy of focusing on automotive, industrial, and communications end markets.
And with the acquisition of Fairchild, we are well positioned to increase our presence in these markets in a meaningful manner.
We expect that our investment should start showing concrete results in 2017 and beyond.
Now I will provide details of the progress in our various end markets.
With inclusion of Fairchild's results for part of the third quarter, the normal quarter-over-quarter comparison that we have historically provided is not quite as meaningful.
Therefore, I'll limit my remarks to qualitative summary and limited quantitative data.
The automotive end market contributed revenue of approximately $319 million and represented approximately 33% of our revenue in the third quarter.
Third-quarter automotive revenue was negatively impacted by a divestiture of Ignition IGBT business, TVS diodes, and Thyristor product lines.
Our automotive design funnel remains robust, as semiconductor growth in light vehicles continues to outpace production.
We continue to see strong demand for our image sensors for ADAS applications.
We have secured wins on marquee platforms and we are well positioned to drive strong growth in our automotive image sensors.
Other applications driving growth in automotive include advanced front lighting, park assist, and DC to DC conversion.
With the addition of Fairchild, we're now very well positioned to benefit from the fast-growing EV/HEV market.
The industrial end market, which includes military, aerospace, and medical, contributed revenue of approximately $212 million and represented approximately 22% of our revenue in the third quarter.
Key drivers on growth in the industrial markets remain intact.
In the medical market, we continue to maintain our leadership in the hearing health market, and we're preparing to launch new products in the fourth quarter.
In machine vision market, we are seeing strong demand for our CMOS and CCD image sensors.
The communications end market, which includes both networking and wireless, contributed revenue of approximately $192 million and represented approximately 20% of our revenue in the third quarter.
Our momentum in the smartphone market remains strong, and our presence with global OEMs and China-based OEMs continues to grow.
We continue to increase our content on marquee platforms by virtue of our innovative power management solutions.
Fairchild further improves our position with key global and China-based OEMs with its wall-to-battery solutions, convertors, audio switches, power switches, and other analog switches.
The computing end market contributed revenue of approximately $116 million and represented approximately 12% of our revenue in the third quarter.
We noticed a slowdown in the computing market due to an inventory adjustment.
The consumer end market contributed revenue of approximately $113 million and represented approximately 12% of our revenue in the third quarter.
We noticed a greater-than-seasonal strength in consumer business primarily due to gaming consoles and white goods.
Now I'd like to turn it back over to Bernard for forward-looking guidance.
Bernard?
- CFO
Thank you, Keith.
Based on product booking trends, backlog levels, and estimated turns levels, we anticipate that total ON Semiconductor revenues will be approximately $1.19 billion to $1.24 billion in the fourth quarter of 2016.
Backlog levels for the fourth quarter of 2016 represent approximately 80% to 85% of our anticipated fourth-quarter revenues.
Our guidance for the fourth quarter is in line with normal seasonality, with our organic business down approximately 2% at mid-point, and Fairchild down approximately 7% at mid-point.
We expect inventory at distributors to be flat quarter over quarter on a dollar basis.
We expect total capital expenditures of approximately $40 million to $50 million in the fourth quarter of 2016.
For the fourth quarter of 2016, we expect GAAP gross margin in the range of 27.4% to 29.5%, and non-GAAP gross margin in the range of approximately 33.6% to 35.6%.
Factory utilization in the fourth quarter is likely to be down sequentially.
We expect total GAAP operating expenses of approximately $327 million to $359 million.
Our GAAP operating expenses include the amortization of intangibles, restructuring, asset impairments, and other charges, which are expected to be approximately $54 million to $72 million.
We expect total non-GAAP operating expenses of approximately $273 million to $287 million.
We anticipate GAAP net other income and expense, including interest expense, will be approximately $40 million to $43 million for the fourth quarter of 2016, which includes non-cash interest expense of approximately $6 million to $7 million.
We anticipate our non-GAAP net other income and expense, including interest expense, will be approximately $34 million to $36 million.
Cash paid for income taxes is expected to be approximately $7 million to $11 million.
We also expect share-based compensation of approximately $13 million to $15 million in the fourth quarter of 2016, of which approximately $2 million is expected to be in cost of goods sold, and the remaining amount is expected to be in operating expenses.
This expense is included in our non-GAAP financial measures.
Our diluted share count for the fourth quarter of 2016 is expected to be approximately 424 million shares based on the current stock price.
Further details on share count and earnings-per-share calculations are provided regularly in our quarterly and annual reports on Form 10-Q and Form 10-K.
With that, I would like to start the Q&A session.
Thank you.
And, Terence, please open the line for questions.
Operator
(Operator Instructions)
Ross Seymore, Deutsche Bank.
- Analyst
Hi, guys.
Thanks for letting me ask a question.
The first one, heading into the fourth quarter and then potentially into the first quarter, can you just talk a little bit about the demand patterns you are seeing by sub segments?
And I realize sequential math is a little screwed up by the full fourth quarter of Fairchild.
But just trying to get into what normal seasonality will be for the full Company for the first quarter and then what the pluses and minuses are that get you to your revenue guide for the fourth quarter itself.
- President & CEO
Okay.
It's a good time to address some of the differences between the Fairchild patterns and ON.
ON normally would be down 2% to 3% in the fourth quarter and then down another 2% in Q1.
Fairchild had a very different pattern.
They were down like 7% or 8% in the fourth quarter and then up 1% or 2% in the first quarter.
So the net of that is a little more smoothing of the transitions on a quarterly basis.
Primary drivers were really the mix of business that the two companies had.
And what you see is pronounced impact on the Fairchild side from the communications or handset market, which had the stronger patterns.
So right now we are seeing things a little better than seasonality going into the fourth quarter and with the backlog patterns going into the first quarter for both companies, which basically says computing is down a bit, the handsets down a bit, automotive down a bit and basically across all markets they are going to be down a little bit from Q3.
There is really no strengthening in Q4 over Q3 market-wise.
Q1 should see a strengthening in industrial and automotive and the other markets should be approximately flat.
- Analyst
Great.
And I guess as my follow-up one for Bernard, can you just walk us through your expectations sequentially and then going into next year on the synergy side and specifically on the OpEx line?
How should it trend from that $280 million market that you are guiding to in the fourth quarter?
- CFO
So as we mentioned in the written remarks, we are ahead of schedule on the savings and, ergo, our mid-point of our guidance is $280 million.
In general terms, we expect those numbers to be flat to down.
We expect the first quarter to still show some improvement over that.
And then as you go into the back half of the year, we should expect still some small reductions but it will be partially offset with our normal merit increases.
But in general terms, we expect our revenues -- our OpEx to move towards the 22% of revenue towards the end of the year.
- Analyst
Great.
Thank you.
Operator
Chris Danely, Citigroup.
- Analyst
Thanks, guys.
Just a clarification on end markets.
So I think you said in the comments and prepared remarks that there was a slowdown from the PCN market.
Was that the reason that you came up a little short with the Q3 revenue?
Maybe talk about how the slow down in the PC market is impacting Q4 and then any impact from the Note 7 problems as well.
- President & CEO
So primary difference in Q3 was not computing.
It was actually the divestiture of the business we mentioned for the ignition IVPs and the thyristor businesses.
So that difference was basically made up the entire gap.
On the computing side our comments where we did start to see some inventory corrections through the computing side.
I believe we see them a little earlier than others, but I think you're going to see that in Q4.
But in general, there was not a big change Q3 over Q2 or Q4 over Q3 for our market basically due to the increased Skylink content.
- Analyst
Okay.
Great.
And then for my follow-up can you just maybe talk about where you are finding these additional synergies?
Is it more on the cogs or the OpEx side?
- President & CEO
It's both.
On the OpEx side we are identifying continued opportunities as we understand the investment profiles in more detail and just getting rid of did redundancies there.
That's opened up some new doors for us.
And on the cog side we now have enough data to do the analysis on insourcing.
And that should provide some earlier-than-expected opportunities in 2017.
- Analyst
Great.
Thanks, guys.
Operator
Chris Caso, CLSA.
- Analyst
Yes.
Thank you.
Good morning.
As the first question, if you could clarify what the Fairchild revenue was for the full quarter?
In addition, Fairchild had a sell-in revenue recognition policy.
Do you guys continue that as part of ON Semiconductor and what are the implications of that?
- CFO
Thanks, Chris.
So Fairchild stop period, which is the one we had on our control, was $53 million.
We don't have full visibility of what occurred before.
It wasn't under our ownership and there was no public forum for that.
In general terms I believe it was pretty much in line with what their management was expecting and was not a surprise in general terms.
But we don't have a precise number.
Indeed, Fairchild is recognized as revenue on a sell-in basis.
We will continue recognizing revenue on a sell-in basis for the Fairchild piece.
And we are exploring the possibility of adopting the -- early adopting the cell in conversion, which, as you know, all companies will have to migrate to sell-in as of 11/18 as the latest.
So we are exploring whether we do an early adoption of that at the beginning of 2017.
It's still not completely defined, but that's the current thought process.
So pretty much after 1/1/17 we should all be moving to a sell-in methodology.
- Analyst
Okay.
Thank you.
And as a follow up, perhaps you could talk about the handset business a bit.
Obviously a lot of moving parts there with some new product ramps going.
How is that going versus your expectations and what can we assume as we go into Q1?
- President & CEO
That's a little bit of why seasonality is a little better than normal.
We've actually seen some pickups in our design platforms, both with the global providers and in China.
And so we think there should be some good opportunities for strength in Q1.
And I think that certainly is going to remain so, at least through the early Chinese new year this year.
- Analyst
Great.
Thank you.
Operator
Vijay Rakesh, Mizuho.
- Analyst
Hi, guys.
Thanks.
Just briefly on the gross margin side.
I know long-term you guys have maintained that 40% outlook.
Is that a pre-2018 target and what topline do you see to get to that -- do you need to get to that 40% longer term gross margin?
Thanks.
- CFO
So we will be giving details on that at the next analyst day but the fundamental tends to get to that 40% remain intact.
And we actually believe that the Fairchild acquisition enhances our chance to get there.
And in general terms, as we have said before, it consistent mainly of follow through on incremental revenue, of self-help on manufacturing and consolidation and mix improvements and potentially divestitures.
Those are the four legs that will really allow us to get to that 40%.
We have in the past talked about a 5% growth in revenue.
That has fallen short in 2015 and 2016.
But we do expect that there will be some low to middle single-digit growth in the markets that will allow us to get there.
- Analyst
Got it.
And on the auto side, you mentioned ADAS being a nice tailwind here.
Can you talk about what percentage of your auto is now ADAS and how that's growing and how you see your mix of auto revenues in 2017?
Thanks.
- President & CEO
I don't have precise numbers of ADAS, because it's defined slightly different by each of the makers and whether it's class 1 through class 5. And so I don't really have access to precise data to give you there.
What I can tell you is we're going to be up double digits in automotive in 2016.
And the opportunity is there in 2017 as well, really on the backs of more adoption of more safety features.
- Analyst
Thanks.
Operator
Rajvindra Gill, Needham & Company.
- Analyst
Thanks for taking my question.
Just housekeeping -- so on the Q4 guidance, the Fairchild business implied something like $335 million revenue to get to the mid-point.
And if I look at the organic business being down about 2%, it implies that it's up about 5% year-over-year.
So I just want to make sure that those numbers are accurate.
- CFO
In general terms, they are indeed in the ballpark.
As we said in the prepared remarks, we expect ON legacy to be down 2%, which is seasonal, and Fairchild to be down about 7%, which is also seasonal, maybe slightly better.
- Analyst
Okay.
Thank you.
And in terms of the gross margin drivers next year, you talked a little bit about that in your prepared remarks, but I was wondering if you could maybe elaborate on the Fairchild business, how that will contribute to a higher gross margin either through fab consolidation or back end test assembly consolidation.
I'm wondering if you could describe where you see some of the gross margin levers as you fold Fairchild in.
- President & CEO
There won't be any consolidation savings in 2017.
It takes us more than a year to actually realize those.
What we are looking at next year is additional insourcing into the combined factory network.
So basically less outside manufacturing.
This will get us better factory utilization and, frankly, some much lower costs in some of ON's factories by moving them from the low 80s up further from there.
So a lot of factory loading, mostly insourcing would be a primary driver and then secondarily continued mix shift, which has been enhanced with the acquisition.
- Analyst
And last question for me and I'll hop back in the queue, in the press earnings release you have a restatement of the end markets going back to March of 2014.
And there are some slight changes there in terms of the actual end markets and then you are consolidating on the business unit split to those three categories.
I'm wondering what was the recent for that and what was the changes that you see that occurred throughout the different products and end markets.
- CFO
So typically we do look at that at that end market every quarter.
And there is -- it typically happens we fine-tune our end market information.
So that's pretty much a regular process that we go through just fine-tuning the information.
- President & CEO
The product groups we specifically -- are organized the way we did because we felt it would accelerate our synergies by aligning similar businesses across the Company.
And so basically that whole restructuring I think has really helped us get ahead of the synergy game.
Operator
Craig Ellis, B. Riley.
- Analyst
Thanks for taking the question.
Team, I wanted to follow up on the ahead of schedule synergies progress and just explore the longer-term implications.
The prior calendar 2017 to 2019 targets were $160 million, $200 million and $225 million.
If you are tracking ahead both on OpEx and cogs now, should we expect there to be upside to those targets?
And if so, can you provide either quantitative or qualitative color on that?
- President & CEO
I'll chime in.
Bernard can give more details.
The answer is, yes, we do expect upsides.
We are not ready to give specific numbers at this point.
But there's no question we will both accelerate -- meaning bring them in time -- and actually have identified more total numbers that we will be able to deliver.
- Analyst
And then the follow-up, Keith, is on the end markets.
And it's not so much about the near-term dynamics, but for the last couple of years ON's has had a focus on auto, industrial and communications at its core end markets, where it strive to drive above industry average growth.
Now that you've got an inside look at the Fairchild portfolio, what did those products due to your relative growth rates and your core end markets.
- President & CEO
I think two areas were pretty exciting.
One was industrial in the motor control and the higher voltage power control areas.
They actually were very well-established and so we are pretty excited there.
Actually I can give you three areas.
In handsets, the charging wall-to-battery products were very well designed into next generation platforms.
And then lastly, the opportunity for EV and HEV vehicles with their silicon carbide products is well-positioned, as well.
So those three areas -- one in each of the three markets we think provides us a much stronger position.
- Analyst
Thank you.
And if I could sneak one in for Keith.
Keith is the -- or excuse me, for Bernard.
Bernard, is the $45 million midpoint CapEx number a decent proxy for what we should expect next year?
- CFO
We still are targeting 67% of revenue.
It is a little bit lumpy.
Sometimes it's higher, sometimes it's lower.
But in general terms, 67% is still our model.
We don't expect to deviate from it.
- Analyst
Thanks, guys.
Operator
Tristan Gerra, Baird.
- Analyst
Hi.
Good morning.
Quick question on the insourcing.
I think a while back, 10 years ago you were touting how outsourcing enabled you to reduce the cyclicality in the business by using the outside sales as a buffer whenever things were slowing down.
Could you remind us now what's the percentage of outsourcing?
What it is going to be once you make those changes?
And is it fair to assume that you have a few of the business being less cyclical that allows you to this relative to your sense from years ago?
- President & CEO
Our model was to have approximately 20% of our business outsourced to help deal with cyclicality.
It turns out the Fairchild business on the backend, for example, was over 50% and so significantly in excess of our target.
And we look at ON's costs structure specifically again on the backend and it's substantially better than any of the outsource opportunities.
So really, Tristan, it's just truing us back up to that 80/20 model with 80% inside will get us most of the gains that we are after.
- Analyst
Great.
And then if I heard the number well, your image sensor group revenue implies a little bit of a year-over-year decline in the quarter.
Could you talk about the trends in that business?
Are we still on track in terms of the accretion for the year and also the type of growth drivers that you see going forward?
- President & CEO
We had very substantial double-digit growth in the automotive sector, which is the focus in that business.
The slight declines year-on-year were all coming out of handsets in the consumer side.
Which, again, we mentioned at the time of purchase we wanted to deemphasize those because they were quite low margin.
And so really everything remains on track as we look at it another year along.
- Analyst
Great.
Thank you.
Operator
Vivek Arya, Bank of America.
- Analyst
Thanks for taking my question.
I wanted to just revisit this synergy question.
So when I look at ON and Fairchild separately in Q2, the combined OpEx, if my math is right, was about $285 million.
And for Q4 you are guiding to $280 million.
So first part is, is that the right baseline for looking at where you are in terms of synergy success?
And the other part of that is what is the right way to look at absolute OpEx for 2017, even if it's somewhat qualitative way?
- CFO
So the Q2 is probably -- Q3 is probably a better base.
If you look at the mid-point of our guidance for the on legacy it was $205 million.
So in that sense -- and if you take Q2 actuals for Fairchild, which I think was around $85 million, you're looking at a starting point of about $290 million.
The way to look at it for next year is we intend to gradually come down to achieve about a 22% of revenue level.
So it will be trending down from the existing approximately 23%.
- Analyst
Got it.
Thanks.
And as my follow-up, Keith, one thing as I look at the power discrete sector -- [denser] trade at a lower valuation.
And one reason could be the lower gross margins versus the rest of the semis.
And I think you mentioned that there are opportunities for some potential divestitures.
So are there things that you can do beyond just topline growth that can help you accelerate the improvement and gross margins so you can get to your 40% target?
Thank you.
- President & CEO
Yes I think there's two things pretty strong in our favor there.
One, we do think with our manufacturing network and the specific market focus we've got that business just naturally can be in the high 30%s.
So 38%, 39%, which is really not 40% but it's very supportive directionally from where it was run by the two companies separately.
On top of that, there are divestiture opportunities.
And I can't give any details on those, obviously, but there are some lower margin parts of that business we will be looking to spin out.
- Analyst
Thank you.
Operator
Steve Smigie, Raymond James.
- Analyst
Great.
Takes a lot, guys, and congrats on all the good work on the synergies.
First question was on the R&D.
You said you got some of the success there was in figuring out stuff that maybe you weren't going to focus on anymore.
I was hoping you might share what products you'll be deemphasizing.
And if it's not appropriate for a public call I understand.
But any color there on what does not work for you guys any more?
- President & CEO
The majority of those synergies are redundant programs where we were both going after highly attractive new markets.
And I would say that accounts for most of it.
The balance is in some -- I don't want to call them skunk works but just some exploratory work that was going after some markets that we had not anticipated that do not look very attract and some technologies that we don't think make any sense.
So it's really just odds and ends but it added up to some reasonable numbers.
- Analyst
Okay.
Great.
Thanks.
And then, Bernard, I was wondering if you could, if you've looked at this yet; in the event that you do shift on over to the sell-in models that everybody has to do at some point here.
What -- how should we think that would impact results?
Is there a one quarter shift over, pulls forward and then we're on track going forward?
How do you anticipate that might look like if you've had a chance to look at it yet?
- CFO
Yes, we have had a chance to look at it.
There should be no impact to the P&L.
The guidance or the rules for this basically eliminates all of the sell through deferred margin through equity without flowing through the P&L.
So pretty much the only thing that will happen is on the financials is that the balance sheet will start showing a deferred margin side and it will be rolled into equity.
From the P&L point of view there will be no impact.
- Analyst
Okay.
Great.
Thanks very much.
Operator
Shawn Harrison, Longbow.
- Analyst
Hi.
Good morning.
I wanted to just delve into debt reduction and how you're looking at that through the end of the year.
I know the series Bs were out there.
But maybe if you can talk about does guidance include any additional debt reduction associated with Fairchild; how you think about that during 2017 and maybe a minimum cash balance you'd like to maintain?
- CFO
So as we said when we announced the deal in September 19, reducing our leverage is going to be one of our priorities.
We do have debt that becomes due at the end of the year.
And we do have a good amount of cash on the balance sheet that allows us to have the flexibility of basically reducing that debt.
And we will be focusing -- as we increase our free cash flow generation, we will be focusing on using that cash to delever up until we get to a level of about two times net over the next couple of years.
- Analyst
Okay.
And then as a follow up, if I may, the $75 million run rate achieved, was that all OpEx related, or did any of that fall into cogs?
And second, I know that the accretion target was $0.20 for 2017 I believe.
What is the new accretion target for 2017?
- CFO
So the majority of the initial savings are coming from OpEx.
There is some savings on a purchasing leverage on cogs.
The $0.20 for right now remains intact and we'll provide more detail in our analyst day.
But right now we're definitely on track to that $0.20 accretion for 2017.
- Analyst
Thank you very much.
Operator
Chris Rolland, Susquehanna International Group.
- Analyst
Hi, guys.
Thanks for the question.
In your written commentary you guys highlighted bringing capacity potentially in-house to Fairchild to help increase utilizations there.
What current facilities do guys plan to bring in there or what products do you guys plan to bring in?
And then also, do you guys plan to equip the half the Fairchild's Korean facilities that were currently empty?
- President & CEO
Okay so two fronts.
One, on the assembly test side across-the-board we're looking at increasing utilization in those locations.
And we will be focusing capital expenditures to expand the factories for increased leverage bringing things inside.
From a wafer fab perspective, really we are looking at doing much more, including expanding Korea on the high-voltage and medium voltage areas.
So the discrete factories of Fairchild should be seeing significantly more loadings from design wins that are ramping now on the onside.
- Analyst
I see.
Okay.
Thank you.
And then I think you guys address the revenue associated with your IGBT business.
I guess it's less than $25 million a year.
But the purchase price was more than $100 million.
So call it four to five times sales.
That's significantly above two time sales where you guys trade at.
So I'm making an assumption that business was significantly more profitable than the rest of your business.
And if that is true, we know it's 2% of revenue, but what kind of percent of profits are we talking about here?
Is it 4%?
Is it 5% of profitability?
How should we think about that divestiture?
- CFO
Chris, let me clarify something.
The ignition IGBT was $25 million, but we also sold some TVS and product lines in conjunction with that same sale that was more on the mandated side by FCC.
So the total revenue for that was definitely more than twice what you quoted for that business.
And we don't give details on the profitability, but I would say it's not above corporate average.
- Analyst
Got it.
Okay.
Thank you for that clarification.
Operator
Kevin Cassidy, Stifel.
- Analyst
Thanks.
This time of year you typically renegotiate contract prices with your customers.
Can you say how this year's negotiations went and maybe give us an idea of what kind of price declines we'd expect in 2017?
- President & CEO
Yes, they are going well and so we are quite pleased.
Our expectations for next year are actually a little better than they were this year.
But they should still average in that 1% give or take range per quarter.
- Analyst
Per quarter.
And what percentage of your revenue would be under contract?
- President & CEO
It's a little less than 40% is under contract.
And of that, a little more than half of that total contract number is annual.
- Analyst
Okay.
Great.
Thank you.
Operator
Harlan Sur, JPMorgan.
- Analyst
Good morning.
Thanks for taking my question.
Historically in a disciplined supply/demand environment the team has trended between 9 to 10.5 weeks on distribution inventories.
Can you give us an update on where inventories are currently sitting and maybe some qualitative views on customer discipline on the inventory front?
- President & CEO
So we are running approximately the same 10 weeks we have been running.
It went up a little bit with Fairchild, but not much.
So relatively good discipline on the acquired piece and I think very good discipline on the traditional on-site.
- Analyst
Great.
Thanks for that.
And then, Bernard, how should we think about the cash tax rate for 2017?
- CFO
So we are basically going to be growing towards that 10% of pretax income as we go throughout the year.
- Analyst
Okay.
Thank you.
Operator
Mark Delaney, Goldman Sachs.
- Analyst
Yes.
Good morning.
Thanks very much for taking the questions.
Two questions from me.
First is on the fourth quarter -- if you could help us with the gross margin between the two businesses?
What will we have normally expected for traditional ON, and then how's Fairchild impacting the gross margin you had for the December quarter?
- President & CEO
We are merging the two companies very quickly together.
So we're not splitting the gross margin.
In general terms I think our normal 50% fall-through on incremental or decremental revenue is the short-term view of things.
That's pretty much FEx supplemented by additional synergies coming on the Fairchild side.
- Analyst
That's helpful.
And then for a follow up question, if you could talk a little bit more on your market share opportunities within XP, divesting a standard products group to Chinese holders.
I know there was talk about some opportunities for ON to pick up share, especially in auto and industrial.
Can you give us either a quantitative or qualitative assessment about how successful you've been on that front?
- President & CEO
Yes, quantitatively going to be difficult right now.
It's still early.
But qualitatively those two markets are very sensitive to supply and supply disruptions.
And I think we are looking like a very good alternative to some of the changes that are out there.
- Analyst
Thank you.
Operator
[Craig], Morgan Stanley.
- Analyst
Hi.
Good morning.
This is actually Diana calling for Craig.
Thanks for taking my questions.
First, you mentioned about reducing the debt focusing on using the cash getting two times lever.
Wondering how should we think about the interest expense run rate going to 2017 and 2018?
- CFO
So the interest rate on our -- we priced term loan B is now LIBOR plus 3.25% as compared to LIBOR plus 4.50%.
If you look of the blended average all of all of our date that we have, it's approximately a little bit higher than 3%.
- Analyst
Okay.
Got it.
Thank you.
And then just a follow up on the inventory.
When you look at the adjusted inventory days is around 113 for the quarter and 120 for (inaudible).
So that's kind of within your 110 and 120 target.
So would Fairchild influence that targets?
What kind of inventory level you guys want to hold going forward?
Thank you.
- CFO
We believe that the 110 to 120 is a comfortable place to be at and we will continue with the targeting to be within that range.
Operator
At this time I'm showing no further questions.
I would like to turn the call back to Parag Agarwal for closing remarks.
- VP of Corporate Development & IR
Thank you, everyone, for joining the call today.
We look forward to seeing you at Radius conference during the quarter.
Thank you.
Operator
Ladies and gentlemen, thank you for your participation in today's conference.
This concludes the program.
You may now disconnect.
Everyone have a great day.