Keysight Technologies, Inc. (KEYS) Q2 2017 Earnings Report, Transcript and Summary

Good day, ladies and gentlemen, and welcome to the Keysight Technologies Fiscal Second Quarter 2017 Earnings Conference Call. My name is Heidi, and I will be your lead operator today. After the presentation, we will conduct a question-and-answer session. [Operator Instructions] Please note that this call is being recorded today, Tuesday, June 6, 2017 at 2 PM Pacific Time. I would now like to hand the conference over to Jason Kary, Vice President, Treasurer and Investor Relations. Please go ahead, Mr. Kary.

Thank you, and welcome everyone to Keysight’s Second Quarter Earnings Conference Call for Fiscal Year 2017. Joining me are Ron Nersesian, Keysight President and CEO; and Neil Dougherty, Keysight Senior Vice President and CFO. Joining in the Q&A after Neil’s comments will be Mike Gasparian, President of the Communications Solutions Group, Gooi Soon Chai, President of the Electronic Industrial Solutions Group, John Page, President of the Services Solutions Group, Bethany Mayer, President of the Ixia Solutions Group and Mark Wallace, Senior Vice President of Worldwide Sales. You can find the press release and information to supplement today's discussion on our website at investor.keysight.com. While there, please click on the link for quarterly reports under the financial information tab. There you will find an investor presentation along with Keysight’s segment results. Following this conference call, we will post a copy of the prepared remarks to the website. Today's comments by Ron and Neil will refer to non-GAAP financial measures. You will find the most directly comparable GAAP financial metrics and reconciliations on our website. We will make forward-looking statements about the financial performance of the company on today’s call. These statements are subject to risks and uncertainties and are only valid as of today. The company assumes no obligation to update them. Please review the company's recent SEC filings for a more complete picture of our risks and other factors. I would also note that management is scheduled to present at the Credit Suisse Semiconductor Supply Chain conference on June 13 in Boston. And now I'd like to turn the call over to Ron.

Thank you, Jason, and thank you all for joining us. As I am traveling internationally today, I will keep my formal comments brief and focus the discussion on three topics. First, we achieved a strong second quarter that was substantially ahead of our expectations and we are pleased with our execution and results. In total, we delivered 6% order growth, 3% revenue growth, 19% operating margin, and 5% earnings growth. Second, we continued to build momentum with our key growth areas. We achieved record orders for 5G including a significant win with Qualcomm as we announced in a press release this morning. We also had record orders for our modular and automotive and energy solutions. We believe our continued progress demonstrates that our strategy is working and our transformation is well underway. And third, we closed the acquisition of Ixia in April, which was ahead of our expected timeline as we efficiently obtained financing and cleared all necessary regulatory approvals. We are thrilled to officially have the Ixia team on-board and now focus our joint-efforts on the integration, innovation, and increased value creation. Let's begin with a review of Keysight's second quarter performance. In addition to our strong total results that I just referenced, Keysight excluding Ixia, delivered 4% organic order growth, 2% core revenue growth, 20% operating margin, and $0.64 in EPS. Taking a deeper look into our bottom-line performance, excluding Ixia and the associated interest expense and share dilution from the acquisition financing, we delivered $0.67 in earnings per share, a 10% improvement over Q2 of last year. The dynamics in our end-markets remained relatively consistent with last quarter as customers continued to focus their investment on next generation technologies. In our aerospace, defense, and government end-market, funding in the U.S. partially recovered off its soft Q1 to bring orders in line with last year. In the growth segments of our markets, we continued to build solid momentum and finished the second quarter stronger than we had expected. Our growth was driven by continued investment in next generation technologies including 5G, IoT, high-speed datacenters, the electric car, autonomous driving, and next-generation process technologies. Our focus on bringing solutions to markets that help customers accelerate their next-generation designs across the communications ecosystem is allowing us to drive multiple avenues of growth across these trends. To demonstrate our progress in capitalizing on these evolving trends, I will share with you a few highlights in the quarter that we find particularly exciting: First, orders for our 5G solutions doubled over Q2 of last year to reach a new record and we secured a significant 5G win with Qualcomm for our industry-first 5G protocol design solution that we just launched this quarter. This solution enables developers the ability to seamlessly prototype designs as they migrate from pre-5G to 5G New Radio and address protocol layer design, an area of the market where we did not participate in 4G. With our targeted efforts in 5G and our leadership in high-frequency technologies and solutions, we believe we have established a leading position in the 5G marketplace, and are on a solid path towards our goal of being first in 5G. Second, in high-speed datacenters, we saw an increase in development activities for 400 Gig, PAM-4 and silicon photonics technologies, which drove demand for our recently introduced 64 Giga baud bit error rate tester developed for electrical and optical PAM-4 transmitters and receivers. Ixia has also taken a leadership role in 400 Gig innovation. Earlier this year at OFC, Ixia demonstrated line rate 400 Gig Ethernet with PAM-4 electrical lanes. Ixia is the first and only player in the market with this solution in the latest double density form factor. This first-to-market solution underlines why Ixia is the leader in the network test market, and delivers continued proof of their technology leadership over the competition. Third, in the automotive and energy market, we delivered a record quarter with strong revenue growth across all regions as the automotive ecosystem continued to grow at a healthy rate and Tier-1 suppliers expanded their design capacity. The rapid electrification of vehicles and the move to autonomous-driving is shifting this industry from mechanics to our areas of strength in wireless communications, radar, and smart battery development. We are gaining strong momentum with leading customers in this evolving industry and growing ecosystem. Notably, in the second quarter, we added 10 key new customers. Our expanding customer base in this end-market includes top-tier automotive makers, as well as specialized automotive electronic module producers, chipset vendors, and energy component and battery producers. And lastly, we achieved another quarter of strong growth in next generation processing technologies, where we have a leading position in parametric test. In the back-half of the quarter, new investments in the build-out of capacity in China drove higher than expected demand, which contributed to the upside in our second quarter results. Our leadership in this end-market coupled with our record performance in automotive and energy resulted in 14% year-over-year revenue growth for our EISG segment. In summary, we are very pleased with our second-quarter performance and continued steady progress in building multiple avenues of growth across a diverse set of end markets where customers are investing in next-generation digital and electronic technologies. We are confident that we have the right strategy in place, it is working and our transformation is well underway. Our strong innovation and solutions portfolio uniquely positions us for growth as these long-term trends continue to evolve and customers invest in next-generation technologies. It is undeniable that the digital landscape is transforming and will continue to influence the way we communicate, drive, shop, and even obtain medical care in the years to come. Whether it is for high-speed datacenters, next generation mobile networks, radar, electronic warfare, automobiles, or medical devices, Keysight’s solutions go where the electronic signal goes from design simulation, to prototype validation, to production test, to optimization in the network. Now, with the acquisition of Ixia, which we closed in April, we have broadened our reach within and beyond these growth trends and the communications development lifecycle. Keysight's reach now includes digital packetized data, applications, visibility and network security, as well as electrical signals. We are excited to add Ixia’s deep bench of talent to Keysight’s team, which will continue to be led by Bethany Mayer. Our integration efforts are off to a great start and we look forward to partnering on end-to-end development of next-generation technologies. Together, we will expand our number of touch points with long-term technology trends and key customers, and accelerate our growth. With that, I will turn the call over to Neil for a detailed review of our financial performance and the third-quarter outlook.

Thank you, Ron, and hello, everyone. Today, we reported second quarter GAAP revenue of $753 million, which includes 13 days of revenue from Ixia, and non-GAAP revenue of $758 million, which excludes the impact of the acquisition-related fair value adjustment to Ixia’s deferred revenue balance. Core revenue, which excludes the impact of currency and revenue from acquisitions completed within the last 12 months grew 2% year over year and was ahead of our updated guidance range. Regionally, core revenue declined 1% in the Americas, 3% in Europe, and 5% in Japan, while in Asia excluding Japan core revenue grew 10%. Looking at our operational results, gross margin was 59.0%, a year-over-year increase of 120 basis points driven by favorable product mix with a higher contribution of software and EISG solutions. Operating expenses totaled $300 million, a $10 million increase over the same period last year reflecting Ixia expenses for the partial-period. Excluding Ixia, year-over-year operating expenses were flat, demonstrating our ongoing operating model discipline. This resulted in second quarter operating margin of 19.4%, up 110 basis points when compared with 18.3% last year. We reported net income of $114 million or $0.64 per share. Excluding Ixia and the associated interest expense and share dilution from the acquisition financing, which was not in our guidance, we delivered net income of $116 million or $0.67 per share, which represents approximately 10% earnings growth versus the second quarter of fiscal year 2016. We ended the quarter with a weighted average diluted share count of 179 million shares. Moving to the performance of our segments. Our Communications Solutions Group, or CSG, includes two primary end-markets. First is the commercial communications end market that reported revenue of $256 million, compared to $257 million in the prior year second quarter. Growth from 5G and next-generation datacenter technologies was offset by soft spending in wireless 4G. CSG also includes our aerospace, defense and government end markets, which generated revenue of $168 million in Q2, compared with $189 million in the same quarter last year. As we mentioned on our last quarterly call, our aerospace, defense and government end- market was impacted in Q1 by soft spending in the U.S. due to delayed budget approvals. A federal budget with increased funding for defense was approved by Congress in late April and we did see a partial recovery in Q2 order results, however, it is difficult to predict exactly when the flow of funding will return to a steady state in this end market. Over the long term we remain bullish on both our market position in aerospace and defense and the prospect for increased defense spending in the U.S. Total CSG revenue for the quarter was $424 million, compared with $446 million in the same quarter last year. CSG reported gross margin of 61.3% and operating margin of 17.6%. Our Electronic Industrial Solutions Group, or EISG, generated second quarter revenue of $220 million, up 14% from the same quarter last year and a record high. Semiconductor measurement solutions and automotive and energy solutions both posted strong growth, which was partially offset by a decline in the broader general electronics market. As we noted last quarter, we have had several quarters of very strong growth in semiconductor measurement solutions and we expect this to moderate somewhat as we move through the remainder of the fiscal year. EISG reported record gross margin of 61.8% and operating margin of 26.1%. Following the completion of the acquisition of Ixia on April 18, we created a new operating segment named the Ixia Solutions Group, or ISG. The reported second quarter results for ISG cover the 13-day period between the closing of the acquisition and the end of our fiscal quarter. During this time, ISG generated revenue of $12 million, gross margin of 77.1% and an operating loss of $2 million. While Ixia was not required to and did not perform a hard close of its first quarter, which ended on March 31st, I’ll provide some color on their order performance for that period. Ixia orders of $128 million were in line with expectations and up 4% year-over-year. Orders for Ixia's visibility solutions grew 18% year-over-year and were 28% of total orders. Ixia's test solutions order performance was in line with the prior year's first quarter, but contained a higher-mix of service and subscription orders, which are recognized as revenue over time. Please note that we do not intend to provide Ixia's order performance on a go forward basis, but will be reporting their financial results as a separate operating segment. As Ron mentioned, our integration efforts are off to a great start, and as our integration plan has solidified, we are able to update our cost synergy timeline. We now expect to achieve annualized run-rate cost synergies of $40 million by Q3 of next fiscal year and remain committed to delivering the full $60 million of cost synergies over time. Moving to the Services Solutions Group, SSG generated second quarter revenue of $102 million, a 6% year-over-year increase. Revenue growth for SSG was driven by an increase in sales for our remarketed solutions and calibration services. SSG reported gross margin of 40.9% and operating margin of 16.2%. Moving to the balance sheet and cash flow. We ended our second quarter with $983 million in cash and cash equivalents. Our cash flow from operations in the quarter was $49 million, which included $60 million in acquisition-related operating cash utilization. Capital purchases were $17 million in the quarter resulting in free cash flow of $32 million. We ended the quarter with $2.2 billion in long term debt, up $1.1 billion from the prior quarter, which we used to fund the Ixia acquisition along with equity raised in the quarter. We were able to take advantage of strong credit markets and issued $700 million in senior unsecured fixed-rate notes, with a coupon of 4.6%. On the equity side, we raised $444 million in net proceeds by issuing approximately 13.1 million common shares priced at $35 per share, which includes the overallotment. Before moving to guidance, we would like to discuss a few modeling items. First, we will continue to report revenue on a GAAP and non-GAAP basis with the difference being the impact of the fair value adjustment to the acquired deferred revenue balance from Ixia. Based on preliminary purchase price accounting, the net deferred revenue balance inherited from Ixia is $44 million, reflecting an approximate adjustment of 70%. Second, we currently expect interest expense to be approximately $24 million per quarter. Third, regarding our go forward tax rate, we are in the early stages of planning how best to bring Ixia and Keysight together from a tax perspective but for the immediate future we are continuing to model a 17% non-GAAP tax rate on Keysight's profits and a 30% non-GAAP tax rate on Ixia profits, which yields a combined rate of approximately 19%. And lastly, we expect our weighted diluted share count exiting fiscal year 2017 to be approximately 188 million shares. Turning to our outlook and guidance for the third quarter. We currently expect Q3 non-GAAP revenue to be in the range of $840 million to $880 million, representing 2% core growth at the midpoint. We expect third-quarter non-GAAP earnings per share to be in the range of $0.51 to $0.65, or $0.58 in the mid-point, based on a weighted diluted share count of approximately 188 million shares. With that, I will now turn it back to Jason for the Q&A

Thank you, Neil. Operator, will you please give the instruction for the Q&A?

[Operator Instructions] And your first question comes from the line of Richard Eastman with Robert W. Baird.

Yes, good afternoon. Perhaps Neil or, I don’t know if Ron wants to take this one from a distance. But I'm a little bit curious the core order number, so excluding Ixia, the core orders were up like 14% which feels strong seasonally from Q1 to Q2. It seems like it's 3, 4, 5 points stronger than normal, and I'm curious which product lines perhaps you're seeing that strength, is it a continuation in the parametric test area or maybe you could just kind of address that?

Yes, so Rick, first of all, I checked your – I don’t know if we misstated something or if your math is wrong, we have core orders up 4% in the quarter, not 14%. Obviously, we saw strength in 5G, we saw strength in modular, we saw great strength in automotive, semi were the strong points, we saw weakness in 4G while aerospace, defense was significantly better than it was in Q1, it was below our average growth rate for Q2 orders as well.

Well, I'm kind of talking seasonally, Neil. So in other words, from Q1 to Q2, I thought the core order number was 791 in core and you did 695 in the first quarter, typically you see barely 10% sequential order improvement. I'm just curious is that –

Okay, I'm with you, I got you. So if you look sequentially, one of the big drivers of sequential growth then was aerospace, defense, we've seen a 20% decline in aerospace defense orders in Q1 of last year. Now it’s year over year, right? Year over year Q1 aerospace, defense was down 20%, whereas in Q2, the numbers were closer to flat, it was actually very slightly up on a year over year basis and so the sequential improvement in aerospace defense was the significant driver of the increase.

I see. Okay, and then just as a follow up. Within electronic and industrial, the IESG segment, the operating leverage that you delivered in the quarter and again, whether it's year over year or incremental, pretty significant, and is that mix in that segment -- and I kind of flag again maybe the semi test business, but is the incremental there a function of mix?

Yes, that's correct. Obviously we saw really strong orders and revenue from our semi business, and that does tend to have a favorable mix impact in terms of the margin incrementals that we can deliver. So you are absolutely correct about that.

And then lastly, and I promise no more. But there was some conversation today, Ron, in the conference presentation, really from Gigamon and they were speaking to some aggressive pricing by Ixia from time of announcement of the deal to close of a deal. And I guess what I'm just asking is as we look forward, well I’ll use your own revenue number, but is it fair to use a gross margin number for projecting Ixia, say between 77 and 78; is that –?

Yes, that's fair. That is their historical gross margin level, and that is the level that we would expect to see from them going forward.

Your next question comes from the line of Brandon Couillard with Jefferies.

Ron, I was curious if you could just elaborate on the aerospace and defense dynamics in the second quarter. Directionally, you feel like the worst is behind us as far as the U.S. order trajectory.

Well, as Neil had mentioned, we saw about a 20% decline in the first quarter, and in Q2 orders were up about 1%. So, although it didn't flush through on revenue where in Q2 revenue was down because of the Q1 orders, we did see the Q2 orders flatten out and that's nice. It’s a little hard to tell what is going to happen in the budget cycle, but we look at the number of wins that we get in our position in the aerospace defense market, and we are positioned very strongly in that space and we're very confident with where we -- how we will turn out on a competitive basis. As far as when the budget will jump up to the next level, it's hard to say. We did say there are three ways in which the budget or we could say that orders and revenue could increase, one was to get rid of the continuing resolution; the second was an increase in the overall aerospace and defense spending where Trump was talking about $54 billion at one point but it’s up any amount, and the third was by mix being more slated towards high technology which we strongly believe will be the case due to a little bit more of a slowdown of new programs over the past eight years. So we still look forward to those three upsides, but as far as the timing it is a little unsure, but we're ready for it as soon as the government starts spending.

And then a two-part question for you, Neil. Number one, was the Qualcomm contract win that you announced this morning included in your 5G orders in the second quarter? And then number two, the services business grew about 7% core but lapped a pretty easy comp versus last year. Is there any timing dynamic that you'd like to speak to there?

Yes, so the Qualcomm -- a portion of that Qualcomm order at least was included in our 5G orders, so that is correct, and in a minute I’ll let Mike comment on that Qualcomm win because I think it's significant. Regarding the services business, as you referenced we did have a relatively softer comp from a year ago but I wouldn't say that there's any particular timing that impacted our revenue stream here in Q2. Mike, do you want to comment on the Qualcomm win?

Sure. Well, you could probably get the highlights from the release. They've selected us for their new 5G network emulation, the solution is going to help them validate all of their RF workflows as well as the higher layers of their protocol for 5G. We've got a great scalable solution that we announced earlier in the months going from sub-six gigahertz up to 28, 39 gigahertz and we will do a great job of transitioning our customers from pre-5G to 5G NR to whatever the final standards are. This is a pretty significant win for us from a number of perspective. First of all, the dollars associated with the win will grow as the 5G program grows at Qualcomm and expands. Secondly, they are a big time leader in chipsets and that part of the ecosystem really plays the role of early adopter and frequently serves as a reference solution for device makers in other parts of the ecosystem. So I think we're going to get some downstream leverage. And perhaps most importantly, I think this is a really big milestone. It was about three years ago where Ron declared the growth initiatives for Keysight and one of which was we want to win in 5G. And I think this win at Qualcomm is tangible proof that we're on the right path. And I think we've established ourselves in a leadership position where we have been and we will continue to -- investing aggressively to win. We've got collaborations all around the world with the market makers that we're leveraging, and we're really well positioned to help our customers accelerate the commercialization of 5G. So it's a really exciting story that’s starting to unfold for us now.

I’ll add just another comment – just a comment to what Mike has said. First of all, what we have won here in 5G on the protocol solution, we did not win in 4G. So this is pure incremental growth to us and Keysight being focused. The way in which we did that was we wanted to bring together the capability of Keysight with the capability of Anite and the capability at AT4. Obviously we made those two acquisitions over the last few years and the solution that we put together was by joining the best of hardware and software into a complete solution from those three companies. And that's what really made us to stand out that puts us ahead of the competition. So we're very very pleased with the progress and with the contributions that those two previous acquisitions have made.

Your next question comes from the line of Vijay Bhagavath with Deutsche Bank.

My question is on 5G and connected cars as a test opportunity. Help us understand how this opportunity in terms of the solutions gets divided among your peer group? For example, would different carriers and OEMs work with different set of test suppliers? Are these end customers dual, triple, multi-sourced? And where I'm coming from is, it will help us to understand in terms of is there any lumpiness in purchases, how much visibility do you have? Would you have any pricing pressures like the service providers playing you off your competition and so on and so forth? Thanks.

Yeah, so obviously those two markets, the automotive market and the 5G market are in two different segments. So why don't I let Soon Chai comment first on how we see the automotive market unfolding and then Mike can make some additional 5G comments. So Soon Chai, do you want to address Vijay’s automotive question?

Yes, okay. So this is Soon Chai here. I think definitely as Ron has mentioned, these are truly exciting time for the automotive segment. It's moving from a mechanical industry to electronic content industry. And if you look at the car of the future it’s really all about electronic, it’s all about connectivity, it’s all about intelligence. So this really plays very strongly to our strengths. Now our capabilities allow us to enable this major transformation in the automotive ecosystem. We provide solution in multiple areas. So firstly, we do design validation and testing of the critical automotive electronic control bots [ph] or the ECU. Okay, second is the area of connectivity, we do solution for telematics where we provide ADS solutions such as radar target simulators, B2B connectivities. And lastly we also provide solution in the power management area. Essentially these are the three points for the area [ph]. So if you look at it, it covers the whole ecosystem from digital testing to telematics all the way to power management. So we have a good momentum of this segment and definitely with strong partnership with key customers. So that’s really little bit about the automotive area. So maybe I need to pass on to Mike to talk about the 5G portion.

Yeah, hi Vijay, I'm not sure exactly where you wanted to go with this question. I’ll make some general comments about 5G and then maybe a little bit of insight about how we manage it internally. From a 5G perspective, we continue to see acceleration of the 5G standard. Most recently the 3GPP committee pulling up 5G NR by about six months, I'm sure you know about that. That has been kind of -- in turn it's got all the global operators and it’s gearing up for large scale trials. Depending on where you are around the world, different spectrum is being utilized below six gigahertz, sometimes 28 gigahertz, maybe 39 gigahertz. So there's a lot of pressure on the chipset and the device companies from a manufacturing standpoint to be able to meet these new aggressive schedules. So that's why we've been working closely with our customers with all these collaborations and came up with this new 5G protocol R&D solution, it's scalable, cover all the global spectrum that's out there, requirements, and it's flexible enough to help people transition from wherever they're entering, this technology way, they could be pre-5G, 5G NR or eventually what the final specs will be. The other thing I'll just comment on, because the way we're structured is with the industry solution team, so Soon Chai really has a great handle on the automotive industry and energy industry. And buried within the Keysight structure we have centers of excellence. So we have -- I manage a center of excellence for high frequency measurements. I also manage one for digital and photonics. But for example, in the high frequency measurement area, that group will have expertise in millimeter wave technology, over the air testing techniques, and those centers of excellence as well as our technology leadership organization, our Keysight labs we will be able to apply that and basically provide that technology to any industry. So Soon Chai can draw on the centers of excellence from all around the company. A great example might be 77 gigahertz in automotive radar. The radar technology is primarily sitting in our high frequency measurement COE but it's accessible to and we work closely with Soon Chai’s industry group focused on automotive.

You know, if I could quickly clarify, and thanks for your explanation. If I could quickly clarify, where I was coming from is, if you walked into an AT&T test lab, would they have instruments from Knotty [ph], from Keysight, maybe Rohde & Schwarz simultaneously for the same test use case, or different test use cases would be from different suppliers including yourselves? But it helps us to understand how they think of the test solutions providers in terms of use cases for these growth opportunities.

Well, I think there are a lot of different segments associated -- I might hand this over to Mark Wallace to see if he has any comment. He's our worldwide sales manager. But there's a lot of different segments. Certainly if you capture a win with Qualcomm, they'll develop a reference test solution for R&D that will really get handed off downstream probably to device maker, which will then parlay into operators. Now operators depending on who they are around the world are going to have different types of conformance testing. And then you'll have -- you'll kind of go from the wireless device side to a base station side and so you could have different suppliers in different parts of the ecosystem. Mark, do you have any additional comments there?

No, Mike, that's very accurate. We do work with the test houses and have actively worked with them through our relationships over the last several years. This is another area that Anite has brought a lot of strengths to us and we're going to continue to leverage that going forward. But as you say it begins at different points across the ecosystem. So as we're working early upstream with some of the chipset providers as well as the automobile manufacturers and some of the component suppliers that leverage gets propagated across the entire ecosystem, including the test houses that you're referring to.

Your next question comes from the line of Toshiya Hari with Goldman Sachs.

Great. Thanks for taking the question and congrats on the strong results. My first question is on your Q3 guide. If you could comment a little bit on the individual segments, how you view growth in the respective segments, that would be helpful? Thank you.

Yes, hi Toshi, this is Neil. So obviously we don't provide specific guidance for each in the individual segments but I can touch briefly on kind of what some of the puts and takes are from a market perspective. We obviously continue to see investment in next generation technologies, 5G and automotive being two primary areas we would expect to continue to see strong growth as we move through the remainder of the fiscal year. As we touched on, we've had a very strong first half of the year in our semiconductor businesses, as not only do you see move to more advanced process nodes with the semiconductor build-out in China. We are expecting some moderation of that build-out here in the second half. Aerospace, defense could be a business that’s a bit difficult to call at this point. On the positive side we did see the budget get passed in April, it did include incremental dollars for aerospace, defense but we know from historical data point that it does take a while to go from the passage of a budget to the actual time at which dollars start to flow. So I would expect aerospace defense to be soft again here in Q3 potentially starting to ramp in Q4 and some of those dollars will continue to get -- the dollars in the current budget will continue to get spent even as we migrate into FY’18. So that's kind of the puts and takes. On the Ixia side, obviously the visibility business I would also mention is another high growth area. And so we’d expect to continue to see a strong growth in the visibility portion from Ixia as well in the second half of this year. I think it is important to note too that if you start to think about the second half of the year and what's included in our guidance obviously we'll be adding the Ixia expense portfolio particularly their R&D, we're continuing to invest heavily in 5G. And as we look forward we expect that our R&D investment as a company now will be close to 15.5% going forward.

And then I have a follow up. On the commercial comm side of your business, I appreciate the fact that you're very focused on 5G and that's obviously a growth driver going forward. But I was curious what kind of activity you're seeing in 4G/ Is it stable, is it declining? And in terms of market share are you picking up share? Any color would be helpful. Thank you.

Yes, so let me just make a really quick comment and then I'll hand off to Mark Wallace here to add on. Obviously one of the themes that's been going on for several quarters in a row and an accelerated ramp up of investment of our customers in 5G and a ramp down of 4G spending that was happening faster than we had previously modelled, but I will let Mark to make some more specific comments.

Yeah, that's right. So in Q2 we saw this occur, especially in Europe we saw the decline in some of the year on year business as you compared to last year for 4G dropped off substantially, that's in both the test houses, conformance test as well as some of the 4G base station build-out. So that was seen there, and we saw in other regions as well a little bit in Japan, although we did see a little bit of a recovery toward the end of the quarter with some of the components supply chain part of the business. So it's definitely a transition, it's not going to zero but it's down quite a bit.

Your next question comes from the line of Krish Sankar with BoA Merrill Lynch.

Hi guys. I had a couple of them. First one, is there a way you can quantify what percentage of revenues, either in the commercial comm group or overall percentages of revenues from 4G, from 5G and how much is autos as a percentage of total revenues?

Yes, so we provide in our IR materials that are posted on our website a breakdown of our revenue across the business groups. And we do provide some level of visibility to the aerospace, defense and commercial communications breakdown. We don't provide a further breakdown of the electronic industrial business to its sub-segments. I'm just flipping pages here real quick to get it in front of me here. But you can find that data on our web. So if you look at commercial communications for Q2 it was about 34% of the total; aerospace defense was 22% of the total. Our electronic industrial business which includes general electronics, semiconductor and automotive together was 29% of the total. Ixia obviously with only thirteen days was a very small sliver at 2%, and services made up the balance of 13% of total revenue.

I was just trying to figure out if you can give exactly how much -- what percentage of 5G, specifically what percentage of auto specifically?

No, we haven't shared this number specifically, we did in our proxy statement disclose our 5G revenue – excuse me, our 5G orders for last fiscal year. And so you could use that as a basis point from which to model. And that’s really for competitive reasons obviously these are highly competitive markets that are moving quickly and we don't want to share too much information.

And then a little bit of a longer term question, when I look two years out, when 5G, you start getting the commercial deployment and standards definition phase, help us understand what is the opportunity for Keysight, both on the legacy Keysight business and also with Ixia, because I think you didn't have much softer revenues during the 3G and the 4G phase but with Ixia you probably have some incremental softer opportunity in 5Galso. So help us quantify what that number could look like. And just as a quick follow-on to that. The Qualcomm win, is it for legacy Keysight or is there any Ixia opportunity in that too?

Yes, so let me just make a couple of comments and then I'll hand off to Mike and potentially Bethany for some follow-on comments. So first of all, the Qualcomm opportunity was a legacy opportunity. I think as you think about -- as you think about 5G moving forward, the nice thing about our portfolio is we really participate in the 5G ecosystem at multiple points, right all the way from pre-R&D with our ESOP tools as people are developing the chips and devices that they're going to operate in 5G -- chip components, chipset devices, base stations and then all of that is ultimately going to drive a dramatic increase in data traffic back through the data centers. And so there's an opportunity for not only our data center business and the core Keysight, but Ixia to benefit from the 5G transformation. So Mike, I don't know if you have anything to add to that.

I’ll just make a really quick comment. Even though the Qualcomm example that we've been talking about today is in fact legacy. As Ron pointed out earlier in the call, this was not a business opportunity we were able to pursue historically when 4G occurred. It was really the confluence of the Anite acquisition and the AT4 acquisition, they're bringing the protocol expertise into Keysight combined with our RF expertise has allowed us to have more of an end-to-end solution. With that I'll turn it over to Bethany to see if she's got any comments about Ixia.

Sure. Thanks Mike. So for Ixia, we also have a very strong opportunity in 5G as well. What we saw in the first quarter was strong wireless quarter for us and double digit sequential growth in wireless, primarily in Asia Pacific, that's where we saw it. But I would also comment that we do have several customers in other parts of the world looking at our products in 5G. And then I would also comment that Qualcomm is a customer of Ixia as well. So we do have some nice complementary capabilities across Ixia and Keysight as we and the entire industry move toward 5G.

Your next question comes from the line of Stanley Kovler with Citi Research.

Thanks for taking my question. Just one more on sort of the 5G opportunity here. When you look at the prior cycles that you had on 3G and 4G, and understanding that now you start talking about a fuller solution. What I wanted to understand is, given the way that 5G looks like it will play out, at first it's going to start off as a fixed wireless solution and then dovetail into more devices or mobility type of deployment. In the past the peak cycle on 3G and 4G in terms of spending has lasted maybe two years. Should we think about a similar cycle for 5G or thinking more about like a three to five year cycle on 4G? And then I have a margin follow-up. Thank you.

Stan, again I'll make some initial comments and then hand it off to Mike. Again we think of these cycles as far longer than two or three years given that we really come in on the front end, as we sell into R&D solutions and that's more true today in 5G than it even was in prior generations. And so right now here we are, we still don't even have 5G standards developed yet and we have a very strong engagement in 5G. And so we do view these as far longer cycles than that. Certainly there's going to be a ramp as you start to look towards standards deployment either in – or standard definition either in ’18 or early ‘19 and then commercial rollout in the early 2010 timeframe. But Mike, I will leave it to you to add any additional commentary.

Yes, just a quick clarification on the model that you threw out. First of all, I would agree with Neil’s comment and maybe Mark wants to add something in here. I would view the peak 5G cycle as a much longer worldwide deployment than just two or three years. The second thing, and coming back to this worldwide dimension of the opportunity, fixed wireless is taking a very strong lead here in the U.S. with both Verizon and AT&T. But if you look in the international markets, in Asia in particular, most of the action is at sub-6 gigahertz, and with massive MIMO, as kind of a primary challenge. So if you look across the different 5G deployments, you see over-the-air challenges, beamforming challenges, massive MIMO, I mean this standard really is a -- it takes it up a step function on multiple dimensions, different frequencies and it just leads to a plethora of measurement opportunities for us to make contributions, right? It's largely uncharted territory whether it's sub-6 gigahertz with massive MIMO, or if it's a 28, 39 gigahertz millimeter wave opportunity, this is all new ground for our customers. Mark, do you have anything else to add?

Mike, I would just add to just build on what you just said, unlike 4G and certainly 3G, there's just such a larger breadth of opportunities that 5G is playing into. From the things that you mentioned to low power low latency IoT applications, medical applications, we talked about automotive and how these industries are colliding, it affects the backhaul of data centers. So it's more than just pushing more through a wireless pipe, it's more than just streaming Netflix. It's about a whole number of different use models that are first of all completely global, this is happening everywhere in the world. And it's touching all these different areas where Keysight is participating and being dominant. So it's definitely more than a couple three years. If you think back from 2G to 3G to 4G, that occurred over a 20, 30 year period. So I expect this to be longer than just that couple of years.

Thanks. If I could just follow up in terms of the gross margin outlook for next quarter, if you bake into the numbers, I’d land somewhere in the low 60s range if I'm correctly blending in the Ixia and Keysight margins. And so that puts me above the range of where you typically operated obviously. Could you just help us revisit how we should think about the gross margin line going forward? Typically you’ve gotten to these levels or near these levels at significantly higher revenue in the past? Thank you.

Yes. So obviously we don't guide the individual line items. But let me make a couple of comments, that might help you. So first of all, you're correct. Obviously we're going to benefit from adding -- on the gross margin line we're going to benefit from the addition of Ixia. You are right, you're adding on an annualized basis approximately $500 million of incremental revenue that has gross margin in the very high 70s in terms of where Ixia operates. So that's going to be a net-adder to the Keysight who has traditionally operated in the high 50s. Now within Keysight’s portfolio we have a wide range of margins generally speaking. Our sales into R&D -- our customers R&D labs come with a higher gross margin than sales into manufacturing. Certain product lines, we talked about semi today having a favorable mix benefit from a gross margin perspective. But I think if you look historically at Keysight’s results we've operated in a pretty tight band, two to three percentage point band and Ixia has been operating in a similarly type band albeit roughly 20 points higher in total. And so I think your math is more or less correct and it's the type of thing you should expect from us as we move forward.

Your next question comes from the line of Farhan Ahmad from Credit Suisse.

Can you just talk about 5G? You talked about more than 100% growth in autos this year. How sustainable do you think that is? And secondly, you are getting a decline from 4G and a growth from 5G. When do you think we get to a point that the 5G growth actually starts to become bigger than the decline that you're seeing in 4G?

Yes, so obviously we did put up triple digit growth here again in 5G and we saw a very strong growth in 5G last fiscal year as well. As for the sustainability, obviously we're benefiting somewhat, that we’re at the very early stages of a ramp and so the numbers are still relatively small. But we certainly expect that 5G is going to continue to ramp aggressively. Now the growth rates are going to come down over time as the base goes up, but we're still at the very front end of a 5G ramp with -- still in a stage prior to standards developments, or standard definition. And so there is an awful lot of 5G runway that is out there. As you said, the 4G business is falling off and it's resulted in a commercial communication segment for us that has been more or less flat last quarter anyway from an orders perspective. And so what you're really seeing is 5G, the next generation data center technology is offsetting the roll-off in 4G spending. Mike, I don’t know if you have any further comments on that as well.

Well, no, I just think it's obvious that at some point in time in the future 5G is going to eclipse 4G. I mean that's not too hard to imagine. So we definitely think that's going to happen. Exactly when, I don't -- I can't -- I don't think it's completely modeled out nor would we share it at this point in time. But what I can say is our 4G sales I think feel like they're stabilizing. And also I don't think we’re going to see dramatic fall off from this run rate. And the 5G number continues to grow. So it's kind of a foregone conclusion that 5G will eclipse 4G going forward.

And then can you just talk about your progress with some of the international customers on 5G? There is a big push in China for 5G. So maybe specific to China, how is your progress there in the markets for 5G?

Yeah, I'll take that. This is Mark. So progress in China is great. And part of this has to do with some decisions that we made as a company seven years ago in China as we started to see the changing landscape there, which is shifting from a manufacturing focus to an R&D focus. So we've been engaging with local indigenous companies in China, multinational companies in China. There's a lot of leadership coming out of China today with a number of companies and we're very well positioned. The collaborations that Mike talked about before, the example that we provided today with Qualcomm is representative of a lot of the work that we're doing around the world. And China is high in place for that. Also, as we mentioned before with the investments being made in developing local semiconductor capabilities and the foundries that feed into these industries, we’re also very well prepared there as well. So it's going quite well.

This is Ron. Just another comment along those lines, we’ve worked with Datong [ph] and they are the ones that sit on the standards bodies in China where that standards body for instance have to be -- you have to be from China to be on it. But it’s more an advisory member to them and we've been working with them for a while on 5G. Another one is Spreadtrum there about a month ago, and we've opened up a joint innovation lab that really helps out and helps the direction of 5G. Another one I was just visiting was SMIC, we have a partnership with SMIC and we put together a memo of understanding for collaborating which will move into 5G also. So we are working at the highest levels with the market makers in China to influence the standards and to be the solution provider of choice.

Your next question comes from the line of Jess Lubert from Wells Fargo.

Hi guys, thanks for squeezing me in and congrats on a nice quarter here. I am not going to ask you about 5G. So maybe just a couple on the Ixia deal, and I was hoping you can maybe help us understand some of the factors leading you to believe you can capture the $40 million of cost synergies quicker than you originally expected, where those savings are likely to come from, and given it sounds like you're seeing some early success there, to what extent do you think you have a chance to upside the original goal of $50 million in 24 months and $60 million in three years?

So it is a great question. I appreciate the opportunity to provide more details. So obviously the acquisition has been closed for a little over a month at this point, and that's a month that we've spent really working hard to solidify and define the integration plan that we're going to be putting in place over the course of the next nine to twelve months, and to make sure that the assumptions that we had made about where we could get cost synergies from the combination of the two companies that those assumptions were correct, and making sure that we still had line of sight to the $60 million. So again six weeks or seven weeks post close of the acquisition, very confident in our ability to ultimately get to that $60 million and as you noted we're pulling forward the timeline on how quickly we're going to be able to get the first $40 million. We're not at this point ready to commit to upside but we do have a direct line of sight to that first $40 million and are working on a plan to get that out over the first twelve months. If you look at where that's coming from, it's a combination of supply chain efficiencies as well as operating expense efficiencies primarily as we look to bring the two IT environments together. So those are the number one things that we will be working on here. The costs are coming out of -- from both sides of the equations. We're leveraging the best of both companies as we bring them together and are very pleased at what we have found as far as opportunities this far into our integration planning.

And then just in a similar regard, can you talk to us a little bit about how you're feeling about the revenue opportunity and what are you hearing from the combined sales team, channels, customers, about your ability to kind of cross pollinate the products from Keysight into the Ixia base and vice versa, and some of the incremental opportunities that could drive over the next few years?

So that’s a great question. And just as we're off and running on working on identifying the cost energy opportunities, we're similarly off and running on generating revenue synergies. As you know, we have communicated previously we really identified three areas where we expect to get revenue synergies. One is from leveraging the breadth and the international scope of Keysight’s field to provide qualified leads to the Ixia team, and then there are some sub-segments of the market where that actually works the reverse direction, where Ixia’s relative strengths are going to provide opportunities for Keysight. Then there's an opportunity for us to accelerate the investment in the channel for specifically as it relates to pursuing the visibility opportunity, the fast growing visibility opportunity, and then finally bringing the two technologies together to bring new solutions to market. In just a minute, I will let Bethany comment on her perspective on how that's going kind of one month in. The one point that I did want to make is we do expect to publish our 10-Q tomorrow and that will include some historical revenue numbers for the combined companies for both the prior six months -- the first six months of FY’17 but a pro forma compared to FY’16 as well, so you'll be able to see those numbers in our Q and it drops tomorrow. Bethany, would you care to comment on the revenue synergy opportunity as you see it six weeks after the close of the transaction?

Sure. Happy to; thanks for the question. So I think it's going very well both within Ixia as well as Keysight. And we've identified some great opportunities, one as Neil had mentioned is that there are opportunities for Keysight sales force to help Ixia’s sales force engage in customers where we haven't been. And vice versa on our side of the equation there are opportunities where we have a very -- key relationship in certain customers that we can engage to help Keysight. And so that activity is -- we're pursuing that very heavily. The second one is the go-to-market activity and basically that's an investment on the part of Keysight into Ixia’s go to market and our channel to centrally leverage the channel that we have and grow that. And so we're very excited about that, because we have an opportunity for a double digit continued growth on the visibility side of our product portfolio and that will really aid us in that growth opportunity. And then on the technology areas of potential revenue synergy, there are three key areas that we focus on together as a combined company. One is in the data center with high speeds. As you know we are the network test market leader for 400 gig and we came out with the first 400 gig PEM-4 QDD test product that is on the market today. And it's very exciting for us and for our customer base. And so we're able to combine our capabilities in the data center with Keysight for some really interesting opportunities across the board. We also see opportunities in 5G with a combination of Ixia and Anite, some great end-to-end solution opportunities that we're already engaging customers and we're even getting pull from the field on these opportunities. And then the last one is in IoT automotive and handheld, we have products that are meant to test Wi-Fi particularly for IoT. We're very well positioned in that space and we also have test products in automotive Ethernet and both of these areas are very strong for Keysight and Ixia and we have identified some potential combined product solutions that literally can be sold to the market now, as well as for future we have a small amount of R&D that we can apply to create something even more differentiated. So there's a lot of opportunity here and we're very excited about this. And we think that combined companies, both very strong companies, have a lot to offer in the market and can really make an impact. End of Q&A

Thank you. That concludes our question and answer session for today. I would like to turn the conference back to Jason Kary for any closing comments.

Thank you, Heidi. And on behalf of the management team, I’d like to thank everyone for joining us on the call today. If you have any questions, please call us at Investor Relations. Thanks again and have a great day.

This concludes our conference call. You may now disconnect.