Item 7. Management’s Discussion and Analysis of Financial Condition and Results of Operations.

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Overview

We design, make and sell semiconductors to electronics designers and manufacturers all over the world. Our business model is carefully constructed around the following attributes:

	•	Industry’s broadest portfolio of differentiated analog and embedded processing semiconductors. Our customers need multiple chips for their systems. The breadth of our portfolio means we can solve more of these needs than can our competitors, which gives us access to more customers and the opportunity to generate more revenue per system. We invest more than $1 billion each year to develop new products for our portfolio.

	•	A strong foundation of manufacturing technology and low-cost production. We invest in manufacturing technologies that differentiate the features of our semiconductors, and we do most of our own production in-house, as opposed to outsourcing it. This ability to directly control our manufacturing helps ensure a consistent supply of products for our customers. We produce billions of semiconductors each year on a mixture of 150-, 200- and 300-millimeter wafers, and we are able to keep costs low for manufacturing facilities and equipment because our Analog and much of our Embedded Processing semiconductors can be made using mature assets that we acquire ahead of demand when their prices are most attractive. In 2016, we increased factory loadings by about 15 percent for our Analog semiconductors on 300-millimeter wafers, which have a 40 percent cost advantage per unpackaged chip over 200-millimeter wafers. The majority of our Analog growth will be produced on 300-millimeter wafers, which will be meaningful to the growth of our cash flow over the long term.

	•	Industry’s largest market channels. Our global sales force is larger than those of our competitors. The breadth of our portfolio attracts an increasing number of visits to our website, where customers often begin their initial product searches and design-in journey. Our web presence, together with our global sales force, provides us unique access to about 100,000 customers.

	•	Diversity and longevity in our products and in the markets we serve. Together, the attributes above result in diverse and long-lived positions that deliver high terminal value to our shareholders. Because of the breadth of our portfolio, we are not dependent on any single product, and because of the breadth of our markets we are not dependent on any single application or customer. Some of our products generate revenue for decades, which strengthens the return on our investments.

The combined effect of these attributes is that over time we have grown free cash flow and gained market share in Analog and Embedded Processing. These attributes put us in a unique class of companies with the ability to grow, generate cash, and return that cash to shareholders.

Management’s discussion and analysis of financial condition and results of operations (MD&A) should be read in conjunction with the financial statements and the related notes that appear elsewhere in this document. In the following discussion of our results of operations:

	•	All dollar amounts in the tables are stated in millions of U.S. dollars.

	•	When we discuss our results:

	o	Unless otherwise noted, changes in our revenue are attributable to changes in customer demand, which are evidenced by fluctuations in shipment volumes.

	o	New products tend not to have a significant impact on our revenue in any given period because we sell such a large number of products.

	o	From time to time, our revenue and gross profit are affected by changes in demand for higher-priced or lower-priced products, which we refer to as changes in the “mix” of products shipped.

	o	Because we own much of our manufacturing capacity, a significant portion of our operating cost is fixed. When factory loadings decrease, our fixed costs are spread over reduced output and, absent other circumstances, our profit margins decrease. Conversely, as factory loadings increase, our fixed costs are spread over increased output and, absent other circumstances, our profit margins increase. Increases and decreases in factory loadings tend to correspond to increases and decreases in demand.

	o	Over time, we have been allocating resources from areas like manufacturing support and SG&A into R&D activities. As a result, R&D expense will continue increasing in 2017.

	o	Our effective tax rate (Provision for income taxes as a percentage of Income before income taxes) benefits from lower tax rates (compared to the U.S. statutory income tax rate) applicable to our operations in many of the jurisdictions in which we operate and from U.S. tax benefits. These lower non-U.S. tax rates are generally statutory in nature, without expiration and available to companies that operate in those taxing jurisdictions.

	•	Our segments represent groups of similar products that are combined on the basis of similar design and development requirements, product characteristics, manufacturing processes and distribution channels, and how management allocates resources and measures results. See Note 1 to the financial statements for more information regarding our segments.

	•	In the fourth quarter of 2016, we adopted ASU 2016-09 related to stock compensation. We applied the new standard prospectively as of the beginning of 2016 for the Consolidated Statements of Income and on a full retrospective basis for all periods in the Consolidated Statements of Cash Flows. See Note 2 to the financial statements for more details.

Results of operations

We continued to perform well in 2016, reflecting our focus on Analog and Embedded Processing. These products serve highly diverse markets with thousands of applications, and we believe have dependable long-term growth opportunities. In 2016, Analog and Embedded Processing represented 86 percent of revenue. Gross margin of 61.6 percent for the year reflects the quality of our product portfolio, as well as the efficiency of our manufacturing strategy.

Our focus on Analog and Embedded Processing allows us to generate strong cash flow from operations. In 2016, cash flows from operations were $4.61 billion, up from $4.40 billion in 2015. Free cash flow in 2016 was 30.5 percent of revenue, up from 29.6 percent a year ago and consistent with our targeted range of 20-30 percent of revenue. During the year, we returned $3.78 billion of cash to investors through a combination of stock repurchases and dividends. Our dividends represented 40 percent of free cash flow, underscoring their sustainability. Free cash flow is a non-GAAP financial measure. For a reconciliation to GAAP and an explanation of the reason for providing this non-GAAP measure, see the Non-GAAP financial information section after the Liquidity and capital resources section.

Details of financial results – 2016 compared with 2015

Revenue of $13.37 billion was up $370 million, or 3 percent, from 2015, due to higher revenue from Embedded Processing and Analog.

Gross profit was $8.24 billion, an increase of $680 million, or 9 percent, due to lower manufacturing costs and, to a lesser extent, higher revenue. Gross profit margin was 61.6 percent compared with 58.2 percent.

Operating expenses were $1.37 billion for R&D and $1.77 billion for SG&A. R&D expense increased $90 million, or 7 percent, due to a combination of our ongoing allocation of resources into R&D activities and higher compensation-related costs. SG&A expense increased $19 million, primarily due to higher compensation-related costs.

Acquisition charges associated with our 2011 acquisition of National Semiconductor were $319 million compared with $329 million. These non-cash charges resulted from the amortization of intangible assets. See Note 13 to the financial statements.

Restructuring charges/other was a net credit of $15 million, which included a gain on the sale of intellectual property of $40 million that was partially offset by $25 million related to restructuring charges. This compared with a net credit of $71 million in 2015, which included gains on sales of assets of $83 million that were partially offset by $12 million related to restructuring charges and other credits. These amounts are included in Other for segment reporting purposes. See Note 3 to the financial statements.

Operating profit was $4.80 billion, or 35.9 percent of revenue, compared with $4.27 billion, or 32.9 percent of revenue.

OI&E for 2016 was $211 million compared with $32 million. The increase is due to income of $188 million from settlements related to intellectual property infringement.

Our income tax provision was $1.34 billion compared with $1.23 billion. The increase was primarily due to higher income before income taxes, partially offset by a tax benefit for stock compensation. Our effective tax rates were 27 percent in 2016 and 29 percent in 2015. See Note 6 to the financial statements for a reconciliation of the U.S. statutory income tax rate to the effective tax rate.

Net income was $3.60 billion, an increase of $609 million, or 20 percent. EPS was $3.48 compared with $2.82. EPS benefited $0.13 in 2016 due to the application of the new accounting standard related to stock compensation.

Segment results – 2016 compared with 2015

Analog (included High Volume Analog & Logic (HVAL), Power Management (Power), High Performance Analog (HPA) and Silicon Valley Analog (SVA) product lines)

		2016				2015				Change
Revenue		$	8,536			$	8,339				2	%
Operating profit			3,380				3,048				11	%
Operating profit % of revenue			39.6	%			36.6	%

Analog revenue increased primarily due to SVA and HPA. Power also grew, but to a lesser extent, while HVAL declined due to the mix of products shipped. Operating profit increased due to higher gross profit, which benefited from lower manufacturing costs.

Embedded Processing (included Processors, Microcontrollers and Connectivity product lines)

		2016				2015				Change
Revenue		$	3,023			$	2,787				8	%
Operating profit			801				596				34	%
Operating profit % of revenue			26.5	%			21.4	%

Embedded Processing revenue increased due to, in declining order, Processors, Microcontrollers and Connectivity. Processors revenue increased due to the mix of products shipped. Operating profit increased primarily due to higher revenue and associated gross profit.

Other (included DLP products, calculators, custom ASICs and royalties)

		2016				2015				Change
Revenue		$	1,811			$	1,874				(3	)%
Operating profit*			618				630				(2	)%
Operating profit % of revenue			34.1	%			33.6	%

*	Includes Acquisition charges and Restructuring charges/other

Other revenue decreased due to, in declining order, lower royalties, custom ASIC products and calculators. This decrease was partially offset by growth in DLP products. Operating profit decreased $12 million.

Prior results of operations

In 2015, Analog revenue grew 3 percent, and Embedded Processing revenue grew 2 percent. Analog and Embedded Processing represented 86 percent of revenue in 2015, up from 83 percent in 2014. Gross margin was 58.2 percent for 2015.

In 2015, cash flows from operations were $4.40 billion, up from $4.05 billion in 2014. Free cash flow in 2015, was 29.6 percent of revenue, up from 28.1 percent in 2014. During 2015, we returned $4.19 billion of cash to investors through a combination of stock repurchases and dividends.

Details of financial results – 2015 compared with 2014

Revenue of $13.00 billion was about even with 2014, as higher revenue from Analog and Embedded Processing was offset by lower revenue from Other. Our 2015 revenue was negatively affected by about $150 million from changes in foreign currency exchange rates.

Gross profit was $7.56 billion, an increase of $133 million, or 2 percent, due to lower manufacturing costs. Gross profit margin was 58.2 percent of revenue compared with 56.9 percent.

Operating expenses were $1.28 billion for R&D and $1.75 billion for SG&A. R&D expense decreased $78 million, or 6 percent, and SG&A decreased $95 million, or 5 percent. Both comparisons reflect savings from ongoing efforts across the company to align costs with growth opportunities, including the completed restructuring actions in Embedded Processing and Japan. These decreases were partially offset by higher compensation-related costs.

Acquisition charges were related to our 2011 acquisition of National Semiconductor and were $329 million, about even with 2014. These non-cash charges were primarily from the amortization of intangible assets.

Restructuring charges/other was a net credit of $71 million, which included gains on sales of assets of $83 million that were partially offset by $12 million related to restructuring charges and other credits. This compared with a net credit of $51 million in 2014, reflecting gains on sales of assets of $75 million that were partially offset by restructuring charges and other expenses of $24 million. These amounts are included in Other for segment reporting purposes.

Operating profit was $4.27 billion, or 32.9 percent of revenue, compared with $3.95 billion, or 30.3 percent of revenue, in 2014.

The income tax provision was $1.23 billion compared with $1.05 billion. The increase in the total tax provision was due to higher income before income taxes and, to a lesser extent, a lower benefit from non-U.S. effective tax rates. Our effective tax rate was 29 percent in 2015 and 27 percent in 2014.

Net income was $2.99 billion, an increase of $165 million, or 6 percent, from 2014. EPS was $2.82 compared with $2.57 in 2014.

Segment results – 2015 compared with 2014

Analog

		2015				2014				Change
Revenue		$	8,339			$	8,104				3	%
Operating profit			3,048				2,786				9	%
Operating profit % of revenue			36.6	%			34.4	%

Analog revenue increased primarily due to HVAL. Power and SVA also grew, but to a lesser extent. HPA declined due to the mix of products shipped. Operating profit increased due to higher revenue and associated gross profit and, to a lesser extent, lower manufacturing costs.

Embedded Processing

		2015				2014				Change
Revenue		$	2,787			$	2,740				2	%
Operating profit			596				384				55	%
Operating profit % of revenue			21.4	%			14.0	%

Embedded Processing revenue increased due about equally to Connectivity and Microcontrollers, which together offset a decline in Processors. Operating profit increased primarily due to lower operating expenses.

Other

		2015				2014				Change
Revenue		$	1,874			$	2,201				(15	)%
Operating profit*			630				777				(19	)%
Operating profit % of revenue			33.6	%			35.3	%

*	Includes Acquisition charges and Restructuring charges/other

Other revenue declined primarily due to custom ASICs. Revenue from DLP products also declined, but to a lesser extent. Operating profit declined primarily due to lower revenue and associated gross profit.

Financial condition

At the end of 2016, total cash (Cash and cash equivalents plus Short-term investments) was $3.49 billion, an increase of $272 million from the end of 2015.

Accounts receivable were $1.27 billion at the end of 2016. This was an increase of $102 million compared with the end of 2015. Days sales outstanding were 33 at the end of both 2016 and 2015.

Inventory was $1.79 billion at the end of 2016. This was an increase of $99 million from the end of 2015. Days of inventory at the end of 2016 were 126 compared with 115 at the end of 2015.

Liquidity and capital resources

Our primary source of liquidity is cash flow from operations. Additional sources of liquidity are Cash and cash equivalents, Short-term investments and a variable rate, revolving credit facility. Cash flows from operating activities for 2016 was $4.61 billion, an increase of $217 million from 2015 primarily due to an increase in Net income.

Our revolving credit facility is with a consortium of investment-grade banks and allows us to borrow up to $2 billion until March 2021. This credit facility also serves as support for the issuance of commercial paper. As of December 31, 2016, our credit facility was undrawn, and we had no commercial paper outstanding.

In 2016, investing activities used $650 million compared with $302 million in 2015. For 2016, Capital expenditures were $531 million compared with $551 million in 2015. Capital expenditures in both periods were primarily for semiconductor manufacturing equipment. In 2016, we had purchases of short-term investments, net of proceeds, that used cash of $113 million. In comparison, in 2015 we had proceeds from short-term investments, net of purchases, that provided cash of $125 million. In 2015, we received $110 million from asset sales, compared with none in 2016.

In 2016, financing activities used $3.81 billion compared with $4.29 billion in 2015. In 2016, we received proceeds of $499 million from the issuance of fixed-rate, long-term debt (net of original issuance discount) and repaid $1.00 billion of maturing debt. In 2015, we received proceeds of $498 million from the issuance of fixed-rate, long-term debt (net of original issuance discount) and repaid $1.00 billion of maturing debt. Dividends paid in 2016 were $1.65 billion compared with $1.44 billion in 2015, reflecting increases in the dividend rate, partially offset by fewer shares outstanding. During 2016, the quarterly dividend increased to $0.50 from $0.38 per share, resulting in an annualized dividend payment of $2.00 per share. During 2015, we increased our quarterly dividend to $0.38 from $0.34 per share. In 2016, we used $2.13 billion to repurchase 35.5 million shares of our common stock. This compared with $2.74 billion used in 2015 to repurchase 51.4 million shares. Employee exercises of stock options are also reflected in Cash flows from financing activities. In 2016, these exercises provided cash proceeds of $472 million compared with $396 million in 2015.

We had $1.15 billion of Cash and cash equivalents and $2.34 billion of Short-term investments as of December 31, 2016, with our U.S. entities owning about 80 percent of these amounts combined at the end of 2016. We believe we have the necessary financial resources and operating plans to fund our working capital needs, capital expenditures, dividend and debt-related payments, and other business requirements for at least the next 12 months.

Non-GAAP financial information

This MD&A includes references to free cash flow and ratios based on that measure. These are financial measures that were not prepared in accordance with generally accepted accounting principles in the United States (GAAP). Free cash flow was calculated by subtracting Capital expenditures from the most directly comparable GAAP measure, Cash flows from operating activities (also referred to as cash flow from operations). We believe that free cash flow and the associated ratios provide insight into our liquidity, our cash-generating capability and the amount of cash potentially available to return to shareholders, as well as insight into our financial performance. These non-GAAP measures are supplemental to the comparable GAAP measures. Reconciliation to the most directly comparable GAAP-based measures is provided in the table below.

	For Years Ended
	December 31,
	2016				2015				2014
Cash flow from operations (GAAP)	$	4,614			$	4,397			$	4,054
Capital expenditures		(531	)			(551	)			(385	)
Free cash flow (non-GAAP)	$	4,083			$	3,846			$	3,669
Revenue	$	13,370			$	13,000			$	13,045
Cash flow from operations as a percent of revenue (GAAP)		34.5	%			33.8	%			31.1	%
Free cash flow as a percent of revenue (non-GAAP)		30.5	%			29.6	%			28.1	%

Long-term contractual obligations

		Payments Due by Period
Contractual Obligations		2017			2018/2019			2020/2021			Thereafter			Total
Long-term debt (a)		$	692		$	1,350		$	806		$	1,021		$	3,869
Purchase commitments (b)			132			173			26			5			336
Operating leases (c)			67			75			41			57			240
Deferred compensation plans (d)			18			38			37			99			192
Total (e)		$	909		$	1,636		$	910		$	1,182		$	4,637

(a)	Includes the related interest payments and amounts classified as the current portion of long-term debt, specifically obligations that will mature within 12 months.

(b)

Includes payments for software licenses and contractual arrangements with suppliers where there is a fixed, non-cancellable payment schedule or minimum payments due with a reduced delivery schedule. Excluded from the table are cancellable arrangements. However, depending on when certain purchase arrangements may be cancelled, an additional $3 million of cancellation penalties may be required to be paid, which are not reflected in the table.

(c)	Includes minimum payments for leased facilities and equipment and purchases of industrial gases under contracts accounted for as operating leases.

(d)	Includes an estimate of payments for certain liabilities that existed at December 31, 2016.

(e)

Excluded from the table are $243 million of uncertain tax liabilities under ASC 740, as well as any planned future funding contributions to retirement benefit plans. Amounts associated with uncertain tax liabilities have been excluded because of the difficulty in making reasonably reliable estimates of the timing of cash settlements with the respective taxing authorities. Regarding future funding of retirement benefit plans, we plan to contribute about $100 million in 2017, but funding projections beyond 2017 are not practical to estimate due to the rules affecting tax-deductible contributions and the impact from the plans' asset performance, interest rates and potential U.S. and non-U.S. legislation.

Critical accounting policies

In preparing our consolidated financial statements in conformity with accounting principles generally accepted in the United States, we use statistical analyses, estimates and projections that affect the reported amounts and related disclosures and may vary from actual results. We consider the following accounting policies to be those that are most important to the portrayal of our financial condition and that require the most subjective judgment. If actual results differ significantly from management’s estimates and projections, there could be a significant effect on our financial statements.

Revenue recognition

We recognize revenue from sales of our products, including sales to our distributors, when title and risk of loss pass, which usually occurs upon shipment or delivery to the customer or distributor, depending upon the terms of the sales order; when persuasive evidence of an arrangement exists; when sales amounts are fixed or determinable; and when collectability is reasonably assured. For sales to distributors, payment is due on our standard commercial terms and is not contingent upon resale of the products.

Revenue from sales of our products that are subject to inventory consignment agreements, including consignment arrangements with distributors, is recognized in accordance with the principles discussed above. Delivery occurs when the customer or distributor pulls product from consignment inventory that we store at designated locations.

We recognize revenue net of allowances, which are management’s estimates of future credits to be granted to customers or distributors under programs common in the semiconductor industry. These allowances, which are not material, generally include volume-based incentives, product returns due to quality issues, incentives designed to maximize growth opportunities and special pricing arrangements. Allowances are based on analysis of historical data, current economic conditions and contractual terms and are recorded when revenue is recognized. We believe we can reasonably and reliably estimate allowances for credits to distributors in a timely manner.

In addition, we record allowances for accounts receivable that we estimate may not be collected. We monitor collectability of accounts receivable primarily through review of the accounts receivable aging. When collection is at risk, we assess the impact on amounts recorded for bad debts and, if necessary, will record a charge in the period such determination is made.

We recognize in revenue shipping fees, if any, received from customers. We include shipping and handling costs in cost of revenue. The majority of our customers pay these fees directly to third parties.

Income taxes

In determining Net income for financial statement purposes, we must make certain estimates and judgments in the calculation of tax provisions and the resultant tax liabilities, and in the recoverability of deferred tax assets that arise from temporary differences between the tax and financial statement recognition of revenue and expense.

In the ordinary course of global business, there may be many transactions and calculations where the ultimate tax outcome is uncertain. The calculation of tax liabilities involves dealing with uncertainties in the application of complex tax laws. We recognize potential liabilities for anticipated tax audit issues in the U.S. and other tax jurisdictions based on an estimate of the ultimate resolution of whether, and the extent to which, additional taxes will be due. Although we believe the estimates are reasonable, no assurance can be given that the final outcome of these matters will not be different than what is reflected in the historical income tax provisions and accruals.

As part of our financial process, we must assess the likelihood that our deferred tax assets can be recovered. If recovery is not likely, the provision for taxes must be increased by recording a reserve in the form of a valuation allowance for the deferred tax assets that are estimated not to be ultimately recoverable. In this process, certain relevant criteria are evaluated, including the existence of deferred tax liabilities that can be used to absorb deferred tax assets, the taxable income in prior years that can be used to absorb net operating losses and credit carrybacks, and taxable income in future years. Our judgment regarding future recoverability of our deferred tax assets based on these criteria may change due to various factors, including changes in U.S. or international tax laws and changes in market conditions and their impact on our assessment of taxable income in future periods. These changes, if any, may require material adjustments to the deferred tax assets and an accompanying reduction or increase in Net income in the period when such determinations are made. Also, our plans for the permanent reinvestment or eventual repatriation of the accumulated earnings of certain of our non-U.S. operations could change. Such changes could have a material effect on tax expense in future years.

In addition to the factors described above, the estimated annual tax rate, which excludes discrete items, reflected in forward-looking statements is based on then-current tax law. Significant changes in tax law enacted during the year could affect these estimates. Retroactive changes in tax law enacted subsequent to the end of a reporting period are reflected in the period of enactment.

Inventory valuation allowances

Inventory is valued net of allowances for unsalable or obsolete raw materials, work-in-process and finished goods. Statistical allowances are determined quarterly for raw materials and work-in-process based on historical disposals of inventory for salability and obsolescence reasons. For finished goods, quarterly statistical allowances are determined by comparing inventory levels of individual parts to historical shipments, current backlog and estimated future sales in order to identify inventory judged unlikely to be sold. A specific allowance for each material type will be carried if there is a significant event not captured by the statistical allowance. Examples are an end-of-life part or demand with imminent risk of cancellation. Allowances are also calculated quarterly for instances where inventoried costs for individual products are in excess of market prices for those products. Actual future write-offs of inventory for salability and obsolescence reasons may differ from estimates and calculations used to determine valuation allowances due to changes in customer demand, customer negotiations, technology shifts and other factors.

Changes in accounting standards

See Note 2 to the financial statements for information on new accounting standards.

Off-balance sheet arrangements

As of December 31, 2016, we had no significant off-balance sheet arrangements as defined in Item 303(a)(4)(ii) of SEC Regulation S-K.

Commitments and contingencies

See Note 12 to the financial statements for a discussion of our commitments and contingencies.