National Instruments (NATI) Q2 2022 Earnings Call Transcript

National Instruments (NATI)
Q2 2022 Earnings Call
Jul 28, 2022, 5:00 p.m. ET

Contents:

• Prepared Remarks
• Questions and Answers
• Call Participants

Prepared Remarks:

Operator

Good day, ladies and gentlemen. Thank you for standing by, and welcome to the second quarter 2020 NATI earnings conference call. [Operator instructions] Please be advised that today's conference may be recorded. I would now like to turn the conference over to your speaker host, Marissa Vidaurri, head of investor relations.

Please go ahead.

Marissa Vidaurri -- Head of Investor Relations

Good afternoon. Thank you for joining our Q2 2022 earnings call. I'm joined today by Eric Starkloff, president and chief executive officer, and Karen Rapp, chief financial officer. We will start with an update on our performance in the quarter before opening it up to your questions.

Our discussion today will include forward-looking statements, including, without limitation, those regarding the company's expectations of meeting or exceeding financial targets, its capital allocation, financing and investment plans, the payment of its quarterly dividend and its future business outlook and guidance, including demand for its products, ability to realize revenue from backlog, future results of acquired companies and execution of growth strategy. We wish to caution you that such statements are just predictions and that actual events or results may differ materially and could be negatively impacted by numerous factors. We refer you to the documents that the company files regularly with the Securities and Exchange Commission, including the company's annual report on Form 10-K filed on February 22, 2022. These documents contain and identify important factors that could cause our actual results to differ materially from those contained in our forward-looking statements.

We assume no duty to update any forward-looking statements to conform the statement to actual results or changes in our expectations. A reconciliation of our non-GAAP financial measures disclosed in this call to the most directly comparable GAAP financial measures or related disclosures are contained in our press release and on ni.com/nati. You can find the press release and quarterly presentation to supplement today's discussion on our website at ni.com/nati. On May 5, we announced the closing of our acquisition of the test systems business of Kratzer Automation AG.

We believe that this investment, along with others we have made in this space will help accelerate our ability to serve customers in the high-grade area of vehicle electrification. We view this acquisition as a tuck in that will contribute to our software technology road map and puts us in a leadership position for vehicle electrification test systems. We purchased this business for approximately $57 million, and we funded the transaction with cash drawn under our existing revolving credit facility in connection with the acquisition of approximately 200 employees joined NI. As is our annual tradition, we will host an investor conference in September with more details to be shared in the coming weeks.

In addition, management will also be hosting meetings at the Goldman Sachs Conference in September and the Baird Conference in November. We look forward to seeing you there. With that, I will now turn the call over to our chief executive officer, Eric Starkloff.

Eric Starkloff -- President and Chief Executive Officer

Thank you, Marissa. Good afternoon. We appreciate everyone joining us today. I'm really pleased with our performance this quarter.

Our focus on areas where we exhibit competitive strength is exceeding our expectations, and we continue to drive strong momentum in customer demand, delivering record Q2 orders, revenue and non-GAAP earnings per share. The key takeaways for Q2 are order growth of 20% year over year and revenue up 14% year over year. Our focused strategy is leading to ongoing share gains. Earnings growth up 15% year over year in the first half, enabled by expense discipline even as we navigate unprecedented short-term pressure on margins due to supply chain constraints.

And we are reiterating our expectations for revenue in 2022, as well as our expectations to meet or exceed our guidance of 100 basis points of non-GAAP operating margin expansion each year from 2022 to 2025. We view this as a foreign expectation and expect to deliver well above this level in 2023. I will comment specifically on our 2023 expectations later in the call. Before Karen discusses the financial results for the second quarter, I want to address a few key topics, including potential future headwinds in our industry, why we believe we are performing well in the current landscape, our industry results in the quarter and a preview of our expectations for 2023.

First, let's discuss potential headwinds in more detail. The outlook on our markets is mixed. On the supply side, the challenges in global supply chains continued in Q2. The shortages of certain components limited our ability to ship product in line with very strong demand.

However, these constraints did not get meaningfully worse from last quarter, and we are now in a better position to navigate this short-term headwind. I'm confident the decisions we've made over the past several months, including increasing prices, adding new suppliers, promoting alternative products and redesigning products to use available components with similar capability are positioning us well to succeed in the current environment. In addition, the combination of our purchasing efforts and some loosening in these supply chains has the potential to drive financial tailwinds into 2023. Turning to the macro.

While our demand remains robust, we acknowledge the likely softening of the macro environment compared to a very strong environment in 2022 and are anticipating and even planning for this headwind, particularly in elements of our portfolio and semiconductor businesses. Despite these potential macro headwinds, we believe that our intentional focus on higher-growth markets, very strong bookings growth over the last six quarters, record backlog position, growing recurring revenue and the steps we've taken to manage our expenses give us the ability to achieve significant revenue and earnings growth even in a potential down cycle. We believe our strong performance over the last several quarters is directly correlated to the strategic shifts we've made in our business to drive growth. Our highly differentiated modular hardware and industry standard automation software align well to the critical customer needs in segments with powerful growth drivers, including electric and autonomous vehicles, wireless communication and new space technology.

Our order growth of 22% year over year through the first half and over 50% over the first half of 2020 is both a leading indicator of our business, and a proof point to the success of this strategy. Now, on to results by industry for the second quarter. Across the industries we serve, we have honed our strategy to focus on top accounts. to increase our share of wallet, ensure operational efficiency and better target our offerings to key customers.

In return, we've seen an increase in program wins and standardization on NI technology, as well as expansion of cross-workflow opportunities from R&D to production tests, further increasing our served available market. Semiconductor and electronics reported all-time record Q2 revenue of $116 million, up 17% year over year, with orders up 10% year over year. Though we expect some future slowdown in the growth of our semiconductor business, we believe the areas that we are focused on, wireless, mixed signal and industrial, will remain much more robust than consumer devices. In particular, the needs of the wireless market will continue to drive demand for test capability for wireless infrastructure, including millimeter wave.

As we've noted before, approximately 50% of our semiconductor and electronics business unit revenue comes from production tests. And the other half of this segment is in R&D, which is considerably less exposed to the fluctuations of the semi cycle. In fact, we have been intentionally forward investing in standardized automated test systems for R&D validation, as well as supporting the semi industry's large fab investments and expect these areas to be ongoing growth drivers. One of the biggest challenges that wireless device makers face is the sheer complexity of wireless devices, which drives up validation time.

Our technology enables customers to get their products to market faster by reducing this time. For example, at Qualcomm, we enabled a reduction in measurement time for validation systems of 40%. This team also uses NI software and data analytics across their workflow and is a lead user on our next-generation millimeter wave test technology. We believe the combination of our exposure to R&D test and our ongoing progress in delivering software across the semiconductor workflow will soften the impact that a semiconductor downturn will have in our business.

Transportation reported record Q2 revenue of $66 million, up 35% year over year with orders up 62% year over year. Our strategic shifts in focus to EV and ADAS where our customers are making significant investments has changed the trajectory of this business, and we expect that we will continue to deliver market-leading growth rates. In Q2, EV and ADAS represented approximately 40% of our transportation business, and we expect will exceed 50% of our transportation business by the end of this year. One recent success is at GM for their partnering with NI and our data management and analytics platform to allow them to connect all of their battery test data and quickly develop the insights they need to bring their battery technology to market at scale.

Aerospace, defense and government delivered outstanding results with record revenue for Q2 of $100 million, up 15% year over year, with orders up 25% year over year. Our growth here continues to be fueled by defense spending, and the current demand backdrop in this area is healthy and along with our growing relationships and top ADG accounts gives us confidence in the continued growth of this business. We also continue to see rapidly accelerating opportunities in new space technologies, including launch vehicles and satellites. And our portfolio business, which serves the majority of our broad-based customers, achieved revenue in Q2 of $113 million, up 2% year over year with orders up 6% year over year.

As I mentioned earlier, this is an area we think is most susceptible to a softening macro environment. Our focus on utilizing global distribution to better position our offerings and optimizing our digital channel to these broad customers have gained traction, further providing leverage and scale in this portion of our business. Today, distribution represents 15% of total orders to the company, up from 10% last year. Longer term, we expect our transition to software subscription will improve the resiliency and growth opportunity for this business.

Across the industries we serve, our business is well-positioned to both R&D validation and in production tests. We estimate across industries that approximately 60% of our business is in R&D and 40% in production. Our software and data analytics platform enable us to uniquely deliver value across these two areas and gain more share of wallet at key accounts. Now, look ahead to 2023.

We remain confident in our ability to meaningfully increase our operating margins. It's a top priority for me and my team, and there are many key initiatives underway to ensure we deliver on our commitments to expand margins. This includes channel optimization, increasing share of wallet at top accounts, driving scale and leverage in our broad-based customers, increased R&D efficiency and G&A cost management. We are committed to achieving an increase of our non-GAAP operating margin of 100 basis points each year from 2022 through 2025 with potential for upside should our revenue and share growth continue to exceed our expectations.

In fact, even though we are currently planning for a weaker macro entering 2023, we expect to deliver revenue growth on the order of 2022's growth rate, an operating margin well above our previous expectation with approximately a 300 basis point increase over 2022. There are several factors that we believe will drive our performance. Our exposure to key growth opportunities in secular cycles, particularly in transportation and ADG. Our expectation for strong backlog entering 2023, favorable gross margin impacts as supply chain pressures ease, the growing impact of recurring revenue and the full year impact of our expense management focus.

We plan to walk through these elements to our model and discuss our three-year strategic plan at the investor conference that Marissa mentioned, and I hope to see you all there. With that, I'll turn it over to Karen to discuss Q2 results in more detail and our outlook for Q3. Karen?

Karen Rapp -- Executive Vice President and Chief Financial Officer

Thanks, Eric. Hi, everyone. In Q2, our GAAP revenue was $396 million, up 14% year over year and ahead of the midpoint of our guidance. The strong dollar had a negative impact to revenue of approximately 2% in Q2.

Core revenue growth, including the benefit from price increases, was up approximately 13% for Q2. Approximately 3% of Q2 revenue growth was from our recent EV acquisitions. The Kratzer test systems business, combined with the previous acquisitions of NH Research and Heinzinger accounted for approximately 17% of transportation revenue in the second quarter. We're pleased with the strong customer demand and revenue synergies that we are seeing from the integration of these companies with NI.

Demand remained strong in Q2 with orders up 20% year over year. For the second quarter, orders were up 33% year over year in the Americas, up 7% year over year in EMEA and up 16% year over year in Asia Pacific. We ended the quarter with backlog of approximately $250 million, up about $40 million sequentially. We continue to have competitive lead times of approximately eight weeks as demand continued to exceed our expectations and supply chain constraints persist.

We firmly see the growth in backlog as a revenue timing issue only. Our confidence in customer demand and our ability to eventually realize this revenue when the supply chain disruptions ultimately ease, remains strong. Because our solutions are often a capital expense and provide unique capabilities for our customers, we do not typically incur any double ordering risk, and we have not seen anything that would indicate a change to that historic pattern. Q2 non-GAAP gross margin was 71%, down 4% year over year driven by broker pricing for difficult-to-find components as we continue to prioritize the needs of our customers.

We expect these temporary headwinds to continue through the second half of the year while the supply chain constraints persist. However, we saw some improvement in our ability to procure components from our traditional suppliers in Q2 and anticipate a sequential decline in broker buys in Q3. We expect to reduce broker purchases to benefit our 2023 margin. In Q2, we generated $21 million of GAAP operating income and $61 million of non-GAAP operating income.

Our non-GAAP record for a second quarter, translating into a non-GAAP operating margin of 15% for the quarter. We reported Q2 GAAP net income of $12 million and diluted earnings per share of $0.09. We reported record Q2 non-GAAP net income of $48 million and record diluted non-GAAP earnings per share of $0.36, an increase of 3% year over year. Now, let me comment on capital management.

Our balance sheet remains strong with $111 million of cash at the end of the second quarter. Cash flow from operations was minus $41 million in the second quarter, driven primarily by $36 million of inventory growth, as well as the timing of revenue in the quarter. As anticipated in Q2, we continued to invest in inventory to enable us to ship systems to customers as soon as the final components are available. In Q3, we expect a net pre-tax cash inflow of approximately $31 million.

This represents the proceeds from the sale of unused property, offset by a contribution to our donor-advised fund to support our corporate impact. The income statement impact is included in our GAAP guidance. We expect our inventory position to turn into a tailwind for future cash. Once the supply constraints ease and the need to build inventory has passed, we expect to bring inventory down, enabling us to generate cash at historic levels or better.

We expect our cash flow from operations to improve in Q3 through sequential revenue growth and reduced broker part purchasing. We anticipate this improvement will help deliver double-digit cash flow from operations as a percent of revenue in Q3. In the second quarter, we returned $76 million to shareholders through dividends and stock repurchases. We repurchased approximately 1 million shares at an average price of $39.06, keeping our share count flat to Q2 2021.

Approximately $190 million remains on the repurchase authorization approved by our board of directors on January 19, 2022. The NI board of directors approved a quarterly dividend of $0.28 per share, payable on August 29, 2022, to stockholders of record on August 8, 2022. The board of directors also approved the company expanding its existing credit facility and increasing the total amount available for borrowing from $500 million up to a maximum of $1 billion. We have begun related negotiations with our lenders and expect to secure their commitments in the near future, only guaranteed once the deal is actually signed.

This will provide additional borrowing capacity and flexibility in anticipation of supporting future growth and our commitment to deliver shareholder value. Our capital allocation strategy remains thoughtfully balanced. We will continue to invest in organic capabilities to ensure we stay ahead of our customers' technology needs and prioritize inorganic investments that strategically align to the business in order to drive growth. At the same time, we will continue to look for opportunities to return cash to shareholders through our dividend and stock repurchase programs.

Now, shifting to guidance for Q3 and beyond. For the third quarter of 2022, we expect revenue to be in the range of $410 million to $440 million. At the midpoint, this represents 16% revenue growth year over year. Our guidance takes into consideration the best information we know today about the deliveries from our suppliers.

We expect GAAP diluted earnings per share will be in the range of $0.34 and to $0.48 for Q3, with non-GAAP diluted earnings per share expected to be in the range of $0.46 to $0.60, an increase of 26% year over year at the midpoint. We expect our tax rate in 2022 to be between 16% to 17%. We've been actively transitioning our single seat licenses to a subscription-based model and believe this shift will improve our ratio of recurring revenue through software and related services, drive more predictability and a meaningful uptick in customer lifetime value to NI. We are on track with this transition and as we've said in the past, we expect a headwind of approximately $30 million to our 2022 revenue and operating profit, which is factored into our guidance.

We expect Q4 revenue to be stronger than normal seasonality due to the work we've done to reduce the impact of supply constraints. We remain confident in our ability to continue to navigate the situation and our expectations for the full year are in line with current consensus estimates for revenue and earnings per share. As Eric mentioned, we see the opportunity to meaningfully accelerate our profitability next year. From a revenue perspective, on top of the strength of our focused market areas, we will be leaving 2022 with excess backlog that we intend to reduce in 2023, assuming the supply's constraints ease.

We also expect our shift to subscription-based software licenses to become a tailwind. In addition, we will benefit from the price increases implemented in 2022 and a full year of the revenue synergies from our acquisitions. We expect significant tailwinds in gross margin in 2023 with the easing of supply constraints and reduced need for broker purchases. This alone is expected to be a 400 basis point headwind in 2022 that we believe will begin to moderate significantly in 2023, and we continue to see the benefits of the actions we have taken to increase scale into our business model.

Despite the temporary headwinds to gross margin, we have improved non-GAAP earnings per share by 15% year over year in the first half of 2022. Looking ahead, we will continue to sharpen our streamlining processes for greater efficiency. With many key initiatives underway, we are confident in our ability to deliver on our commitment to non-GAAP operating margin improvement. Even in a potential recessionary environment, we now expect to increase our non-GAAP operating margin by 300 basis points in 2023, followed by 100 basis points of additional improvement each year through 2025.

Eric, back to you.

Eric Starkloff -- President and Chief Executive Officer

Thank you, Karen. In summary, we are confident in the actions we have taken to better position the company to perform despite the headwinds that may occur. We remain committed to our goals for long-term growth and profitability and see the current momentum in orders and revenue as a proof point of our strategy. We believe strong customer demand is a direct result of our technology differentiation.

[Audio gap] leading software that enable our customers to get fast-moving technology to market even faster. And we believe we are well-positioned within large and growing markets, including electric and autonomous vehicles, wireless communication, and new space technology. And looking ahead to 2023, we expect the existing momentum and actions we've already taken to enable us to grow revenue and exceed our previous margin expansion commitment even in an uncertain economic environment. Finally, a big thank you to all of our employees who are working tirelessly to drive demand beyond our expectations while also ensuring customer success.

Employees in manufacturing and operations, in particular, have been working very hard to navigate unprecedented challenges in our supply chain. I sincerely appreciate your hard work, determination and perseverance. With that, we will now take your questions.

Questions & Answers:

Operator

[Operator instructions] And our first question coming from the line of Mehdi Hosseini with SIG. Your line is open.

Mehdi Hosseini -- Susquehanna International Group -- Analyst

Thanks for taking my question. Two follow-ups. Can you please elaborate what your revenues would be if there was no supply chain disruption?

Karen Rapp -- Executive Vice President and Chief Financial Officer

Yes. Mehdi, maybe the way to think about that is the backlog position that we have with it being about $250 million and about eight weeks of lead time to our customers, we've historically carried much less than that. We've talked about it before, but our goal is not to take that down to the levels we've been at historically. As we shift to more of a systems business and solutions for our customers that we do expect to have longer lead times.

There is still a significant portion of that that we would have expected to flow through into revenue during this year without the supply constraints that we've seen.

Eric Starkloff -- President and Chief Executive Officer

The increase in the quarter alone, Mehdi, was $40 million. So you can think of that as maybe a model for what would have ultimately been revenue.

Mehdi Hosseini -- Susquehanna International Group -- Analyst

Got it. OK. And then, with software revenue and more and more subscription, remind me, is that a factor that would dampen your software revenue in the near term? It is growing at a lower rate compared to product revenue. And I'm just curious if this has to do with just how you're signing new subscription revenues.

Karen Rapp -- Executive Vice President and Chief Financial Officer

Right. That's correct. So as we shift our single seat licenses to a subscription model, we do expect to see some of our customers decline to renew in that model. And that launch, we've estimated is about the $30 million for the year.

So that is an impact that would have flown through into revenue this year that we are anticipating as a loss.

Eric Starkloff -- President and Chief Executive Officer

And then that shift in the future years, Mehdi, as a tail -- and we mentioned that the tail in future years going into 2023 and beyond where we are recognizing that subscription revenue.

Mehdi Hosseini -- Susquehanna International Group -- Analyst

Sure. And apologies, a quick follow-up. So should I assume a $120 million annualized software revenue that is now spread into the future year? Is that the right way to think about it?

Karen Rapp -- Executive Vice President and Chief Financial Officer

Because you're taking 20% --

Mehdi Hosseini -- Susquehanna International Group -- Analyst

I thought it was $30 million of software revenue were pushed out due to change in licensing agreement moving to subscription model. I'm just wondering for -- just want to make sure I understand the tailwind impact over the next few years, should I assume that there's that much of a revenue recognition on the software that is pushed out like at $30 million a quarter?

Eric Starkloff -- President and Chief Executive Officer

No. So $30 million is the total impact for the year that we estimate from the transition in the single seat licenses to subscription. At that point, a substantial majority of all of our software revenue will be on subscription. The rest of it we had previously transitioned with our larger enterprise agreements.

And then, most all of our software business will be annually recurring revenue. Mehdi, I'll just say also that that conference we're going to do in September, this is one of the topics we want to delve in a bit deeper so that we can create the longer-term model for recurring revenue because we do believe that's going to be a bigger portion as we move forward over the next several years.

Mehdi Hosseini -- Susquehanna International Group -- Analyst

Got it. Thank you. Apologies for misunderstanding.

Eric Starkloff -- President and Chief Executive Officer

No problem. Thanks, Mehdi.

Operator

[Operator instructions] Our next question coming from the line of Mark Delaney with Goldman Sachs. Your line is open.

Mark Delaney -- Goldman Sachs -- Analyst

Yes. Good afternoon. Thank you for taking the question. Just start hoping to better understand the comments on 2023.

If I understood correctly in terms of the topline view, you're looking for something like mid-teens revenue growth. And I believe you're breaking in a slowdown in a few areas like semi production test in parts of the portfolio. I am hoping to make sure I understand that correctly, how much of those weaker areas potentially contracting? Obviously, there's some strong offsets. So if you could detail the revenue view a little bit more, that would be helpful.

Eric Starkloff -- President and Chief Executive Officer

Sure, Mark. Yes, absolutely. So first, just some context. As we said in the prepared remarks, the business has stayed really, really strong.

We think it's prudent to plan for some of these things so that we're planning for a downside scenario and prepare for that even if that's not what happens. But to calibrate it some, if you think about from a demand point of view, what does the downturn potentially look like? Well, 2020, we were minus 5% in demand. So that's like a potential sort of downturn scenario. As Karen commented, when you look at this year, we've had very, very strong bookings growth, a strong backlog position.

We expect to end the year in a strong backlog position. In fact, we expect the backlog position to be above what level of backlog we think is appropriate to sort of efficiently run the business and meet customer commitments. And so, we expect that to come down some in 2023. So that even in a downside scenario, that means that revenue downside in this scenario being potentially negative bookings, revenue translates kind of into that mid-teens revenue rate of growth.

Karen Rapp -- Executive Vice President and Chief Financial Officer

We also get to layer in a full year of the EV acquisitions next year, Mark, and some of the pricing that we've seen the benefit of this year will also be another part of that benefit next year from a revenue growth standpoint.

Mark Delaney -- Goldman Sachs -- Analyst

OK. That's helpful and looking forward to getting into it more at the investor day. Yes, and then a follow-up just on the EBIT margin. I mean that's a very substantial EBIT margin increase and ahead of consensus expectations.

Maybe you could help us understand where we would see that in terms of the different drivers. I mean maybe how much is topline leverage, how much may be better gross margins? Is there anything on operating expense reductions that are a piece of it? And to the extent revenue is lower than that mid-teens, are there structural things that you're considering to do in terms of variability of your cost structure that you perhaps allow you as bad margins even if revenue doesn't grow in that mid-teens level?

Karen Rapp -- Executive Vice President and Chief Financial Officer

Perfect. Yes, we did touch a little bit about the revenue pieces and where we see that could be. We've modeled that in different scenarios, as Eric mentioned, to understand in our recessionary situation versus different growth scenarios what that would look like. And one of the biggest factors that makes the difference on that, to think through is the gross margin tailwinds that we expect next year are very significant.

You see that this year where we've had about 400 basis points of impact from the broker pricing that we are absorbing this year. We're going to start buying less from brokers in Q3 than we have been. But that timing of when that flows through to the P&L is delayed because we've been buying them previously, and we expect that to actually start flowing through probably early 2023 in terms of having used the parts with that excess pricing. So that 400 basis points of impact that we see in gross margin this year becomes a tailwind next year that enables a tremendous amount of leverage.

The other thing that we've done is made our cost structure much more variable. We continue to make it a more variable cost structure, and that provides benefit going into 2023 as well, depending on what we see the topline doing so that we can match our expenses with the revenue throughout the year.

Mark Delaney -- Goldman Sachs -- Analyst

Thank you.

Operator

Thank you. One moment for our next question. Our next question coming from the line of Meta Marshall with Morgan Stanley. Your line is open.

Karan Juvekar -- Morgan Stanley -- Analyst

Hi. This is Karan on for Meta. Just a quick question. So last quarter, you sort of noted maybe ramping up your semi lab business.

And so, I was just wondering if you've seen any sort of traction on growing that lab business in the quarter? And maybe how you think at a higher level of how the lab business versus production business would perform in a recessionary environment?

Eric Starkloff -- President and Chief Executive Officer

Sure. Sure, I'll take that. Yes. So we've always had a real strong position historically in labs, especially our software position is a sort of a de facto standard for automated validation systems.

But to your point, we have been focusing on that. It is about half our business in semiconductor and electronics is in R&D labs and the other half in production. And as I noted on the call, we certainly expect that lab business to be sort of less volatile in terms of in a semiconductor cycle. R&D spending tends to be less correlated to those cycles.

And so, that's been a deliberate area of focus, and it's an area that we have actually the technology and offerings and products we're delivering into that space, and we're pleased with the traction. I noted one particular customer on the call is an example of the kind of customer in that space. The other important point is that our software and particularly the analytics and the newer piece of software that we have actually scale across both. They're used in both in labs and in production, and we think that's a real differentiator for us in that space.

While we're on the topic, I'll make one more comment just on semiconductor market volatility. As I said in the comments, we're not naive to the potential down cycle. We're looking at that very closely. I will say that our business -- we think we're well-positioned from an end market point of view.

Our focus is primarily wireless and mixed signal and industrial applications, less direct exposure to processors and consumer kind of the consumer part of the market going into the laptops and phones and so forth. And so, we think that those also tend to be the more resilient parts of the market.

Karan Juvekar -- Morgan Stanley -- Analyst

OK. Got it. That makes sense. And then, just a follow-up to the operating margins and sort of 200 bps.

I know you mentioned that the gross margins maybe is a fair portion of that upside. But I guess just if you're looking at sort of areas within the operating margin line, sort of like the channel becoming more effective or larger relationships taking off? Is there a way to rank order sort of those factors if you sort of take out the gross margin tailwind?

Karen Rapp -- Executive Vice President and Chief Financial Officer

Yes, you've called out the ones that are pretty impactful, right? The transition that we've done to distribution has been incredibly successful. We find that there's a tremendous amount of leverage there. It does a couple of things. It provides our ability to focus on our top accounts and really make sure that those relationships are robust and that we're expanding and creating additional SAM, building out new opportunities on the top customers.

And that leverage continues to flow through from an operating expense standpoint because we don't have to invest at the same rate to support that customer growth that we had historically. And so, from an operating expense standpoint, we're really focused on making as much of our incremental costs as variable as we possibly can, and distribution fits right in line with that. That enables us to do exactly what our goal is, which is truly align our expenses with the revenue and how it flows through even in short time flows like even quarter-on-quarter as it fluctuates, we want the ability to align the cost with that revenue profile.

Eric Starkloff -- President and Chief Executive Officer

I think a way just to add on, a way to think of this is that we've taken a number of actions over the past many years, including this year, on our cost structure and the variability of our cost structure, the efficiency of SG&A and other areas of the business. This year, some of the impact of those are sort of muted by the fact that revenue is supply constrained, as we've said, and there's a 400 to 500 basis point impact from both the broker pricing and freight. And so, really, what we're talking about is the investments and the things that we've done to improve our efficiency from an operating expense point of view, really starting to show through more in operating income as those two issues start to moderate. We start to get the flow through to revenue and the margin starts to reverse.

So it's not so much about future actions, of course, it's something we'll always focus on. It's about actions we've actually already taken to get our cost structure in a substantially more efficient position.

Karan Juvekar -- Morgan Stanley -- Analyst

Got it. Thank you.

Eric Starkloff -- President and Chief Executive Officer

OK. Thank you.

Operator

Thank you. One moment for our next question. And our next question coming from Samik Chatterjee J.P. Morgan.

Your line is open.

Angela Jin -- J.P. Morgan -- Analyst

Hi. This is Angela on for Samik. Thanks for taking my question. My first one would be, looking at your 2023 revenue guide of sort of mid-teens growth.

Is there a way to sort of ballpark estimate or rank order the largest drivers of that outlook? So between the synergies from your acquisitions, your pricing increases, working down the backlog and so on? And then I have a follow-up.

Eric Starkloff -- President and Chief Executive Officer

Yes, Samantha, I'll take that. This is another one that we do plan to layer that on more specifically, frankly, in the investor conference and update some of our end market models. We've talked about our objectives by end market in terms of growth. So one of the things that we'll do in September is sort of give a refreshed outlook not just for '23, but for a sort of three-year time horizon.

And we'll also kind of in a more detailed way, walk through the bridge that we were discussing on one of the previous questions between sort of different booking scenarios and how it stacks up to revenue. Because we do think that there'll be a pretty -- a big turnaround from a book-to-bill as we go into 2023. So you got to take that into account as well. What's your follow-up?

Angela Jin -- J.P. Morgan -- Analyst

Just a quick question. So for the broker and freight pricing being sort of a 400 to 500 basis point impact to the gross margin. Does that imply as you sort of work through that and that comes down that you can get back to sort of that 75% gross margin level exiting 2023?

Karen Rapp -- Executive Vice President and Chief Financial Officer

Yes. That's the intent is to bring it back up to historic levels, probably right in that range. I don't know the exact timing in 2023 because we still will be working through spike and straight through the end of this year. We're not at a point that I have a full outlook on what that looks like.

But the goal is to get back to our historic gross margin rates, which is 74, 75 kind of percent.

Eric Starkloff -- President and Chief Executive Officer

Probably over more than just that one-year time period just future expectations.

Karen Rapp -- Executive Vice President and Chief Financial Officer

Yes.

Eric Starkloff -- President and Chief Executive Officer

Yes. So it will probably be a tailwind for more than one year is a way to think of it.

Angela Jin -- J.P. Morgan -- Analyst

Got it. Thank you.

Eric Starkloff -- President and Chief Executive Officer

Thank you.

Operator

And our next question coming from the line of Rob Mason with Baird. Your line is open.

Rob Mason -- Robert W. Baird -- Analyst

Yes. Good afternoon.

Eric Starkloff -- President and Chief Executive Officer

Hi, Rob.

Rob Mason -- Robert W. Baird -- Analyst

Hi. Eric, I want to spend a second on the portfolio business. Of course, we're well aware that that's where you have a lot of PMI sensitivity, at least historically. Could you just remind us what some of the larger end market exposures are within that piece? I know academic is there at some of the -- maybe some of the medical healthcare exposure is there.

But what are some of the larger pieces that are in that part of the segment? And then I'm just curious how it trended as we've gone through the quarter and into July, just because the order rate was lower? Is it responding kind of real time to PMI?

Eric Starkloff -- President and Chief Executive Officer

Yes. Thanks, Rob. Yes, let me put some context points. First, just to answer your direct question, it is part of the reason we collected together in portfolio is it's a pretty long tail of industry.

So none of them are particularly large, but it does include academic is one of them, life sciences, energy is in there, but it's pretty small, as well as a number of other smaller industries. I will just say that from a just to contextualize it some, you're right. And as I mentioned that it is more exposed to the macro. That is still our expectation.

If you look back a few years, that was 50% or above 50% of our business. It's now about 30% of our business. So as a company, the mix, if you will, and the exposure is significantly less. And then, on sort of the trajectory of the business, if you look at Q2, we're 2% revenue, 6% orders.

So really in line with our longer-term expectation. We said that's kind of a mid-single-digit kind of market growth rate area. Now, it did slowdown from Q1 to Q2, but still in a pretty good territory in terms of growth. And then, finally, what are the things we're working on to create more resiliency.

That's been our big, big focus on that area. The channel work we've done for distribution and making products and offerings that better fit distribution and digital channels. Those are really gaining traction. We're real pleased with how that's going, the reception of customers, the response of the business.

And then, the software, the single seat license transition and software that Karen spoke of, that sort of disproportionately impact portfolio and certainly in a positive way, we believe, going forward in terms of the steadiness of a higher percentage of recurring revenue. Now, all that being said, it's not our expectation that that means that that 30% of our business is completely immune to the macro. The way we think of it is just more we have a smaller percentage of our business that will be less impacted by the macro than, say, in the last cycle, and that is our expectation going forward.

Rob Mason -- Robert W. Baird -- Analyst

OK. OK. Understood. And then, just a quick question around your backlog.

Is it proportional to your revenue mix, your current backlog or what you would expect to be your backlog? And then just how do you think about cancellation risk within the backlog?

Eric Starkloff -- President and Chief Executive Officer

End revenue risk, you mean by end market? .

Rob Mason -- Robert W. Baird -- Analyst

Yes. Yes.

Eric Starkloff -- President and Chief Executive Officer

That's your question, Rob? Yes. I mean it always -- yes, and it fluctuates by end market because it's all due to component availability. And so, it just really depends on quarter to quarter, which components have shortages in terms of where the backlog sits. So it does fluctuate between the business units quarter-to-quarter.

But overall, generally speaking, it's proportional if you look over time. And then, your question about cancellations, we watch it real closely. It's still significantly less than 1% of orders that are canceled due to lead time. So as Karen mentioned in the remarks, we still have confidence on the durability of that backlog and the expectation that that backlog ultimately turns into revenue.

And we think our lead times are still highly competitive. I mean, eight weeks is a lengthening of lead times certainly for us. But if you compare it to peers in the industry, it still stacks up quite well, significantly better than most of our peers. And even though I know many of our customers would like the product sooner, we're able to deliver them sooner than most of our competitors in the industry.

Rob Mason -- Robert W. Baird -- Analyst

If I could sneak in one quick one? Karen, what is the -- what's the underlying gross margin within the third quarter guidance -- expectation within the third quarter guidance?

Karen Rapp -- Executive Vice President and Chief Financial Officer

I expect it to be pretty similar to Q2, Rob, close on 71%.

Rob Mason -- Robert W. Baird -- Analyst

OK. And in that case, operating expenses would be down sequentially too?

Karen Rapp -- Executive Vice President and Chief Financial Officer

Correct. Correct. Remember in Q2, we had our large customer event, and I connect, that won't repeat in Q3. And let me correct margin.

I think it's right -- I think between 70% and 71%, maybe 70.5%, somewhere in that.

Eric Starkloff -- President and Chief Executive Officer

Yeah. Great. Thanks, Rob.

Rob Mason -- Robert W. Baird -- Analyst

Thank you.

Operator

And I'm showing no further questions at this time. I would now like to turn the call back over to Mr. Eric Starkloff for any closing remarks.

Eric Starkloff -- President and Chief Executive Officer

OK. Thank you all for your questions. Thank you for joining us today. We hope to see you at our investor conference in September.

Have a great day.

Operator

[Operator signoff]

Duration: 0 minutes

Call participants:

Marissa Vidaurri -- Head of Investor Relations

Eric Starkloff -- President and Chief Executive Officer

Karen Rapp -- Executive Vice President and Chief Financial Officer

Mehdi Hosseini -- Susquehanna International Group -- Analyst

Mark Delaney -- Goldman Sachs -- Analyst

Karan Juvekar -- Morgan Stanley -- Analyst

Angela Jin -- J.P. Morgan -- Analyst

Rob Mason -- Robert W. Baird -- Analyst

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