ON Semiconductor Corporation (ON) Earnings Call Transcript & Summary

Very happy to welcome the management team from ON Semiconductor onto the virtual stage here. We have Keith Jackson, the CEO; Bernard Gutmann, the Executive VP and CFO; and I believe Parag Agarwal from Investor Relations as well. So as with all these other presentations, if you have questions, just either within the webcast link in the system, you can ask them there or just e-mail me at ross.seymore@db.com, and I'll happily and anonymously ask the questions to the management team.

So first and foremost, guys, thank you for joining me. I guess, Keith, given the news from a week ago or so, what's leading to the retirement? And what sort of priorities do you have between now and when you step aside in May?

I think the retirement hopefully isn't too shocking to anyone. Certainly, reached an appropriate age and have been here quite a while. I think the company is in good shape. And our outlook is for continued recovery. So feeling good about the timing. And my priority right now is making sure we have good leadership selected going forward and continue to make the recovery financially with the markets over the next 6 months or so.

So with all the companies, especially the broad-based companies like ON, I've been starting off with some of the macro themes first. And obviously, one of them that's made this year very strange is COVID, the pandemic. So I want to talk a little bit about both the supply and the demand side there. You guys had some significant supply disruptions in the first half of this year due to some of the shelter-in-place orders in Malaysia and Philippines. I think it hit your revenues by over $100 million or so in each of the quarters, if I remember correctly. Can you talk a little bit about where we stand on those issues? Is the supply side back up and running? And are we going to see any catch-up of that demand? Or is that demand just pretty much disappeared at this point?

Yes. It's -- the first downturn we've had where there have been both supply and demand issues simultaneously. So this has been interesting. In the second half, we are not expecting any supply disruptions due to COVID at all. And so the opportunity there is to catch up all of the stuff we missed. From a demand perspective, we'll talk more about the trends I'm sure, but we do see a continued demand pickup. There are a few spots that are constrained from a market perspective. But in general, supply is ample for the ramps that we've been forecasting.

And you mentioned -- and we'll go into some of the other demand dynamics a little later by segment. But in aggregate, on your last earnings call, you noted that order trends had improved in recent months. Can you give us just a little color on that? Do you think that's because of true demand rebounding in areas like automotive? Is it just that the factories are turning back on? Or are you worried that some of that might be a little bit of pull in because people are afraid of wave 2 and additional round of shutdowns, and so therefore, inventory is actually building up and could create some problems as we look into maybe the early parts of next year?

Yes. What we're seeing so far, we believe, is end demand related. The automotive one you mentioned, clearly, the factories were shut down in the second quarter, and they're now largely all back up. And so that's all pure demand. And of course, you know that auto inventories overall are pretty low as far as number of days on the parking lot. So we see that as the biggest driver and feeling very comfortable there. Most of the other markets did not shut down as hard, and so therefore, the rebound is much less. And so the new orders we're seeing there, again, makes sense to be relatively aligned with end demands as opposed to building inventories.

And what percentage -- if you were going to look at your business and say, work-from-home tailwinds, COVID tailwinds, things like medical, what percentage of your business do you think is seeing those sorts of tailwinds and how structurally important are they or are you viewing them more as kind of a near term and maybe transitional boost in demand?

Yes. Actually, one of the bigger tailwinds we had from COVID was computing as everyone refreshed, whether it's their video systems or audio systems or PCs or handsets, whatever it was, they had to do a refresh for work-from-home. And so you've seen some untypically strong computing opportunities. Medical, little counterintuitive. We actually -- people were prevented from getting a lot of elective types of procedures and things like hearing aids, et cetera, all got pushed out. And so those were actually not headwinds -- are not tailwinds, excuse me, with COVID. We do expect that to recover here as we get into the fourth quarter. But really computing was probably the primary tailwind from COVID.

So the other or a second macro dynamic that I've been focusing on with companies before we get to some ON specifics here would be on the U.S.-China trade tensions. I think you mentioned in your third quarter guidance that it was impacted by the trade restrictions that kick off this week. I also think, historically, that customer has been a low- to mid-single-digit percentage of sales. So if we look at that, how are you viewing the headwinds from the most recent rounds of trade restrictions?

So yes, the trade restrictions there were not anticipated, frankly, before August. And so they are more significant than what we were expecting. And certainly, we'll have an impact until there are licenses granted, which we are expecting to happen. But certainly, there's going to be a pause or a gap before any of that does happen. So it's an additional, I guess, headwind for us as we look forward to Q4. But as you mentioned, it was not a significantly large portion of our business going into that quarter.

And how do you view the license application process? Is that a black box you mentioned. You do expect license to be granted, kind of what gives you that belief in this instance?

Yes. It was -- we've gone through this process earlier, different scale and different parameters. And it did take some number of months, somewhere over 6 months, but licenses were granted. There were some things that stayed in limbo, but most of the ones that were not 5G specific did come through.

And I guess that would be my final question on this topic. And I know you don't want to talk about specific customers with too much detail. But to the extent 5G infrastructure is the portion of the business that is least likely to get a license to ship, but things like handsets, maybe 5G handsets, wouldn't be necessarily as problematic. Can you just talk about how your business is split between those markets, whether you want to make that specific to the one customer or more a generic in general sense?

Well, from generic sense, we are very well positioned with all of the 5G infrastructure players. And so on that side, we're comfortable with whatever transitions go on in that business, we're going to be able to service it. And on the handset side, again, there are many other large players that we are very, very well positioned with. So in general, from an end market perspective, we're not worried about impact to the business overall. But in specific, from a timing perspective and that opportunity to work through the inventories that may be there, et cetera, there are going to be some short-term impacts.

Maybe the last question on that dynamic. Like you said, this has been going on for a couple years. People on my side have been wondering about buffer inventory being built ahead of each of these new regulations. What's your view on either the channel inventory, probably specifically in China, not specifically with any one customer and also the OEM inventory. If you put that in aggregate, do you believe that some significant buffer has been built across the board there? Or are there offsetting reasons why you don't actually think that buffer exists?

I think there are specific buffers in China, but we have not seen any in the supply chains anywhere else. And if you look at the way that the trade sanctions have been worded, I doubt there's much outside of the end customer himself. So we are expecting some inventory there, maybe significant, but not a full supply chain work.

And Ross, if you look at our distribution inventory, in general, we called out at the end of Q2 that we were at the higher end of our comfort range, but still within the comfort range and in light of an expected recovery, the markets being on the higher side is probably a good thing. Previous experiences, we ran our inventories very tight, and paid the price for not being able to react to short-cycle orders. So we feel we're in a very good position to take advantage of recovery with the level of inventory which is reasonable, but a little bit on the higher side.

Thanks for that color, Bernard. So I guess just wrapping up these macro questions before I get to some ON specific stuff. When you mentioned about the shortages, to my initial question that the supply issues are now behind you, you should be able to catch up to the demand, et cetera, that seems like a nice tailwind. But then some of these entity list issues could be a bit of a headwind looking into the fourth quarter. It might just be a timing difference, one being more short-term and transitional and the other taking a little bit longer. But how do you view those as somewhat offsetting trends? Is one more powerful than the other as you look into the second half of this year and the first half of next year?

Yes. Again, it falls into, I guess, just mathematical equations. We see a lot of strength going into Q4 with most of our markets. And that is a much bigger impact than any specific set of restrictions.

Got it. Good to hear for you guys. So the next topic I want to get into is very ON specific, and that is some of the structural changes that you're putting into place. On the manufacturer side, you guys, a while back, bought a 300-millimeter fab, now you're shutting down some facilities. If we take this to kind of the financial metric and the financial results of this, there's been a period of -- the gross margin, frankly, been pretty disappointing late last year and early this year. But now you've taken some structural actions to address that. Talk a little bit about what went wrong in the gross margin side, and how these structural actions are going to rectify that issue?

Yes. So Ross, this is Bernard. We did have some one-off issues in the late fourth quarter that also, I think, was a little bit in Q1 that were more mix related. And those are completely taking that up. We have put controls in place so those do not reoccur. And to your point, we did -- we have addressed the gross margin issue with self-help. We announced the closure of 1 facility, Rochester and the intended sale of 2 additional facilities, Belgium and Niigata, Japan. The sum of all 3 should get us about $75 million of annual savings that at the time of which depends on the final agreement we reached with the buyers of these entities. But net-net, we are working on eliminating some of the excess capacity that we have, which will -- which we are allowed or we are afforded by the fact that we will be getting a nice amount of incremental capacity when we finally get the ownership of East Fishkill in 2023. Also, I would like to note that within our Q3 guidance, which is already 220 basis points stronger than what we delivered in Q2. We still have headwinds due to COVID, probably around 90 basis points that we expect will also go away, but the timing of which is probably more a function of how the pandemic evolve. But this is another aspect that we will be getting in terms of self-help. We have also accelerated our in-sourcing programs that should also help the tailwinds to our gross margin. And as we have talked multiple times in the past, we also expect to continue seeing improvements due to mix, whereby we are expected to grow at a faster pace in the end markets where the gross margins are above corporate average, with the flip side on the ones that the gross margin is below corporate average. So we do have -- and obviously, revenues, thus wonder, we expect a 50% fall through at a minimum for any incremental revenue. And as we mentioned, we are cautiously optimistic about the future. We see that the global PMIs and the global GP are showing some signs of revival. And we are also very, very optimistic about all of our secular growth drivers in the different end markets that we have put our R&D efforts in. So all in all, when you take all of that, we do believe that we can achieve our target model of 43% gross margin at about the same level of revenue that we talked about in the Analyst Day, which is about $7.1 billion.

So talk a little bit about the 300-millimeter fab importance to that. It's -- when you mentioned about $75 million in savings from shutting down or selling the 3 fabs that you've announced thus far, I assume that's only on the cost side of the equation. But if you're moving that utilization to 300-millimeter, I would assume there's another tailwind there. So it's not just like you said, in-sourcing more. That's part of it, so your utilization rises, but also where you in-source will matter. So to the extent that's a 300-millimeter discussion, just walk us through some of the math at how much that can help?

Sure. So the 300-millimeter will take ownership in 2023, at which point of time is when we'll see the full benefit of owning that facility. In the meantime, we are happy to report that we are doing pretty good progress in transferring stuff in there. Right now, the priority is to transfer all the required technologies and devices and processes. And we designed them from lower geometry into 12-inch. So that when we pick up the capacity in 2023, we have a line of sight to get full and good utilization. In the meantime, we still get some benefit from a foundry price we're getting from global foundries, but it's not the same as when we would get the full ownership. As you said, this is a domino effect in our facilities. So when we close down or sell a 6-inch, we may move that into an 8-inch and we get the better utilization on that 8-inch. And then we will move stuff from 8-inch into the East Fishkill facility. In the long run, when we own it, we should see a delta cost by just being in the 12-inch facility that will be incremental to the amounts we have talked about incremental to the $75 million.

Thank you for all that color, Bernard. I guess whether it's you or Keith that wants to answer this one either way would be great. When you talked about your 43% gross margin target on the last analyst meeting, that had a time frame aligned to it that obviously didn't capture COVID, let alone, the trade wars, et cetera. So timing-wise, it seems like it has to be later. But the $7.1 billion in revenue, I'm just wondering, how do you optimize? And why do you optimize to that number? It seems to be 20%, 30% above either the best revenues the company ever did or closer to 30%, 35% above where you are right now. So I know you need to keep extra supply out there to be able to grow into. But what's the magic about $7.1 billion to optimize to that 43% gross margin?