ON Semiconductor Corporation (ON) Earnings Call Transcript & Summary

So good morning, good afternoon and good evening, everyone, wherever you are. Since these things are virtual now, there's probably some people listening from Moon, who knows. Anyway, it's Chris Danely, again, your favorite neighborhood semiconductor analyst here at Citigroup. Thanks for joining our global technology conference this year. It's our pleasure next to have one of our favorite stocks pirated, ON semiconductor. Why do we like ON so much? Number one, compelling valuation, one of the most compelling valuations in our coverage universe. And then number two, strong earnings growth, driven by the eventual recovery in semis. Hopefully, we can talk about that a little bit today. Here today from ON Semi, we have Bernard Gutmann, the CFO; and Parag Agarwal, who's VP of Investor Relations.

And I guess, Bernard, first of all, thanks for joining. And really, you guys put out a press release last week to address the veritable elephant in the room. What's going on with Keith? Sounds like you're going to get a change in leadership here, maybe talk about since Keith is not here, maybe he's already sashaying into semi-retirement. But just give us a sense of what's going on? What the replacement plans are? And what led up to his decision?

Sure. I'll be glad to do that. Thanks, Chris, and thank you, everybody else, for joining us today. So let me address that question. As you pointed out, we did come out with the press release. There is really not much to it. Simply, Keith, over the weekend, turn 65. He had already been in discussion with the Board, basically advising them that he was ready to move on and spend time with the family and grandkids and play more golf. He has been on the treadmill for 19 years as the head of this company, bringing it successfully from a $300 million valuation to an -- about $9 billion market cap. He -- him and the Board agreed to a pretty nice transition of 9 months through May of next year. So Keith is still active. He's still our CEO, and he's still acting as such until he leaves, which again is targeted to be May of next year. The Board's succession plan is to consider internal candidates, but they have expanded the search to also cast a wider net by also looking at the external world and based on -- and optimizing and looking for the best that they could take to a -- to take the company to a next level. Executive team is right on and pretty stable in all good hears. So we will all keep doing our jobs and continue with the paths and the steps that we have taken to shore up our margins and deliver better results in light of also impending recovery of the markets. So all in all, it was a personal decision. There is nothing more to it, and we wish Keith the best. He has been a great boss, what I can say on a personal basis, a great CEO. But he said, "Hey, after 19 years, it's time."

Okay. I guess a few questions just on that. Were you surprised that he's sailing off it as a sunset? Or was this something that Keith sort of had hinted that, that would happen when he turned 65?

He had hinted that at the appropriate time, he was going to retire. He didn't go and specifically discuss that with -- in general. But no, I wasn't too surprised because it's pretty taxing. Somebody was saying that being a CEO in semiconductor is like a dog year. And he has been 19 years, so he has been CEO for 135 years or so. All in all, it wasn't a surprise. It was kind of an expected.

And then the next question is -- so it sounds like 65 is like the mandatory retirement age that begs the question, how old are you Bernard? And does this have any impact or influence on your status? Are you looking at heading for the exits? Or are you going to stick around?

I'm sticking around. I'm too young. I'm going to be turning 61. And by the way, there is no 65 mandatory retirement. It's any -- it's a personal choice. And we have executives within our staff that are also above that age, and they are not planning on leaving. So -- but my personal, I'm excited to continue and excited to continue adding value as long as possible.

Great. So let's get back to the biz. I guess it's obviously been a topsy-turvy year for -- well, not just semis, but for everything, but also for ON. So maybe let's just take a step back. I still get asked about this. You guys had a bit of a mixed sort of Q4 and Q1 quarter end results. You guys talked about a few execution issues, but those also seem to be getting fixed in the most recent quarter. So maybe if you could just kind of set the table. What wrong -- what tripped you up in Q4 and Q1 that led to the disappointment in terms of margins and a little bit higher expenses? And then subsequently, you guys announced some actions to fix things, and it seems like those started to manifest themselves in Q2 and into Q3. So maybe just take us through that, and we'll go from there.

Sure. So the issue, the mixed issue we had of selling some low-margin stuff was primarily Q4. I would say that Q1 was mildly affected by that, but corrective actions had already been taken, and it was only a carryover. Q1 was indeed affected by COVID because we had some shelter-in-place mandates in different countries that caused us to recognize period expenses, not capitalize the expenses for that abnormal capacity utilization. We continued seeing that in Q2, but at the same time, we're able to deliver results better than our guidance. And we definitely are guiding for a nice improvement of 220 basis points at the midpoint of our guidance for Q3, stemming from mostly the elimination of some of the COVID impacts as well as the revenue fall-through. We did, as you said, also took actions that will result in future benefits that we have not seen in terms of our actual numbers yet. One is the closure of our Rochester facility, that's on its way out and should be getting the full benefits in '21. And 2 others are the intended sale of our 6-inch facilities in Belgium and in Niigata, Japan. The combined of all 3 factories should result in savings around $75 million in -- per year. Timing of that is still undefined, depends on what the actual individual negotiation is with the buying party and whatever manufacturing services agreements that result from that. But bottom line when we are done, we should be helping ourselves by reducing from about 11 front-ends existing to about 8, which helps us also in terms of shoring up our capacity utilization. The number I quoted earlier is mostly the elimination of fixed cost. We also get the side benefit that it also improves unit cost on the receiving factories as we have better utilization. So with that, we are taking measures. We still are targeting to achieve our 43% target model for gross margin. It does require that we get to approximately $7 billion in revenue. And obviously, 2019 and '20 were not very kind from the revenue point of view with the -- about 6% down in '19 and about 8%, if you look at sell-side models, for 2020. Nevertheless, we are quite excited about all the secular drivers and the recovery we are seeing and take -- and ready to take advantage of that and show some pretty good fall-through on the incremental revenues as we move back from the existing low utilization to our sweet spot, which is around 85%.

That's great. So just to run through some questions there, and some of these are questions I've received for investors. So just to go through the sort of execution issues or margin impacts. One of them was a higher-than-expected sale of lower-margin products. Can you talk about, I guess, why or how this happened? And then more importantly, how can we prevent this from happening in the future? What gives you confidence that it won't happen again?

It was because of decision mechanism to make that decision was taken at the wrong level in the organization, and that was remedied by putting controls in place that prevent things like that to happen again. Again, it was more a Q4 event that is not -- that did not repeat itself. So this is now, I would say, fairly old history, and we have not seen any of that and don't expect to see that in the future anymore.

Okay, great. And then, I think, there was another one on depreciation. Depreciation was higher than expected. How did that happen? And how can we prevent that from popping up in the future?

Well, depreciation, obviously, is a function of our CapEx. And we did invest heavily in '17, '18 and '19 and didn't see the offsetting increased revenue to do that. And that's the reason why we're taking actions in terms of reducing our footprint with the factories' sales and closures that we talked about in -- earlier today.

Got it. And then you mentioned COVID costs, which we're seeing across the industry. Have your COVID costs peaked? Can you give us a sense of how big they are? And then how will these sort of fall off going forward? And what milestones we can look at?

So the Q2 effect was -- we publicly talked about that in our earnings call, was about $24 million, which is close to 200 basis points of margin, made up about $13 million of those by period -- from period expenses stemming from abnormal utilization and the other $11 million are mostly freight and logistics as well as safety cost incurred for the safety of the employees. The period expenses are assumed to be eliminated as we go into Q3 and our guidance reflect that. That's part of the reason why we're showing a 220 basis point expansion in gross margin. However, the $11 million, which is close to 90 basis points of margin for the freight and the safety cost are still in our numbers, and we don't expect that they will go away until the pandemic is resolved. Some of them -- we don't have a time line. It depends on really the supply and demand on freight as well as really the -- whatever safety costs we need to spend on employees until the pandemic disappears. My guess on it is that it'll be a gradual thing over the next 5 to 6 quarters.

Got it.

So we have about 90 basis points, $11 million is what's baked into our current Q3 number guidance.

Sure. And so now that we've had a few quarters of COVID, what sort of structural changes to your business longer term do you think are resulting from COVID, whether it's operationally or different thoughts on the end markets?

I -- we have seen some short-term benefits on the end markets where we saw some tailwinds in the client computing space with the work-from-home effect. But fundamentally, we don't think it's going to change that much. We have yet to see on the internal employee situation, whether -- how will that shift in terms of the mix of work from home versus work from the office. Obviously, we're a manufacturing company. So if you do manufacturing, you'll require people to be there, and they have been there all along. We have some pretty stringent safety protocols that have been put in place into all of our locations that guarantee -- well, they don't guarantee, but ensure as much safety as we can for employees, and they have worked out, okay. We have 36,000 employees and have been able to keep all of our operations open, safe for those that government mandates prohibited us from operating back in the late Q1, early Q2 time frame. So long term, we still are believing that the -- that we are going to get out of this and recover and be able to take advantage of all the secular drivers in our different end markets.

I have a question from an investor, is asking about this -- the COVID impact. Do you think that it's possible that due to increased automation that this could be a driver for accelerated growth of the industrial end market? And then also, do you think that this could be a little bit of a headwind to the automotive end market. Any thoughts on either of those, Bernard?

So in industrial, it is possible. One of the things we talked about in the short term is that we are seeing tailwinds coming from a lot of interest in design wins in the warehouse automation and robotic delivery. Some of it might be induced by COVID. Factory automation where you want to reduce the number of people on the floor space versus having an automatic tool is probably a -- makes sense that it might be accelerated. On the cars, I don't know that it will be a long-term effect. When we're looking at the external IHS type of data, it looks like 2020, SAAR is going to be somewhere in the 15% to 20% down. And by the way, our revenue should be better than that because we do have content growth. And the expectations for next year is a 12% to 15% growth over 2020. So it wouldn't get back completely to 2019 levels, but it will shore up the gap in a pretty meaningful way.

So Chris, if you look at our industrial revenue, there are 2 drivers. One is speed efficiency, energy efficiency; and second is automation. With this COVID definitely, we'll see industrial will be just towards increased automation. Energy efficiency, again, there's a global trend that everybody wants to conserve energy, they have mandates and everything else. So all in all, automation should see acceleration. On the automotive side, longer term, I think, many of our competitors have commented that people are a bit wary of taking public transportation. And that might help automotive sales in the near term. But our model -- our long-term model is based on SAAR growth, global SAAR growth of 1%. And that should remain intact. I mean if at all, anything, it should have an upside as we go forward.

Okay. I guess let's dig into the end markets a little bit. Maybe, Bernard, if you could just take us through how the end markets have trended this year? I guess let's start with autos because it's had the most volatility. Talk about how far it declined? And then, I believe, that it's starting to recover for you as well as the rest of the industry. Just give us sort of a time line on auto demand? How it's trended throughout the year up until now?

Sure. So Q2 was our -- we saw a significant decline, stemming mostly from North America and U.S. OEM and Tier 1 factories being shut down on the customer side. We were 26% down on a sequential basis, which we believe fared a little bit better than some of our peers, but nevertheless, a pretty steep 26% decline. As we guided into Q4, and by the way, we did have a -- our earnings call was a little bit late in the cycle. So we may have had a little bit more visibility than our peers. We guided for a pretty strong up-recovery in automotive in the third quarter, and we also said that we are cautiously optimistic about the back half of the year. And that's not only automotive, but that's a generic statement. So definitely, we did see no more factories closed in -- on the automotive front, and as a result, we saw a good recovery on our top line. We do have a good portion of the automotive business that's run through just-in-time warehouses. So that, on one hand, prevents inventory accumulation, and at the same time, gives us pretty real-time feedback on what's going on because if a factory gets shut down and your consumption goes to 0, your sales go to 0. So it's pretty bad. And at the same time, when you reaccelerate it and restart it, you'll start seeing that right away. So we're quite happy about what we're seeing in terms of the recovery. As I said earlier, by looking at some of the external data, it still looks like about a 15% to 20% down year-over-year in terms of the SAAR, and our revenues should have a -- should be better than that because of content.

Yes. And so just another question on those. You guys reported just -- I believe, just a few weeks ago. So did you see your bookings kind of continued to strengthen as this quarter went on up until your reporting date or was it more of a steady?

It was pretty steady recovering through the time we announced. So that gave us confidence that we should -- that we were able to guide to a sequential fairly seasonal 4% growth in -- on our total revenue.

Yes. And I think after this quarter, we'll still be, I don't know, 10%, 15% below where the peak was for auto for you guys, which is in line with most other semis. Some of the other folks are talking about it. It doesn't seem like anything is going to slow down, i.e., continued recovery throughout the rest of the year. Any reason to not believe that?

We said in our call that we're really cautiously optimistic about the rest of the year.

Yes. Great. And then maybe take us through the industrial trends. You guys actually had a pretty good Q2 on the industrial front. So talk about how industrial has gone this year?

Industrial has gone pretty well. We did talk about design wins in warehouse automation and robotic delivery. But in general terms, we did pretty well in Q2. We guided to an abnormally low Q3, stemming from the restrictions on one of our customers affecting our Q3 sequential growth. Instead of being flat to up, we guided it down. But in general terms, we feel industrial is doing pretty good. As Parag said earlier, longer-term growth drivers there are automation and energy efficiency or energy conservation, and we believe these are solid long-term drivers that will help us for multiple years to come. In addition, we have also a pretty good medical franchise that's also growing in a nice way and has pretty good margins. So say for this onetime -- this one-off situation in Q3, we believe it's also a market that is showing signs of recovery. We've always looked at the industrial market being pegged to macros and to mostly global PMIs, and we are seeing some pretty good inform -- or data on that, that gives us the point in the right direction.

Great. And if we take a look at your industrial business, without the impact of that one customer, would it be up in Q3?

It would have been seasonal.

Yes. And so how big is that customer? And are -- were you still shipping to that customer for part of Q3? In other words, is it going to be a bit of a drag on Q4? Or is this the last sort of negative impact we'll see in this quarter?

So we don't individually talk about our customers, but I can frame it by saying that we don't have any customer that's greater than 6%, and that customer is not the top customer. And we have seen that customer also declined in size over the different restriction waves that have come through in May of '19 and in May of '20. So we said in the call that we have substantially de-risked that customer. We are, like everybody else, shipping to that customer for most of Q3, and we are still evaluating what the situations will be as we go into the future, as it relates to licenses, which at this stage is unknown. But it has been substantially de-risked as it has become a -- less of a factor at each round of restrictions that have been put in place with the bigger one taking place in this May time frame, which affected the Q3 guidance.

Do you think there is the potential for any other customers to get thrown on the band list? And is there anything that ON could do to prepare for that? Or is there anything that you're looking to do to try and prepare for this? Or is it just kind of see what happens?

So obviously, we don't know the mindset and intention of the administration and the governments. We are not overly concerned. We have taken an approach of go wide, go west in terms of our products, so to make sure that we diversify as much as possible and not have any concentration. As we have said, we don't have any customer that's greater than 6%. And in that sense, it isolates us from a -- at least material impact. Obviously, we're still subjective. If there are immediate things are put in place, we could be affected, but we don't see that as a significant material effect.

Okay. And then the third sort of large end market for you guys is communications. Maybe give us a sense of how communications has trended for you, especially given the strength that we're starting to see in 5G?

Yes. So 5G, if we bifurcate communications into the base station infrastructure, that's one that's gone very well. We have shown some pretty strong tailwinds on that one. We expect that in the medium and -- in the next 3 to 5 years as 5G is deployed, we should be able to take a good advantage of that. We have strong presence at all of the global base station manufacturers. So in that sense, we are fairly agnostic to who wins and who doesn't because our parts go in all of them. It's about $150 per macro cell. So it's a pretty nice content, and it's pretty -- it's a good driver as part of our revenue recovery in the next several years. The smartphone side of it, we do benefit some from the 5G content. It increases our content by maybe $1 compared to the base of $9. In the long run, it's a market we are putting less emphasis on, and we believe it's going to be low single-digit to flattish type of units. So it's -- say, for this content that will come from 5G, it is less of a focus for us as a company. We did say in our third quarter same situation with industrial, we're seeing also on smartphones or on communications, where we have the same restriction supplying that caused us to guide that end market to be down, where the normal seasonality would be up. But we also said there was a delay in the launch of some global programs for some global manufacturers that -- on the smartphone side that caused us also to be a little bit less than normal on the third quarter, yes.