ON Semiconductor Corporation (ON) Earnings Call Transcript & Summary

Good morning, everybody. My name is Gary Mobley. I'm 1 of 3 publishing semiconductor analyst over here at Wells Fargo Securities. With us today, we are featuring ON Semiconductor's management team, including Bernard, CFO; and Parag, Vice President of Investor Relations. And I know this is Bernard and Parag's third presentation this week, if I'm not mistaken. So while I'm going to ask Bernard to start off with some opening comments and a brief overview of ON Semiconductor, I'm going to try to fill in the blanks from prior day's presentations and try not to duplicate discussion points from those prior presentations. And so with that, perhaps I could turn it over to Bernard, and you can give us just a brief overview of ON and then we can delve right into some of the more current events. Bernard, I think you are on mute.

Sorry. Thank you, Gary, and thank you, everybody, for joining us today. So let me -- a quick overview on ON. A broadline company focused on high-growth end markets, particularly industrial, automotive, servers and 5G. We are also a manufacturing company, which produces about 2/3 of what we sell with the -- we have target model to aspire to a 30 -- a 43% gross margin in the long run, predicated on a $7.1 billion of revenue. And have a 21% OpEx target that should yield about $1.2 billion of free cash flow per year when you achieve that. We got, like everybody else, affected by the pandemic in 2020 and also had a more cyclical downturn in 2019. So we have had the last year that has been more challenging. We troughed in the second quarter from the revenue and the gross margin point of view. And since then, it showed some pretty encouraging signs of recovery in the third quarter and guided the fourth quarter to be also up sequentially with showing some improvements in gross margin. We're still quite far away from where we desire to be. And as a result, we have implemented several self-help actions in terms of reducing our manufacturing footprint. And that, combined with the expectation of a significant growth in 2021. If you look at the sell-side models, it shows greater than 10% growth for 2021 and confidence that we see in the secular growth drivers in the high-growth end markets. We believe that we are on our way to show some pretty good and nice recovery in the next couple of years, starting in 2021 That's a high-level summary, Gary.

Okay. Appreciate that. And that's a good segue into your view into next year. So $5.7 billion, roughly, I think the census view for fiscal year '21's revenue, and that's up about 10%. And so given that auto is almost 1/3 of your revenue, I was hoping that maybe you can share with us how easy it is to get to that number if we just see some normalization of global light vehicle production from where we were and have been in calendar year 2020 and where it could normalize back to in calendar year 2021?

Sure. I'll be glad to do that. So if you look at automotive, we did see a pretty steep decline in Q2 stemming from automotive customers in Europe and North America having shut down their factories. So we were down 26%. We covered 28% in the third quarter on a sequential basis and guided for an increase in the fourth quarter -- sequential increase in the fourth quarter, which should get us to -- pretty close to pre-COVID levels in Q4. Having said that, if you look at the SAAR for 2020, we believe when you look at the different external pundits, should be down in the high -- in the 18% to 20% rate. We expect our revenues to be down probably 10% or less. So we are confirming the content story that we have been talking about for several years and have been able to deliver to that. So high single-digit content increase every year. And then the rest depends on the SAAR. If you look at next year, most of the experts are predicting the SAAR to be up about 14%, at least that's the last IHS numbers that we saw. And that should allow us to grow using the same content differential, we should be able to grow in the low to middle-20s. So that being 1/3 of our total revenue, as you mentioned earlier, growing in the 20s, gives us a good confidence that we should be able to show some pretty nice growth for the overall total company. And that's just looking at automotive. Obviously, we have other secular growth drivers and other areas where we should be able to complement that growth and also show some pretty good growth.

Okay. So if I read between the lines correctly, and correct me if I'm wrong here, if you just see some normalization of global light vehicle production, you're a very similar content growth trajectory that you've been on, all else equal. The other 2/3 of our revenue is not automotive. Normally, you should be able to get 70% of your growth just coming from the automotive market.

That's a correct calculation, yes.

Okay. Appreciate that. And your neighbor there in the Phoenix area yesterday was at a -- on a presentation talking about the booking strength that began in the September quarter has continued so far through the December quarter. Can you guys give us any sort of similar update on how bookings have been trending?

So we don't give mid-quarter updates. But when we guided for the third -- the fourth quarter, we guided above seasonality. And at that call, hinted the fact that the strength might continue into Q1 and may give us a chance to be above seasonality in the Q1 factor. We do see also the external factors, global GDP, global PMIs, which are a good -- pretty good correlation with our revenue showing some pretty good encouraging signs of improvement.

Okay. So in the past couple of days, we have started to see different countries around the world report their country specific light vehicle sales. And I guess it's not really surprising that in Western Europe and the U.S., where we've seen a bit of a resurgence in COVID and some additional knockdown measures, that we're seeing some pretty significant year-over-year declines in unit sales. But that is largely being offset by strength in other regions like India, China, Japan, South Korea. And could you share with us how your automotive exposure is from a geographical perspective? Is it more European focused? Is it more U.S. focused? Or is it more broadly, globally distributed?

It's pretty globally distributed with maybe a little bit of higher -- historically, our highest -- the bigger strength we have is in Europe, followed by North America then China and Korea and lastly, Japan. But we're pretty global. And I would say, fairly well represented equal to kind of the SAAR type of approach, geographic distribution.

Okay. And in your September quarter, you saw your distributor inventory, which I believe distribution is about 60% of your total revenue. You saw distributor inventory come down 2 weeks. And I think you mentioned yesterday in a separate presentation that you're now at the low end of your normal range. But what is embedded in your fourth quarter guidance? Are you assuming that you're going to see distributor inventory come down even more?

Actually, keeping it pretty flat. We're not looking at decreasing it. We believe we are at a very healthy level now. It gives us the opportunity for upside, but we don't have an issue of stopping the channel or anything like that. To the contrary, we are in a pretty good and lean position. So -- but we don't expect to decrease it further.

Okay. And your own inventory is a bit of a different situation. Obviously, at some point throughout the year, you got to a level that's unsustainably high. And could you speak to what your own efforts are to deplete your own internal inventory?

Yes. So we peaked in Q2 at 140 days. That is about 20 to 25 days higher than our target range of 115 to 120. In the third quarter, we brought it down to 133 days, and we indicated in our third quarter call that we intend to gradually bring it down to more acceptable levels. And that's the reason why we are also not increasing our utilization in the short run. But we are not doing some drastic actions. We're just gradually bringing it down to more acceptable lots.

Okay. Keith Jackson, your Chief Executive Officer, has announced his retirement. And I believe his retirement date is what March or is it May? I can't quite remember.

It's May.

It's May. And so how has that search process gone with respect to consideration for internal candidates, consideration for external candidates? Any update there would be helpful.

So I can't comment too much on it. What I can tell you is that the Board, as part of the succession planning, has had a cast of wide net to consider internal as well as external candidates, and they are progressing on that process. And I guess we'll have to stay tuned until we get the resolution on that. But I know they are actively in the process of doing that.

Okay. Your December quarter gross margin guide calls for an improvement of roughly 300 basis points from the lows that you produced in the June quarter. However, the gross margin guidance for the December quarter is still about 300 basis points off the levels that you saw in fiscal year '19 at a commensurate revenue level. Can you walk us through the factors that may be holding gross margins back in the near term? And related to this, what the gross margins -- what happen to gross -- factors driving gross margin to get back up to the high 30% level?

Yes. I think the biggest one is that we did invest for growth, and we continued spending a good amount of CapEx throughout '17, '18, '19, and even early '20. So one of the big differences between what we saw when we -- in the prior -- in '18, '19 was: one, better utilization; and two, a lower fixed cost base. So right now, we have set up a bigger fixed cost base. Good news about that is that we should be able to get the offsetting -- thing that we saw when the revenues were coming down, we should be able to get some pretty good fall-through on the incremental revenues as the revenue pick back up with at least a 50% fall-through as we already have a good amount of the fixed cost structure in place. Second, we should also be able and be in a much better position to take advantage of a recovering set of numbers because we have the capacity, and we're running our facilities at the -- only at a 70% utilization. And third, as we have publicly said multiple times, we're also doing some self-help to reduce that fixed cost base so that we can get back to more align the gross margins to what we should be doing.

Okay. And so a confluence of events, more or less. So we're talking about just higher revenue is going to be matched with maybe some capacity rationalization, 3 fabs specifically? And can you walk us through the total cost benefit -- I believe you mentioned $75 million in total, but maybe sort of the stages of the divestiture of those 3 main facilities?

Sure. So it is actually 3 facilities. The first one is a very -- it's a small one. And that one, as of today, is already closed. So we should start seeing the benefits, which is $15 million a year, flowing through our financials immediately at the beginning of the year. So one. And that's the Rochester fab that used to do the CCD products. The second and third are intended to be sold. So we are in different levels, active negotiations with potential buyers. The timing of that is still up in the air depending on really how the actual individual negotiation is done and what kind of manufacturing services agreement will result in the timing of the transfer. But the bottom line news is once the fixed cost that we eliminate by shutting down these 2 factories is $60 million, about $30 million each. So the net, some of the 3 factories is $75 million, as you mentioned earlier, which is about 1.4% of margin improvement. And this is just the elimination of the fixed cost structure associated with these -- the infrastructure with these facilities. We should see, as an additional benefit, the -- 2 things. One is redesigning these devices from 6-inch to 8-inch, which should also give us a better cost per mask layer or cost per wafer. And the second thing is the increased utilization that we'll see in the recipient factory within our network that should -- that's not part of that $75 million. So there should be some additional on -- as a result of these actions.

Okay. So consolidating what was in Niigata, Belgium, Rochester into existing fabs will not only be met with rising revenue and lower underutilization charges. The underutilization charges, the decline in those will accelerate as you consolidate those fabs. Am I reading that right?

That's correct. Yes.

Okay. Is it unreasonable to expect any meaningful proceeds from the sale of the Niigata or the Belgium fab?

Our goal is more making sure that we avoid employee liabilities and that we do this in an expeditious way as opposed to maximizing -- remember, these are old factories that are 6-inch and there are subscale. So expectations are not very high on the proceeds. It's more the benefits that we get on the cost side and the avoidance of some of the employee-related liabilities.

Got you. So you want to maintain continuity of employment while...

It's more that we also want to maintain, at the same time, continuity of supply for our customers and making sure that we hand this off in a way that doesn't disrupt our customers, especially in a growing year.

Okay. On this topic, you have an influential shareholder that has recently suggested that ON move to a fab-less business model. How reasonable is this recommendation just given sort of the composition of the types of products that ON manufacturers? I know you outsource what you can, case in point, the Quantenna WiFi products. But it seems to me that it would be very difficult to implement a fab-less business model.

It is something we need to study in more detail. But actually, I don't think they recommended fab-less, they recommend fab-light. But still, that's a degree of the same thing. We see that most of our competitors in the power discrete space are all IDMs that manufacture and actually have doubled down in investments in 300-millimeter capacities. So that's something we need to account for as we go through that. The other factor, and I'm talking mostly about power discretes. There is not a lot of external capacity for the nodes that we produce. So there is no unlimited foundry capacity for these nodes. And then the other one is -- the other thing to consider is that a lot of these are duals of the family, and there is IP considerations that also need to be taken into account when we think about moving that stuff outside. And last but not least, having control of your own quality and delivery and upside potential that is targeted primarily for industrial and automotive customers, which are really tough customers, is also, we believe, a key consideration. Having said that, as you mentioned, we do outsource about 1/3 of what we sell. All the nodes that are very advanced and require significant investments beyond what it makes economic sense for us, we externally source and we'll continue externally sourcing it. And we'll look at whether are there any other opportunistic areas in which we should be able to consider that. But for mostly power discretes, we think that, that's going to be a difficult challenging thing.

Yes. Yes. There's not too many companies out there with the ability to process compound semiconductor materials, is there, as it relates to your power business? Moving on to OpEx. You have brought down non-GAAP OpEx about 10% in the past year. How much of this is permanent? How much is temporary? How much will quarterly OpEx bounce off the $284 million volume we saw in the third quarter once salaries are normalized and everything else is normalized?

So we did, I would say, half and half. We did take some headcount reduction actions that resulted in about $100 million of annual savings being eliminated. Having said that, in the last 2 years, both '19 and '20, the amount of variable comp that's embedded in our OpEx, and based on business results has been extremely low, if not nonexistent. So that's what we basically communicated in our third quarter call is that we expect a step function increase in the variable comp, and as such, increasing our OpEx by about $25 million to $30 million when we go into 2021. Obviously, assuming that this is a good year and we get results that are conducive to paying a variable comp. And after that, we expect to keep OpEx fairly in line, fairly flat for the rest of the year. Our goal is still very valid, and we still want to achieve 21% of revenue for our OpEx, which basically means we are going to grow OpEx at a lesser pace than our revenue growth. And over time, should move towards that 21%. But we will see a step function increase in Q1 when we reinstate some of this variable comp. R&D investments should be in that 11% to 12% rate, and we expect that we will continue investing in high-growth areas, things like the EFK transfers, silicon carbide, LIDAR, other sensors, more power discrete, industrial IoT, all of those are where we are putting our dollars in for R&D. But at the end of the day, we will grow OpEx at a lesser pace than revenue and move towards the 21% target.

Appreciate that. I want to change the topic to your migration to 300-millimeter, which involves the acquisition of GLOBALFOUNDRIES fab in East Fishkill, New York. On your recent earnings call, you talked about favorable yields coming out of this facility. But can you give us an update on the timing of various milestones such as the qualification of ON's products that transition to production from GLOBALFOUNDRIES to ON's products and the full ownership transferring from GLOBALFOUNDRIES to ON?

Yes. So we structured the deal with GLOBALFOUNDRIES that allows us to buy the fab in 3 years at the beginning of '23. 2023 is when we pay the balance of what we own and we become the owners of that facility. In the meantime, we have a foundry arrangement with GLOBALFOUNDRIES that gives us the ability to redesign our existing 8-inch production and devices and technologies into 12-inch. And get as many and as much as we need so that when we pick up full ownership, we are in a good position to fill the facility to an acceptable utilization level. And as was -- as we said in the last earnings call, we already have our first revenues coming from that facility for one technology within the products that we're transferring. And as we said, we are seeing very good performance, which we believe will make it easier for us to work with our customers to transfer, and ties them to have higher-performing parts for the same thing they are buying from us. So goal and focus right now is not to maximize the run rate today. Because again, we don't own it, and we don't get -- we get just a foundry price. But to focus on qualifying as many of the required technologies are in that fab, so that -- and then start ramping those. So that when we pick up ownership, we are in a solid position to utilize that asset how it should be.

Okay. Appreciate that. We're running close on time expiration, and I wanted to ask you guys and Parag, maybe this is a good point for you to come into conversation to give us what will be your main message during your upcoming March 5 Analyst Day with respect to pillars of growth? I know you've historically positioned industrial, automotive and cloud power as your 3 main pillars. Any change to that messaging or any change to messaging about the long-term target operating model?

So we are still working on those details. And still, we've got a lot of time, right? But at the same time, I don't want to front-run the Analyst Day yet on this conference. Having said that, the long-term strategy of the company does not -- remains unchanged. We will continue to focus on automotive, industrial and cloud power. We'll continue to drive gross margin expansion, and we'll try to generate free cash flow. And the goal will be to provide an update on how we get there and when we get there and what will be the target model. So still, I mean, at this point of time, we are just starting the process. So let's hold -- wait till March 5, and we will know what exactly the message is.

Just to be clear, Bernard, you guys are sticking with your long-term target operating model on $7.1 billion of revenue, hitting that target gross and operating margin?

We will revisit that, but I don't expect any -- I think the model is still a valid one at the $7.1 billion. We think it is a good financial target we have out there. And we have to define the timing, and it depends when we get to that $7.1 billion.

Okay. Hopefully, by March 5, we'll all be vaccinated. And we can visit each other in person. That will be a nice feeling for sure. But I'm going to wrap it up there today, and I appreciate the time you guys have spent with us here on this fireside chat. And I hope you guys have a good rest of your day at our conference. Again, appreciate it.

Thank you, Gary, and thank you, everybody, for joining us.

Bye.

Bye.