Keysight Technologies (KEYS) Q2 2021 Earnings Call Transcript

Keysight Technologies (KEYS -0.14%)
Q2 2021 Earnings Call
May 19, 2021, 4:30 p.m. ET

Contents:

• Prepared Remarks
• Questions and Answers
• Call Participants

Prepared Remarks:

Operator

Good day, ladies and gentlemen, and welcome to the Keysight Technologies fiscal second-quarter 2021 earnings conference call. My name is Gabriel, and I will be your lead operator today. [Operator instructions] Please note that this call is being recorded today, Wednesday, May 19, 2021, at 1:30 p.m. Pacific Time.

I would now like to hand the conference over to John Kary, vice president, treasurer, and investor relations. Please go ahead, Mr. Kary.

Jason Kary -- Vice President, Treasurer, and Investor Relations

Thank you, and welcome, everyone, to Keysight's second-quarter earnings conference call for fiscal year 2021. Joining me are Ron Nersesian, Keysight's chairman, president, and CEO; and Neil Dougherty, our CFO. Joining us in the Q&A session will be Satish Dhanasekaran, chief operating officer; and Mark Wallace, senior vice president of global 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.

We will also make references to core growth, which excludes the impact of currency movements and acquisitions or divestitures completed within the last 12 months. You will find the most directly comparable GAAP financial metrics and reconciliations on our website. All comparisons are on a year-over-year basis unless specifically noted otherwise. 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. Lastly, I would highlight that management is scheduled to participate in upcoming virtual investor conferences hosted by JPMorgan, Stifel, Baird, UBS, and Bank of America.

And now I will turn the call over to Ron.

Ron Nersesian -- Chairman, President, and Chief Executive Officer

Thank you, Jason, and thank you, everyone, for joining us. Keysight delivered a record quarter, and we are entering the second half of the year with momentum. Our broad portfolio of differentiated solutions continues to drive growth across a diverse set of growing markets. Today, I'll focus my comments on three key headlines.

First, we delivered outstanding Q2 results with all-time record orders, revenue, and free cash flow. Second, Keysight is enabling leading-edge disruptive innovation around the world. Our solutions have significant differentiation and contribute significant value to customers, which is fueling our growth for the long term. Third, while we are managing longer lead times and component availability, our leading market position, strong customer relationships, and supply chain resiliency gives us the confidence in our ability to deliver on our commitments.

Now let's take a deeper look across our second-quarter performance across both business segments. Record orders of $1.3 billion grew 22%. Revenue grew 36% to $1.2 billion, which was an all-time high. We delivered second-quarter gross margin of 64%, operating margin of 26%, and earnings of $1.44, which was above the high end of our guidance and represents 85% year-over-year earnings growth.

We also achieved record free cash flow of $369 million. Over the last 12 months, Keysight generated just over $1 billion of free cash flow that we've deployed through approximately $500 million in acquisitions and $455 million in share repurchases. We continue to be active and disciplined in our capital deployment. Second-quarter strength was broad-based with double-digit order and revenue growth across all markets and regions.

Outstanding results by both business segments demonstrate the power of Keysight's diversified portfolio in 5G and beyond. Our electronic industrial solutions group achieved its third consecutive quarter of record revenue with strong double-digit order and revenue growth in general electronics, semiconductor, and automotive. The breadth of our contributions across multiple industries is exemplified by our double-digit order and revenue growth in our general electronics business. With ongoing investment in broad digital transformation, including advanced consumer electronics, digital healthcare, and industrial IoT, Keysight is enabling innovation and capturing technology inflections for the IoT ecosystem.

Strong demand for our semiconductor solutions drove record orders and revenue. Customer investment in advanced technology nodes remains high, while capacity is expanding for mature processes to address surging global semiconductor demands. In automotive, record orders resulted from improved macro conditions and increasing investments in EV and AV technologies. Keysight solutions portfolio for the automotive market continues to expand with new advanced technologies such as AC power emulation, millimeter wave radar, power semiconductor technology, automotive ethernet, C-V2X, and cybersecurity software systems.

As the reinvention of automotive ecosystems continues, Keysight is enabling the disruptive innovation of new mobility technologies. Our communications solutions group achieved record orders and delivered double-digit order and revenue growth in commercial communications and aerospace defense and government. Aerospace, defense, and government revenue grew 46%, driven by strong demand in space, satellite, signal monitoring, 5G, and early 6G research applications. Keysight's engagement with key industry players remains strong.

We recently enabled a large prime contractor's first testbed and have secured multiple 5G solutions wins in the aerospace, defense, and government markets. Commercial communications orders and revenue both grew double digits, driven by the ongoing investments in 5G and 400 gig, 800 gig Ethernet solutions for data centers. As 5G progresses and deployments drive sustained investment, we are uniquely positioned to capture the opportunities ahead as the ecosystem scales. Recent engagements include a broadening set of new customers, as well as key industry players such as NEC, Fujitsu, and MediaTek.

We continue to maximize the 5G life cycle opportunity and lead the industry with differentiated 5G solutions. In addition, the success of our application layer strategy is reflected in the strong demand for new technologies such as O-RAN and business expansion in new end-to-end verticals. Our ability to provide complete solutions for network protocol test, security, and visibility is enabling us to solve many challenges across the industry. In another area of disruption, we continue to advance our long-term initiative to enable the quantum revolution.

We are growing our quantum engagements with key customers worldwide. We also expanded our quantum solutions portfolio this quarter with the acquisition of Quantum Benchmark, which brings deep expertise in the performance validation software for quantum computing. Keysight's software-centric solutions in higher-value services continue to drive differentiation and recurring revenue growth. For the second quarter in a row, software and services each delivered double-digit order and revenue growth.

Beyond innovation, execution, and financial discipline, Keysight's culture has long embraced corporate social responsibility. We believe our focus on climate and diversity provides us with a competitive advantage. We recently published our annual CSR report, which includes progress toward our prior goals and the announcement of our commitment to achieving net-zero emissions in the company operations by 2040. We are working to set interim science-based targets to ensure our progress toward this goal.

Diversity and inclusion are also embodied in our Keysight leadership model. As a CEO priority, we have specific goals and actions that will be tracked by our leadership team and the Board of Directors. Diversity and inclusion brief will be published this month that describes our long-standing D&I philosophy, as well as the details of our strategies and goals. While there is more work to do, Keysight remains steadfast in our commitment to CSR and building a better planet.

As we look ahead, we are encouraged by the strong demand for our differentiated solutions while managing the longer lead times and component availability constraints. Our in-house high-performance semiconductor fab and the strength of our order fulfillment team are helping us manage these near-term supply challenges and give us confidence in our ability to navigate them entering the second half of this year. In summary, Keysight is enabling disruptive innovation across multiple waves of technology with a decades-long runway ahead of us. Our execution in the face of many dynamic challenges this past year is a testament to the Keysight leadership model, our employees, and the breadth and depth of our customers.

Now I would like to turn it over to Neil to discuss our financial performance and outlook in more detail.

Neil Dougherty -- Chief Financial Officer

Thank you, Ron, and hello, everyone. As Ron mentioned, the Keysight team delivered another outstanding quarter and better-than-expected results as robust demand for our differentiated solutions and continued macro recovery resulted in strong growth across all regions. Second-quarter revenue of $1.22 billion was above the high end of our guidance range and grew 36% or 33% on a core basis versus a soft compare due to COVID-related disruption. Q2 revenue growth was driven by broad strength across all markets and geographies as the Keysight team navigated macro-dynamics and supply chain constraints.

We achieved second-quarter orders of $1.332 billion, up 22% or 19% on a core basis. Turning to our operational results for Q2. We reported gross margin of 64%, which increased 170 basis points. Operating expenses of $467 million were well managed, resulting in operating margin of 26%.

As discussed last quarter, variable pay expense increased approximately $30 million sequentially as a result of higher revenue growth and operating margin. We achieved net income of $270 million and delivered $1.44 in earnings per share, which was above the high end of our guidance. Our weighted average share count for the quarter was 187 million shares. Moving to the performance of our segments.

Our communications solutions group achieved second-quarter revenue of $877 million, up 34% while delivering gross margin of 65% and operating margin of 25%. Commercial communications orders and revenue in the second quarter were all-time highs. Revenue of $606 million increased 30%, driven by continued investment across the 5G life cycle. Aerospace, defense and government revenue of $271 million grew 46%, resulting from strong demand across all regions, primarily in the U.S.

and Asia Pacific, followed by a strong recovery in Europe. The electronic industrial solutions group generated record revenue of $344 million, up 42% or 37% on a core basis. Order and revenue strength was notable across all regions, particularly in Asia Pacific. Semiconductor, general electronics measurement, and automotive solutions orders and revenue all grew strong double digit.

EISG reported gross margin of 64% and operating margin of 28%. Moving to the balance sheet and cash flow. We ended our second quarter with approximately $2 billion in cash and cash equivalents and reported cash flow from operations of $402 million and free cash flow of $369 million or 30% of revenue. Our capital allocation priorities are unchanged and are focused on investments in organic growth, value-creating acquisitions, and share repurchases.

Under our share repurchase authorization during the quarter, we acquired 1.59 million shares on the open market at an average price of $138.36 for a total consideration of $220 million. Now turning to our outlook and guidance. We expect third-quarter 2021 revenue to be in the range of $1.205 billion to $1.225 billion, which represents 20% revenue growth at the midpoint. We expect Q3 earnings per share to be in the range of $1.39 to $1.45 based on a weighted diluted share count of approximately 187 million shares.

In closing, we are entering the second half of the year with strong momentum. We are pleased with our operational execution and remain confident in our ability to drive growth and deliver on our commitments. With that, I will now turn it back to Jason for the Q&A.

Jason Kary -- Vice President, Treasurer, and Investor Relations

Thank you, Neil. Gabriel, will you please give the instructions for the Q&A?

Questions & Answers:

Operator

[Operator instructions] Your first question will come from Mehdi Hosseini, Susquehanna. Please go ahead.

Mehdi Hosseini -- Susquehanna International Group -- Analyst

Yes, thanks for taking my question. Neil, both segments, CSG and EISG, had sequential increase in revenue, but operating margin declined. Can you elaborate, is that due to the ongoing COVID costs, and what else is impacting? And then where are we in the evolution of millimeter wave? And when is Keysight's expectation for millimeter wave to go from like R&D into full production? Thank you.

Neil Dougherty -- Chief Financial Officer

Yeah, Mehdi. Hey, thanks for the question. So yeah, you're correct. And as I had indicated last quarter, we were expecting a very sizable sequential increase in our variable pay expense in Q2 relative to Q1.

Given that one of the primary drivers of that payout is organic revenue growth, and we had the soft revenue comp a year ago because of the COVID disruption. So we saw about a $30 million sequential increase in variable pay as a result of that. And then I'll hand it over to Satish and he can address your millimeter wave question.

Satish Dhanasekaran -- Chief Operating Officer

Yes. Hi, Mehdi. You know, as we have said before, you know, millimeter wave is a long-term opportunity for Keysight. We are already seeing a pretty steady business for millimeter wave offerings from our customers for the past few years.

So we expect it to continue to grow. Again, we're on the front end of something that's going to play out over the next decade because of the progression in millimeter wave spectrum from 20 to 40 to 70 to 90 gigahertz. And then with 6G coming in with terahertz, so there is a big long-term road map that's playing out. Specific to your question on 5G, maybe I can offer a data point.

If you think of the certification being a critical parameter for 5G devices, about 150 devices are being certified right now. About 30% of them have millimeter wave in it. So, you know, that paints the picture, hopefully. And the total number of 5G devices right now that are being released is about 700.

So it sort of gives you maybe a framing on where we are. It's still very early days.

Mehdi Hosseini -- Susquehanna International Group -- Analyst

Thank you.

Operator

Your next question will come from Samik Chatterjee of J.P. Morgan. Please go ahead.

Joe Cardoso -- J.P. Morgan -- Analyst

Hi. Yes, this is Joe Cardoso on for Samik Chatterjee. I just wanted to follow up on the last question, particularly around the supply chain issues that have been impacting companies industrywide. I guess just a clarification on my part.

You know, in this quarter, did you see an impact from supply issues on your top line and margins? And if so, what was the impact -- can you quantify the impact? And then relative to the guidance, are you guys baking in any headwind, material headwinds on the top line, or margins? Thank you.

Ron Nersesian -- Chairman, President, and Chief Executive Officer

Hi, this is Ron. As you know, in the last quarter, we exceeded our revenue guidance. And you've seen our guide for the next quarter, very pleased with the performance and how we've been able to deliver the revenue despite what's going on in the world. Of course, we see some COVID manufacturing decreases in capacity, as well as some supply chain components shortages.

However, we planned ahead. We fought for those. And the most important part is that when you look at custom ICs, which have a very, very long lead time for many folks in the industry, we have an on-site fab that creates and produces all of our custom ICs. So that enables us to basically have complete control of that supply chain for the critical custom parts.

We're very confident in the guide that we have. But there's no doubt that we have built backlog and our order book is strong. So as the world situation unravels, we could increase revenue even more and more in the future.

Operator

Your next question will come from John Pitzer of Credit Suisse. Please go ahead.

John Pitzer -- Credit Suisse -- Analyst

Yeah, good afternoon, guys. Congratulations on a strong quarter. Ron, I'm just kind of curious, with the recent C-band auctions in the U.S. now behind us, can you help me better understand how that kind of impacts your view on your comms business as we go throughout the balance of this year? And as you do that, I'd be kind of curious as to the sort of geographic distribution specifically.

As you think about next quarter and beyond, how much more important is China? Or are you actually starting to see things percolate in the U.S. and beyond?

Satish Dhanasekaran -- Chief Operating Officer

Yeah, John, you know, it's a good question. With regard to the deployment scenarios globally, you know, as we all know, China started to lead the 5G deployments. And with the C-band auction coming in, the major announcements from the U.S. operator referencing a road map to deploy more 5G in the country, we view it as a positive.

We saw an uptick of our -- in our business in the U.S., specifically for capabilities in the C-band this quarter, and we view the funnel and pipeline to be strong there. But again, not to get too siloed on one spectrum, because at the end of the day, our customers are looking to test for creating devices and products that cater to the global marketplace. And right now, we have 9,000 different band combinations that our customers have to test for eventually. And today, they're testing 2,000.

So -- and we're enabling all our customers who are staying in the lead, and we feel good about our position there.

John Pitzer -- Credit Suisse -- Analyst

And then just quickly, Neil, on the variable comp, was this quarter a particularly sort of step-up quarter? And how do we think about kind of the growth in variable comp from here as you guys continue to execute?

Neil Dougherty -- Chief Financial Officer

Yeah. So I mean, this quarter wasn't unusual. Obviously, we delivered, you know, 36% revenue growth. That's the total.

There was some of that was, it was inorganic. But with those high levels of revenue growth, it drives our variable compensation toward the high end of the -- of what is possible. I think as you look forward next quarter, we still have a reasonably soft comp. We're guiding into the kind of low 20% range, which is still quite aggressive growth and it's going to see variable comp high again in Q3.

Not quite as high as Q2, but still quite elevated. And then we start to get to more normalized comps here in the first year and a little bit more of a return to normalized levels.

John Pitzer -- Credit Suisse -- Analyst

Well, that's helpful, guys, and congratulations.

Ron Nersesian -- Chairman, President, and Chief Executive Officer

Thanks very much, John. And please note that the comp that we're talking about, the variable comp is for all employees in Keysight. And that is paid. One big factor is revenue growth, and you saw our revenue growth number, which is driving that near the extreme limit.

Operator

Your next question will come from John Marchetti of Stifel. Please go ahead.

John Marchetti -- Stifel Financial Corp. -- Analyst

Thanks very much. I was wondering if you could just comment a little bit on the Malaysian operations that you guys have. Obviously, with some of the surges that we're starting to see, particularly in Southeast Asia, if there's concerns there on your side, you know, that you may have to slow some things down there from your own manufacturing standpoint.

Ron Nersesian -- Chairman, President, and Chief Executive Officer

No, our manufacturing is very well distributed. We have the largest test and measurement factory in the world in Penang, Malaysia, but we also have facilities that do development, early production runs, as well as produce certain products in Europe, as well as in the U.S. But the bulk of it is overseas. We don't manufacture anything of scale in China.

So that's not an issue to us. And Penang seems to be in a very good position to capitalize on any type of regional shift.

John Marchetti -- Stifel Financial Corp. -- Analyst

Got it. And then maybe just a quick follow-up regionally. When we think of the China business overall, you mentioned some of the uptick on the semi side as you're seeing some of the increased capacity, not just there but elsewhere coming in. But any change that you've seen relative to some of the language or what's going on in China, just given the bit of exposure that you have across the portfolio there.

Ron Nersesian -- Chairman, President, and Chief Executive Officer

No. We actually saw, you know, strong order results and order growth, as well as revenue growth. Mark will tell you a little bit more about it. We did have about three points of headwind from Huawei, where this is really, you know, the second to last quarter that we expect to have that.

But despite that, we had very strong order and revenue growth. And I'll let Mark, our Head of Sales, give you a little more color.

Mark Wallace -- Senior Vice President of Global Sales

Yeah. Thank you, Ron. John, it is another quarter where we've mitigated the impact from the headwinds, as Ron said, about three points during the second quarter. And we pivot to other opportunities and other customers.

It really exemplifies the breadth and strength of our business, as well as the investments we've made in our direct sales organization there. And we're seeing strong opportunities and growth across China in semiconductor, 5G commercial space. Automotive is really starting to pick up, and then general electronics as well. So I'm very pleased with what we've seen.

We've got one more quarter in Q3 with some headwinds, but the bottom line is our business in China is strong with this broad footprint of customers.

John Marchetti -- Stifel Financial Corp. -- Analyst

Thanks for the color.

Ron Nersesian -- Chairman, President, and Chief Executive Officer

Yeah, John, I'd just like to point out the fact that Xiaomi was effectively -- the trade restrictions were loosened, is a positive sign for us. Not so much the account of Xiaomi, but the fact that there is some progress that is being made.

John Marchetti -- Stifel Financial Corp. -- Analyst

Got it. Thank you, Ron.

Ron Nersesian -- Chairman, President, and Chief Executive Officer

You're welcome.

Operator

The next question will come from Mark Delaney of Goldman Sachs. Please go ahead.

Mark Delaney -- Goldman Sachs -- Analyst

Yes. Good afternoon, and thanks very much for taking the question. I think in the last earnings call, the company had talked about the potential for EPS this fiscal year to grow in the mid- to high teens range. And through the first half of the year and with guidance for fiscal 3Q, you're tracking very well relative to that.

So hoping to better understand if, you know, you're still expecting that sort of a mid- to high-teens growth rate and we need to be thinking about potentially a slower fiscal fourth quarter. So what would be the cause of that? Or perhaps there's now some upside to the prior commentary around EPS growth this year.

Neil Dougherty -- Chief Financial Officer

Yeah. Mark, I don't have a specific update for you to that prior number. But obviously, you know, we exceeded the high end of our guidance range here in the second quarter. And you've seen our guide for Q3.

So I think, you know, at the margin, things are trending a little bit better than they were when we made that statement three months ago. And -- but I don't have a specific update for you at this point in time.

Mark Delaney -- Goldman Sachs -- Analyst

OK. Understood. I will turn it over. Thank you.

Operator

Our next question will come from Adam Thalhimer of Thompson Davis. Please go ahead.

Adam Thalhimer -- Thompson Davis & Co. -- Analyst

Thanks. Great quarter, guys. Hey, just quickly, there was another expense in the quarter. Just curious what that was because it did detract from the Q2 performance, it looks like.

Neil Dougherty -- Chief Financial Officer

Yeah. We did have -- we did a modification to our pension schemes in the Netherlands and had some settlement expense as a result as we transferred those liabilities to an insurance company.

Adam Thalhimer -- Thompson Davis & Co. -- Analyst

OK, thanks.

Operator

Our next question will come from David Ridley-Lane of Bank of America. Please go ahead.

David Ridley-Lane -- Bank of America Merrill Lynch -- Analyst

Good afternoon. So I definitely heard you on Keysight having its own supply chain under control. Other companies may be struggling a lot more than you and placing orders ahead of time, trying to make sure that they get the equipment that they need. So I'm wondering, are you seeing anecdotally any sign of pull forward on orders or maybe companies placing the order earlier that would have influenced your strong order growth this quarter?

Mark Wallace -- Senior Vice President of Global Sales

Yeah, this is Mark. No, we really didn't see any evidence of that. What we saw was some -- a little bit of pent-up demand from the impact of COVID last year, which we kind of expected it to somewhat offset the trade headwinds that we talked about earlier. We watch cancellations very closely.

They were at a record low for the quarter, and we're seeing, again, this steady, broad demand. So we have no signs thus far that there's any material pull-in of orders.

Neil Dougherty -- Chief Financial Officer

And David, if I could just add on, you know, I like your characterization of the, you know, vertically integrated supply chain potentially making us a little bit less susceptible to some of the supply constraints than maybe others are facing. You know, as I sit and look at it, you know, the challenges with regard to movement control and social distancing do make it a challenge to add capacity during these times. And so, you know, I've talked about in the past, our seasonality being more muted at least through the first part of the year. I think those things are going to really serve to keep that kind of muted seasonality in place really through the end of this fiscal year.

David Ridley-Lane -- Bank of America Merrill Lynch -- Analyst

Thank you very much.

Operator

Our next question will come from Jim Suva of Citigroup. Please go ahead.

Jim Suva -- Citigroup -- Analyst

Thank you very much, and congratulations on the results outlook and all the details so far. My question is, you know, there's lots of talk about double ordering and double booking, maybe from other industries like automobiles or consumer electronics or PCs and such. Or are you building in some conservatism for some double ordering or customers that may be, you know, putting in a little more orders due to the semiconductor shortage. Just kind of, kind of see if you're building in a little bit of conservatism or simply in the test and measurement industry do companies just not double order due to the lead times in specialty configurations needed?

Mark Wallace -- Senior Vice President of Global Sales

Yeah, Jim, this is Mark. As I said earlier, we do watch for this, and there's really no evidence. You know, our funnel is very strong now for many months as we continue to supply our solutions. The results, as you've seen, are very broad-based.

And unlike other industries, as you point out, oftentimes, the planning associated with customers procuring some of our systems and solutions can go out many months. So it really doesn't lend itself to that sort of double booking, if you will. If you look at semiconductor as one of our stronger segments, you know, we see activities that are a year or more out in preparation for outfitting a new fab or growing capacity, so it makes it very difficult to see any sort of hedging or double booking. And as I said before, we really aren't seeing that occur thus far.

Jim Suva -- Citigroup -- Analyst

That's what I thought. Thank you so much.

Mark Wallace -- Senior Vice President of Global Sales

You're welcome.

Operator

Our next question will come from Tim Long of Barclays. Please go ahead.

Peter Zdebski -- Barclays -- Analyst

Hi, this is Peter on for Tim. I was wondering if you could give us some color on how much of the double-digit order growth in Commercial communications was related to 5G versus the other businesses? And in particular, if you could talk a little more on the opportunity on the application layer side in light of some of these new deployments?

Satish Dhanasekaran -- Chief Operating Officer

Yes. So the commercial comps front, again, was broad. It covered both the wireless and wireline, so it's 5G on the wireless side and 400 gig on the wireline side as well. We also saw some recovery in our network visibility business as enterprises are planning for return to work and thinking about what that IT infrastructure spend looks like.

So those all looked favorable. So generally, a very positive dynamic. Specific to the application layer, we identified a few areas around the different end market verticals and new applications to focus on about a year ago, and that's paying rich dividends. On the new application front, it's the Open RAN, where it's an open virtualized network, bringing in new customers and more players into the ecosystem.

So we had strong demand for our solutions that we launched in Q1 and -- Quarter 1. And on the new vertical side, we gained traction with a lot of the aerospace and defense companies that are looking to invest in the DoD's 5G program. So both those are going very well. And when we look forward and look at the funnel for both these opportunities, they are very healthy, and they're very rich with customer -- strong customer collaborations that are building.

Peter Zdebski -- Barclays -- Analyst

That's great color. Thank you very much.

Operator

Your next question will come from Rick Eastman of Baird. Please go ahead.

Rick Eastman -- Baird -- Analyst

Thank you. Thanks again. And good quarter to be sure, and good work by the Keysight team there. Hey, just a question around maybe the backlog, and maybe let me just start for one second.

Again, it looks like you built backlog again and maybe my rough math says your backlog is up maybe 15% or so year over year. When you provided second -- or excuse me, third-quarter revenue guide, is the assumption that, you know, orders or your book-to-bill will be about 1.0? Or is there an assumption that you work off some backlog into that revenue guide for fiscal Q3?

Ron Nersesian -- Chairman, President, and Chief Executive Officer

Hi, Rick, this is Ron. You know, our assumption is that our book-to-bill will be about one. And we have strong backlog, and we expect to exit Q3 with strong backlog.

Rick Eastman -- Baird -- Analyst

OK. Is there a lengthening in your backlog in terms of deliveries? You know, obviously, another supply chain question, but is there a lengthening out? Or are you foreseeing some ability to clear some of that backlog in Q4 by year-end?

Neil Dougherty -- Chief Financial Officer

Yeah. I think the most important thing at this point, we feel like we are doing a good -- I'm sorry, I didn't have my microphone on. Sorry about that. I said I think the most important factor at this point is that we feel like we're doing a good job meeting the needs of our customers and getting them the product that they need in the timelines at which they need it.

And, you know, while we're not immune to some of the supply chain constraints that are out there, I think we're doing a good job managing them. We're benefiting from having to vertically integrated supply chain. And, you know, we are making investments to add capacity. Obviously, our revenues are going to be up substantially year over year, but not just because of the soft comps, very substantially over 2019 levels as well, and we'll continue to make the investments necessary that -- you know, to get products into the hands of customers.

Rick Eastman -- Baird -- Analyst

Thank you.

Ron Nersesian -- Chairman, President, and Chief Executive Officer

It's also worthwhile to note that if you look at software and you look at services, not only do they both have great double-digit order and double-digit revenue growth. We've seen more and more ARR, which is going to go into the backlog, and let's put it this way, slow a little bit how that peels off, but it will provide a great consistency of earnings as we go forward.

Neil Dougherty -- Chief Financial Officer

It's pointing north of $1 billion now. So that's great, great, yes, position to be in.

Rick Eastman -- Baird -- Analyst

$1 billion, OK. And then just a last follow-up here. Neil, on the guide for fiscal Q3, maybe the conversion -- is the conversion margin here, which I'm kind of calculating maybe low 20s, is that again reflective of variable comp step up here?

Neil Dougherty -- Chief Financial Officer

That's correct.

Rick Eastman -- Baird -- Analyst

OK, all right. Very good. Thank you. Thank you, again, and a tremendous quarter.

Ron Nersesian -- Chairman, President, and Chief Executive Officer

Thank you.

Operator

And your next question will come from Chris Snyder of UBS. Please go ahead.

Chris Snyder -- UBS -- Analyst

Thank you. I wanted to follow up on Satish's earlier comments, which if I heard right, that companies are currently testing 2,000 bands, and this is going to 9,000 bands. So more than a quadrupling of the testing. I guess the question is, how should we think about this, what it means for industry test capacity? I assume it's not a one-for-one relationship there.

But any color on that just higher level of intensity would be helpful.

Satish Dhanasekaran -- Chief Operating Officer

Yeah. I think it's band combinations. But you're right that the more frequency spectrum, you know, in a heterogeneous manner that gets deployed, the test intensity goes up. And if you think of a typical device maker or, you know, companies in the O-RAN space that are putting radio and CU components together and they have to do the testing, the amount of time they have to do the testing doesn't go up.

And so essentially, you know, some of the COVID restrictions, of social distancing and all that, essentially means that customers have -- are looking at ramping up capacity for the future. But it's a steady demand that gives us confidence in our long-term outlook for the business. That's just one dimension of capacity. The other ones being all of the complexity associated with Release 15 deployments and now with Release 16 ramping up, we have new capabilities to offer such as what you saw with our press release with MediaTek this quarter.

Chris Snyder -- UBS -- Analyst

I appreciate all that. And then I guess following up on the buyback. You know, you guys bought back a lot more shares this quarter than just kind of been the historical run rate. I guess going forward, you know, is it fair to assume that the majority of free cash is going to go to share repurchase, assuming there's no M&A? I guess the question is, is like this $2 billion cash kind of balance, you know, the right maybe go-forward run rate to model and put everything excess into share repurchase until, you know, M&A starts coming through until we see M&A come through?

Neil Dougherty -- Chief Financial Officer

I think you've seen a pretty balanced use of capital from us. As we mentioned in our prepared comments, we generated $1 billion of cash over the last four quarters. We spent $500 million on M&A, just under $500 million on share repurchase. You know, and I would expect you continue to see balance as we look to invest in the future growth of our business.

I think specifically as it relates to share repurchase, we've committed to at least being anti-dilutive with our buyback program. But we've proven, you know, with significant buybacks both in Q4 of last year, as well as in Q2 of this year, that when appropriate, we'll step up and be more aggressive.

Chris Snyder -- UBS -- Analyst

Thank you.

Operator

Your next question will come from Matthew Niknam of Deutsche Bank. Please go ahead.

Unknown speaker -- Deutsche Bank -- Analyst

Hi, guys. This is Nick on for Matt. Congrats on the quarter. Just two quick ones.

So first on free cash flow, came in really strong this quarter. I was just wondering if you guys could provide a little bit more color on that. And kind of how free cash flow should trend moving forward? And then just the follow-up would be, obviously, some other guys or some other companies are seeing tighter gross margins because of the supply chain issues and inflation, etc. And so what are we -- your margins are really stable here.

Is that because of the in-house fabrication? Any color there would also be really helpful. Thanks.

Neil Dougherty -- Chief Financial Officer

Yeah. So let me take those questions. First of all, with regard to our free cash, obviously, we're very, very pleased with the cash generation of the business. Cash penetration was unusually strong here in the second quarter.

I think there are a couple of drivers of that. One is the increasing, you know, deferred revenue balance as a result of our push into software and services and building recurring revenue. So that's a great long-term trend. And there's one significant timing difference, which we've already talked about.

And that has to do with the variable pay. Obviously, we've recruited that variable pay based on what was earned here in the second quarter, but that will not hit the paychecks of our employees until Q3. And so there'll be a bit of reversal of that over the course of a couple of quarters because we expect accruals to be high here in the third quarter as well. As it looks to gross margin, you know, we are seeing, in some cases, you know, some increasing input costs.

But as we've said, most of our highly differentiated ICs are manufactured in-house. I think that helps shield us. I think long term if you look at our business, you know, the push that we have, again toward increasing software content, increasing recurring revenue, the migration of business into selling into our customers' R&D labs, the move toward complete solutions that are more highly differentiated, all of those things are helping to drive the gross margin performance that you've seen in this business over a number of years, right? At the time of our spin, we were in the mid- to upper 50s, and now we're in the mid-60s. And so I think we've got a lot of great momentum in that space.

And as we continue to build software in our solutions portfolio, I think there's still room for further improvement.

Operator

Your next question will come from Brandon Couillard of Jefferies. Please go ahead.

Brandon Couillard -- Jefferies -- Analyst

Hi, thanks. Good afternoon. Ron, the strength in aerospace and defense was pretty impressive. Could you just talk about how you're feeling about the durability of that current momentum? And how would you characterize the degree of visibility in terms of the funnel there relative to history?

Mark Wallace -- Senior Vice President of Global Sales

Yeah, Brandon, this is Mark. You know, as we've said, we've had an ongoing focus on aerospace defense and aerospace defense, both in the U.S. and around the world. The orders that we saw during the quarter were very strong across Western Europe as we saw increased program funding.

Business in Asia was up. We had several strategic wins as was mentioned earlier for 5G. So the long-term growth drivers are really remaining in place around the whole defense modernization with space and satellite with the addition of 5G. And we are continuing to see our funnels continue to grow as these investments continue.

So growth across multiple regions and strengths in the next-generation technologies as they're going to be deployed over, really many years.

Brandon Couillard -- Jefferies -- Analyst

One more in-market question --

Satish Dhanasekaran -- Chief Operating Officer

Yeah. One more point to Mark. You know, the Biden administration has just released their first pass-through budget for '22, and it actually points to a higher number. That combined with any other potential technology spend from the administration, we view as a favorable dynamic.

Brandon Couillard -- Jefferies -- Analyst

Got you. And then just switching gears. In terms of the auto market, it's been soft for a few quarters now. Do you feel like that space is finally may be beginning to start to turn the quarter, in terms of investments in sort of next-gen programs?

Satish Dhanasekaran -- Chief Operating Officer

Yeah. You know, the automotive market had a very solid quarter in Quarter 2. And is driven by some return to normalcy for manufacturing. And I know that as the automotive end market production is projected to increase in the second half, that should be a favorable dynamic for the business.

But consistent with what we saw even through last year, the demand for R&D offerings in auto continues to be steady. We actually saw an uptick in that, especially around EV and AV. And our funnel for the automotive EV offerings that we have is very strong looking into the second half. We just launched solutions to solidify our EV portfolio in charging test, and we continue to see a long runway for those offerings.

Brandon Couillard -- Jefferies -- Analyst

Great, thanks.

Operator

Thank you. And that concludes our question-and-answer session for today. And now I'd like to turn the conference back over to Jason Kary for any closing remarks.

Jason Kary -- Vice President, Treasurer, and Investor Relations

Well, thank you all for joining us today. We look forward to speaking with you at the upcoming conferences and just wish you a good day. Thank you.

Operator

[Operator signoff]

Duration: 45 minutes

Call participants:

Jason Kary -- Vice President, Treasurer, and Investor Relations

Ron Nersesian -- Chairman, President, and Chief Executive Officer

Neil Dougherty -- Chief Financial Officer

Mehdi Hosseini -- Susquehanna International Group -- Analyst

Satish Dhanasekaran -- Chief Operating Officer

Joe Cardoso -- J.P. Morgan -- Analyst

John Pitzer -- Credit Suisse -- Analyst

John Marchetti -- Stifel Financial Corp. -- Analyst

Mark Wallace -- Senior Vice President of Global Sales

Mark Delaney -- Goldman Sachs -- Analyst

Adam Thalhimer -- Thompson Davis & Co. -- Analyst

David Ridley-Lane -- Bank of America Merrill Lynch -- Analyst

Jim Suva -- Citigroup -- Analyst

Peter Zdebski -- Barclays -- Analyst

Rick Eastman -- Baird -- Analyst

Chris Snyder -- UBS -- Analyst

Unknown speaker -- Deutsche Bank -- Analyst

Brandon Couillard -- Jefferies -- Analyst

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