NXP Semiconductors N.V. (NXPI) Earnings Call Transcript & Summary

I'll finish the story later, I guess, but hi, everybody. I'm Joe Moore from Morgan Stanley. Happy to have with us today Jeff Palmer from NXP. He's going to explain why Bill Betz is not here. But just quick research disclosures. For important disclosures, please see the Morgan Stanley research disclosure website at morganstanley.com/researchdisclosures. If you have any questions, please reach out to your Morgan Stanley sales representative. So Jeff, did you want to?

Yes. Great. Good morning, everyone. I know you were expecting Bill Betz, our CFO, to be here today. But unfortunately, yesterday morning, he had a family emergency that came up. I think as you can all agree, family is number one, even though we all spend a lot of time together. So Bill is with his family today and tomorrow, and we wish him the very best. So with that, I'm his stand in.

Yes. I wish for the best for Bill, and I'm glad you were able to fill in. Thank you for doing that. Maybe if we could just start discussing kind of the general environment. You guys have done well, the key growth drivers in place, but you've also talked about a mixed demand environment with some areas of lead time compression and weakness, particularly in consumer. Can you just talk generally to what you guys are seeing?

Yes. So let's kind of set the table. So about 2/3 of our revenue is a combination of automotive and core industrial. And by core industrial, we mean things like factory automation, smart building and things like that. And that continues to be fairly good. We continue to be chasing supply. We still have escalations occurring. Even as our suppliers continue to improve supply to us, where we started to see weakness, which is probably not a surprise. Beginning early last year, we started to see kind of the PC more consumer markets start to weaken. The Android handset market started to weaken and then the kind of consumer IoT followed suit. And our assessment of this is it's really kind of a hangover from the work-from-home effort, the kind of everyone went through in '20 and '21. While we see it as a kind of a cyclical weakness, we don't see it as a secular downtick. We think things will come back. We're not in a position today to provide an update on when things will rebound. We're not changing our guidance today, everyone. So don't be hoping for that. But with that as the setup with automotive and industrial being pretty robust and kind of more consumer side of the business being a little weaker, we've decided to take a pretty aggressive stance on inventory. As you all know, about half of our inventory, our business goes through distribution. Normally, our target inventory level in distribution is 2.5 months. We're keeping that at about 1.6 months and allowing a little bit more inventory on our balance sheet to build up. So that gives us maximum flexibility. As we see demand in the channel come back in a more robust manner, we will continue to rebuild that back to the 2.5 months.

Great. Sounds good. Obviously, kind of a wild supply chain environment the last couple of years, given what's happened with shortages with your lead times. Can you talk about the real lead times? At one point you had talked about I think 70%, 80% of your catalog being out over 52 weeks, which seems extreme. And can you talk about where you are with that now? And you still have talked about not being able to meet all the demand this year?

Right. So the lead times really start to reflect what I just mentioned about the end markets. So automotive and core industrial, we're still looking at over 52 weeks. Effectively, we're sold out here for '23. The consumer side of things as the weakness in the demand environment has come up, those lead times have come in a bit. So it's clearly, it's a dichotomy. We use that term on our Q3 call, and more and more of that appears to be the best way to describe it.

And can you talk about the areas where you are still limited from supply? And I think you've talked about kind of specialized non-volume memory processes, automotive-centric. What are the pain points that sort of still keep you from being able to do that?

Yes. So I'm going to kind of answer that question, Joe, from a viewpoint of how our manufacturing strategy is. So as you all know, we have a hybrid manufacturing model. Roughly 40% of all of our revenue comes from factories internally, 60% is outsourced. Over the course of the last few years, on our internal factories, we've pushed out of those factories any bulk CMOS requirements. And so internally, basically our 4 fabs are proprietary mixed signal process factories. These are things anything above 90-nanometer, specialty processes that we can't buy in the open market, GaN, 180 UHV, things like that. We continue to be short on the specialty processes. That's probably one of the longer poles in the tent. I would say our foundry partners have done a good job of improving supply, but there still are some key areas that are tight for us. One in particular is 55-nanometer embedded flash for automotive microcontrollers and things like that.

And if you could talk to the way your customers are thinking about these supply chain issues now and in particular, they seem hyper aware of the foundry relationships of the geography of manufacturing. Over the next several years, TI as one of your competitors is clearly going to try to focus the customer base on how much domestic capacity they have. How important do you think those things are to customers? And how do you make sure that you're keeping everyone having...

So I think over the last couple of years, geographic distribution manufacturing has become more and more important and more critical, especially when you're starting to bid on opportunities a little further out on the horizon. We have customers who've told us point blank, "If you cannot manufacture a certain product for us here in the United States, don't even bother bidding on the program." So as a quick reminder, NXP has 4 fully owned factories, 1 in the Netherlands, 2 in Texas, 1 in Phoenix. And then we have a joint venture in Singapore with TSMC, and that joint venture, we own 62% of and it consolidates into our financials. That represents 40% of our total revenue. Our partners and pretty much the who's who, TSM Global, Samsung, are starting to build factories in a more distributed global fashion, and that will help us over time.

And just those conversations with the OEMs, it seems like a good thing. It seems like you guys are much more a part of the decision making. Can you talk about how the automotive industry might look different after 2 years of shortages that are really impactful that cost them billions of dollars of revenue. How are they going to manage inventory differently? How are they going to think about vendor selection define?

I think the best way to characterize it is prior to the pandemic, semiconductor companies were just seeing as another commodity by the auto OEMs. And I think as the pandemic really impacted their supply chains and as cars become more and more electronic-centric, they started to realize having a secure source of semiconductors was strategically important. So we see different models happening. We still hear from the auto OEMs that they would like to have strategic safety stocks. We don't believe they've built that up at this point. We hear safety stocks ranging from 3 to 6 months, which kind of matches our cycle time. We've been very clear that we would not be holding those safety stocks they would have to be held somewhere between the Tier 1s and the OEMs. And we still think that's ahead of some point maybe later this year and maybe into '24.

Yes. I mean it seems like that's a very sensible reaction to all of this.

They lost billions of dollars.

Yes. And I mean they're talking about holding inventory of components that don't depreciate, don't go obsolete, they have flexibility on anyone. But I guess the notion that they are not there yet, but they're not getting ahead of it. How do you know that? I mean how do you get that visibility?

Yes. Look, and I know we get asked this question a lot, which is, hey, what do you know about the inventory sitting at Tier 1s or OEMs and things. And the reality is no semiconductor company has a systematic mechanism for reading the inventory at their Tier 1 location. Do we get some anecdotal data? Yes, when we talk to them on an ongoing basis, yes. We do see that the OEMs, the Tier 1s and ourselves are being much more pragmatic about how to move demand around. So if we have 1 Tier 1 that maybe has too much of 1 component in a certain month, and another Tier 1 that doesn't have enough of the same component, they will allow us to redirect it. That's also partially why we'd like to keep more inventory on our balance sheet to give us that maximum flexibility. But do we truly know what's made up of all the inventory at the Tier 1s? No. I would say that the majority of this is not semiconductors, that would be my assessment. I would also say that you have to remember there has been significant inflation over the last couple of years. So while DIO metrics look highly elevated, remember there is that inflationary aspect to that.

And it's not that elevated relative to the types of builds you're talking about. I mean, it's not like Tier 1 inventories are they're not -- they're up...

They're not that high.

Yes. I think it's a good sign that the customers are being open with you that that's what they're doing. I mean, there's no double ordering. There's -- they're telling you that we're going to build up this safety?

That's what they're trying. I mean I think we've all -- and by we, I mean, the semiconductor industry has been playing a game of whack-a-mole or the golden screw, whichever you want to call it. But the automotive supply chain is a fairly deep supply chain. And from the time we ship a raw chip to when a car comes out of a factory somewhere around the world, that can be anywhere from 6 to 9 months depending on the OEM, right? And so there's different points of transformation from raw chips to finished cars. And each point in that transformation chain does need a certain amount of inventory just to effectively and efficiently run the supply chain. It's not like the handset supply chain, where chips go into a factory in the morning and handsets come out in the afternoon. It's nothing like that at all.

Okay. And I thought you guys did a good job on the call of kind of characterizing the NCNR coverage in the areas where you might enforce customers who have taken an obligation to take inventory versus where you've been more flexible. Can you talk about that a little bit?

Yes. So we had -- we'd be a little more explicit. In the mobile Android marketplace, as you know, in mobile, we supply, which is an embedded mobile wallet, which enables payment capability on your phone. The manufacturing of those parts at a certain point in the manufacturing process, we actually inject a customer-specific code into the device. It's how it works. Once we do that, that product becomes effectively custom. And so once we had products built for certain customers who had NCNR orders last year, we had to actually enforce the NCNR orders because we had customized the product. And that's really what we enforced in the second half of last year that we talked about. I can tell you today, we have no more mobile NCNR orders. Our whole NCNR order book is automotive and core industrial.

Okay. And with those customers, your goal is to sort of match up your shipments to kind of what they want?

Correct.

Yes. Okay. Maybe just since you mentioned mobile, I know it's a small part of your business, but if we could just get that part of it out of the way. You're down a lot in the first quarter. We've seen weakness across the entire Android supply chain for over a year now. Like are we at the point where you're pretty comfortable we're under-shipping in demand, and we think there will be a rebound? Or what's the visibility to that?

Joe, we are a niche player in the mobile market, to be very honest. And I would think that kind of a question somebody to give you more of a holistic view of the mobile market be 1 of our bigger competitors. I would say the seasonality, which most of you guys know, I hate that term, it's probably more pronounced here Q4 into Q1, a combination of the non-Android operating system phone, company has done very well, and I think they had a great year last year, a great year in the prior year. Android continues to be facing some headwinds and then you have the NCNR issues. I think those things combined are why we're seeing maybe what you might consider to be greater than normal seasonality end of Q1. But whether or not this is the bottom and it rebounds in Q2 or what have you, really not here to provide that online.

Okay. So we can focus on the core elements of your story are around automotive. Can you talk about what you think from a semiconductor perspective, what this year might look like if SAAR kind of flattens out. If we have a macro weakness and it flattens out, what's the growth opportunity within that?

Right. So our -- as you remember, in November of '21, we -- at our Analyst Day, we provided our growth outlook and we said that automotive would grow at 9% to 14% 3-year CAGR from '21 to '24. In that 9% to 14%, we contemplated very low single-digit global production. So if you had a situation as you call that Joe were was basically 0 SAAR, we think that the content per vehicle naturally could be 9%, 10%, right? And we feel pretty confident we feel more confident today about that content tailwind than we even did a year ago. I would say that 2022 was a banner year for NXP in terms of design and win awards, especially in automotive. And a lot of those projects will not come to fruition until '24, '25, '26 and beyond. So we feel very good about that setup.

So just to clarify, that's NXP's growth in content not including any like-for-like price increase. That's just...

That's correct.

Okay. And then you do get still some price increase?

That's correct. As we said on our last earnings call, we grew 19% '22 versus '21. Of that 19%, roughly 14 points was inflationary pricing that we unfortunately had to pass on to our customers. And we said that pricing into '23 would be up again but not as high as it was in '22.

And is there any view on whether that pricing at some point on a like-for-like basis comes back down?

I don't think -- I think there's been a lot of discussion as it's just going to be 100% reverse back to where it was exiting '19, and we don't see that. We may have a situation Joe, in the future periods where supply and demand or an equilibrium where we may offer to customers annual concessions as we had done in the past. But I think they will be at a much lower level than they've ever been historically.

Great. So maybe looking at some of the specific automotive growth drivers. Microcontroller has kind of been your bread and butter. You've talked about the S32 family. What are you seeing both in terms of the complexity and content growth within the MCU market and the growth in terms of the number of SKUs there?

So overall, if you think about to kind of set the table, today, average automobile is basically a flat device with point-to-point connections, processors, sensors and a ton of miles of wiring in between. What that is limited the auto OEMs to do is provide any type of software life cycle management. And so over time, the auto OEMs have to come to the idea of building more hierarchy into the car. And the hierarchy is around this idea of domains and zones. So think of domains, it's very much like a networking idea. You would build very specific domains in the car, and those domains would manage all the sub nodes below it. So the S32 family is a family of domain and zonal processors. These aren't microcontrollers. These are more multicore MPU type of devices. The S32 family was about $300 million in '21. We expect it to grow to about $600 million by '24. And that's actually -- think of that almost the analogy of the airplane taxing down the runway. The real need of growth of that product line is -- begins in the kind of '25 -- model year '25 and '26 and really starts to accelerate because most of the auto OEMs want to build this ability to do software-defined vehicles, the ability to overengineer the car the day it leaves the lot so that they can add software features over time.

And is there a reduction in the number of overall controllers and processors that go into the car. I mean if you look at Tesla is the pioneer of a lot of what you're talking about, they've talked about simplicity and fewer such systems...

We would disagree with that. We would say there is not a massive compression of embedded microcontrollers in the car. There would be more of an additive domain processes. Now there's probably a blurring of the lines between certain microcontrollers and certain zonal controllers, but I don't see a massive compression of a number of microcontrollers in the car.

Okay. Helpful. Maybe in terms of other drivers of your automotive business, you've talked about battery management. Obviously, analog device is pretty strong there, but you've talked about specific growth numbers. Can you talk to that opportunity?

Sure. So our electrification business was about $200 million in '21, and that's made up of battery management systems, inverter control, early, early efforts in DC to DC control and then a little bit of electrification domain process. And so that's kind of a rank order. We thought that our electrification business would grow at about a 30% CAGR from '21 to '24. With the hyper acceleration of xEVs in the marketplace, that business for us has grown dramatically above our own expectations. And as we said in our recent call, our electrification business doubled from that $200 million to, call it, roughly $400 million in '22. So we are ahead of where we'd like to be.

I mean it seems pretty impressive that the automotive industry has inflected that way, right? I mean we don't normally see a movement that's that rapid within 1 year of adoption of new technologies. Is that just sort of the Tesla effect and what you're seeing there?

I think there's that. I think there's a heavy regulatory oversight, especially in Europe and in China, where they're mandating CO2 reduction. And if auto OEMs are not able to reduce their CO2 of the total fleet, they're going to be cost to them from the government, yes.

I mean it just seems interesting in the context of we're having conversations with automotive purchasing people who are having to qualify and ramp things within 12 months, which is obviously very different than any normally happens there. So it seems like an interesting environment. And then radar is another opportunity that you talked to. Can you speak to that as well?

Yes. So radar was about $600 million in '21. We expect it to grow to about $1.2 billion or 25% CAGR in '24. Yole, the third-party market research firm, recently published a report that shows that NXP is the clear market leader in 77 gigahertz automotive radar on a revenue basis. We feel very good about that. We continue to win significant opportunities. In terms of its year-on-year growth in '22, we're above that 25% growth rate. So we continue to feel very positive about that tailwind.

And what is driving that growth in the sense of -- we've had radar and adaptive cruise control for a number of years? Why are you seeing that higher adoption?

Well, there's kind of a 3-way multiplicative driver to the radar business. Every year, there are more cars with radar. That's step 1. Step 2 is every year, there are more nodes of radar nodes per car. In the beginning it was only a single node going to 2, going to 3 and so on. And then thirdly is a more content per node. So the OEMs want more features in each 1 of those nodes. And that kind of 3-way multiplicative effect is what's the tailwind that's driving the business.

Okay. Great. So generally, you're seeing all of the growth trends that you articulated 18 months ago are ahead of where you thought they would be.

In line to ahead, yes.

Yes. And then the balance of the business is sort of more in line with the auto industry, which is still...

The way we implemented the cost increases, we did not -- we spread it across the total portfolio of the company. So even our core automotive business, which we said we thought would grow kind of mid-single digits at the Analyst Day, definitely grew better than that. And a portion of that was ASP.

Okay. And then -- so then you've said that -- do you think that -- I mean if there's that much inventory build still ahead of us, you have to be pretty confident in terms of what the year looks like.

We are very confident in our 9% to 14% growth, which is, again, back to reiterate, net of any pricing, very, very low global SAAR production. Remember, at our earnings call, we said that we still feel very confident in hitting the $15 billion company target in '24. And to do that, we have to have automotive do what it's going to do.

Okay. Helpful. Maybe moving over to industrial and IoT. You talked about kind of a mixed environment. When you talk about the more consumer-centric industrial, can you kind of draw the lines in terms of which parts...

Yes. So we have an industrial and IoT reportable segment, which is roughly 20% of the total company revenue. We said that about 60% of that segment was core industrial and 40% was consumer IoT. Clearly, the consumer IoT is quite weak right at the moment. And some interesting characteristics about that segment. It is a highly distribution exposed business because it's tens of thousands of smaller customers. It is a higher China manufacturing or ship to business. And when we were getting ready for the earnings call, we were looking at a lot of trends where we came to the conclusion was, one, a combination of just weaker macro environment, which we all saw through '22. But also in December, as the Chinese government lifted the zero-COVID policies. We started to see both in our own facilities and our partners and our logistics partners infection rates go up significantly, which also added further headwind to that business in the tail end of last year. So we think that, as I said at the beginning of our conversation, Joe, we don't think it is a secular headwind we're facing. We think it's more cyclical. And we feel pretty confident that the products will continue to get great traction going forward.

And on that China data point, I mean, it seems like there's a consistent messaging that China remains pretty difficult, but it also seems clear that the economy really is reopening that there should be a significant increase in demand. So how are you thinking about the full year? And particularly, when you talk about being more cautious with distribution, things like that, do you look at this as a market that could inflect more positively and you want to overshoot on that?

So Joe, I'm not going to give you guidance for the full year. It's probably no. I think we feel very confident in all the trends that we see in the business. I think we've given enough kind of crumbs on the road for you, draw your own conclusion on where you think this year goes. Now barring any significant recessionary environment, which would collapse automotive or collapse core industrial, we feel fairly confident.

Yes. I mean I'm not trying to...

No, no I just want to be straightforward.

But it does seem like you're being very conservative on the way you're running your business, you're taking distribution inventory down and yet one region of the world, things might be about to improve.

And so having inventory on our balance sheet is a great position to be in, right? We get -- over the course of the last 5-plus years, we have improved our distribution system management, if you will. And so we are able to get information from our distributors on a daily basis on sell in, sell out inventory on a distributor-by-distributor basis, product by product. So we know exactly how things are trending. As we see China reopening and the polls out of distribution start to accelerate, we had the inventory, we'll be able to satiate that demand and we'll be in an ideal position to take advantage of it. If it doesn't occur, if it pushes out a little further, we're comfortable with having inventory on the balance sheet. As you said earlier, it is long life. There's low chance of obsolescence of that product.

Yes. Makes a lot of sense. All right. I have one more question, and then we'll open it up for guidance. Can you talk about on the financial side, gross margin structure? You've seen -- you've talked about kind of a gross margin that goes up largely through mix from here and that you've been very cautious of to the extent prices are going up, it's purely passing through cost increases. How do you think about that trajectory over the course of the year? Yes. So.

Gross margin target is 55% to 58% on a non-GAAP basis. We got to the 58% probably faster than any of us anticipated. There's a couple of things under the covers to think about it. So earlier in our conversation, we talked about how 40% of all of our wafers come from our internal factories, 60% outsourced. We talked about how our internal footprint is exclusively mixed-signal proprietary processes. In that footprint internally, it is highly bias towards automotive and core industrial. So long as those end markets hold up well, our utilization of our internal factories should stay relatively high. Now all through last year, our utilization on our internal factories was in the high 90% range, which is really unsustainable. They don't operate efficiently like that. In Q4, we said that our utilization came down at about in the low 90s and for Q1, the guidance contemplates utilization being in the mid-80s. Mid-80s is kind of the sweet spot for this generation of fabs that we own, 8-inch fully depreciated factories. So long as automotive, the core industrial stay elevated, we believe we can run the factories above certain levels where we would have to take any type of underutilization charges and in turn, keep gross margins elevated. Now over the long term, what will drive gross margins potentially higher or give at least a tailwind to gross margins or new product introductions. And so as you all know, NSP is very fixated on this idea of relative market share. And as we greenlight new projects for R&D, they must be accretive to the gross margin -- the company's gross margin at the time of kind of green lighting those R&D projects. So the pipeline of new products should be richer in mixed than the historical mix of products. That makes sense.

Makes sense. Yes. Thank you. So let's pause there and see if there's any questions from the audience. If not, can you maybe give us an idea just of the capital allocation strategy how you think about priorities between the buyback dividend is M&A possible for you?

We think we have a very simple and straightforward capital allocation policy. We're going to return all excess free cash flow to our owners, what's not invested into the business. We have 2 levers we can pull there. First is our dividend. We aim to have a 25% cash flow from operations payout ratio. In '22, that was about 21%. And we just recently increased the dividend by 20%. So we think we're on a nice trajectory to kind of achieving that 25% payout ratio. The remainder of the excess free cash flow will go to buybacks. And our kind of go, no-go on buybacks is so long as our leverage is at 2x or below we can be in the market. Now we don't try to time the market. We're not that smart. We basically kind of did cost average into the marketplace. I would say Bill Betz, our CFO, is a little more conservative than Peter used to be. And last year, when it was clear that there were some storm clouds building on the horizon, Bill did take the opportunity to build a bit more cash on the balance sheet. So we were not in the market in Q2. I think he's built up a nice safety cushion at that point. So I think he feels pretty good about moving forward with executing towards that capital allocation policy. Now in terms of M&A, we always do small tuck-ins. And by small, we mean things under $100 million. These tend to be either IP shops or small R&D teams that have some unique value to us. But these are smaller kind of we do these as we operate the business. Large transformative M&A, while the industry probably has to consolidate, we think the regulatory environment globally is not very conducive to large global M&A but we'll always keep our eyes open.

Okay. Great. Well, we'll wrap it up there. Jeff, thank you so much.

Okay, great. Thank you, everyone. Appreciate it. Thanks, Joe.