ON Semiconductor Corporation (ON) Earnings Call Transcript & Summary

Good morning, and thank you for attending JPMorgan's 19th Annual CES Technology Forum, obviously, virtual this year. My name is Harlan Sur, semiconductor and semiconductor capital equipment analyst for the firm. Very pleased to have the team from ON Semiconductor: New President and Chief Executive Officer; Hassane El-Khoury; Bernard Gutmann, Chief Financial Officer; and Parag Agarwal, Head of Investor Relations. I've asked Hassane, who we know very well from his tenure as President and CEO of Cypress Semiconductor, I've asked him to start us off by giving a brief background of himself, to discuss what he's looking to bring to ON Semi from a strategic, operational and financial best practices perspective and any early observation of the team's market position today and where he hopes to take it over the coming years. And then we'll go ahead and kick off the Q&A. So gentlemen, thank you for joining us today. Hassane, welcome to ON Semiconductor, and let me turn it over to you.

Great. Thank you, Harlan, and thank you for having us. Great to be back talking to you. So a little bit about my background. Prior to ON, I was President, Chief Executive at Cypress Semiconductor, which was acquired by Infineon, closed the deal in April of 2020. But that's not, I guess, the key milestone that I would focus on. What I would focus on is the journey that we've gone through Cypress because it's going to draw a lot of parallels to what really attracted me and drew me to the role at ON. And that journey is a journey of value creation for shareholders. And that's value creation through growth on the top line, revenue growth, but more importantly, earnings growth through a gross margin expansion story, both by product mix, by product investment, product and funnel growth, but more importantly, operational efficiencies in order to grow that gross margin or expand that gross margin faster than otherwise you would have. And along the journey, of course, we were -- prior to being acquired, we were -- Cypress was an acquirer or consolidator. We've done a few, whether it's joint ventures or acquisitions or mergers of equals, so anywhere from strategic company transformative to value-added growth drivers like the IoT, in this case, for Cypress. But enough about the past. What drew me to ON is I saw at ON a lot of the same tenets that I see and I saw and we drove at Cypress. Great value company, as far as -- if I look at the product or all the building blocks that the company has, I put a lot of value on those. And I put a lot of value on those from personal experience. As we were performing at Cypress, I saw a lot of ON Semiconductor products on the same bill of material, which was a positive thing because that's a reflection of the company, the gross -- the value of the products and really, more importantly, in markets we talk about like automotive, it's a reflection on the quality of the products. So that's what drew me to the company. But what more -- drew me more to the company is the ability of the company to unlock the value that I believe the company has. And how are we going to do that? We're going to do that through a very surgical and strategic approach, which we have already started. Now I'm not going to lie, I walked in the door with a preconceived notion of what this -- what I'd call the thesis or my personal thesis is going to be. I walked in the door with, "Here's what I'm going to do, A, B, C, D, and here's how it's going to work out and everything." And what I've been spending time on right now is putting data and numbers and analysis to support that thesis, just like you would do with any acquisition in this case. And what I'm happy to say is, I am pleasantly surprised. I've had surprises, but they're on the positive side because the opportunities that I saw we are able to do here as a team for the company and for shareholders are valid based on my thesis. But there's more that we could be doing. I'm not going to label all of them as low-hanging fruit because we have a lot of work ahead of us. But do I see a path? The answer is yes. And if I were to summarize my comfort level, I've been in the role -- we're just counting. I've been in the role for a month, including the holiday break. And not once did I wake up and go, "And what the heck did I just do?" It's been waking up and let's get at it and let's do more and let's do more. So that's the excitement and the momentum I have, the team has and what you are going to expect to see from us as we deploy our plans.

Great. No, that was great. I appreciate that. And maybe just to start it off, and again, this goes back to your commentary around the value creation, as you put it. And coming from Cypress, I think a key part of the success or value creation of Cypress under your leadership was the focus on systems-level solution, compute, connectivity, analog, software, firmware. Do you think the ON business model and strategy can benefit from also offering compute, i.e., microcontroller solutions, alongside its power analog and leadership in sensor portfolios?

So not necessarily. Not -- when we say a system-level approach, it doesn't mean we have to do the whole system. Now ON already has system-level exposure, meaning we're not selling 1 component per board or 2 components per board. We have a very broad portfolio. Now it may not include the compute. Like I said, no 2 companies are created equal, and in no way I would draw a parallel between ON's product offering and Cypress'. ON has, for its own credit, a good product portfolio that is able to service multiple products into a system. So that is a system-level approach. So when we say about a system-level approach and how is that a benefit and a competitive advantage, it's the ability to be able to get more content at every customer interaction and every customer board. And we already have that at ON. And that's really clear in the automotive story, where -- the content story at ON, where it's exceeding the growth in the automotive market is proof that there is there, that system-level approach. But what also it allows us to do when we have a system-level view of it is, how do we create more of those products to work better together in order to serve and solve a customer issue, which creates an opportunity for us. That's what a focus has been. So we're not starting it from scratch. We're going to be redirected. In my view, we have a broad portfolio of products. Not all products are created equal. Some of them are strategic. Some of them are high margins. Some of them are depressed margin. The key is if the good margin is growth, we're going to double down and grow it faster. If the lower margin is not going to be supporting our new strategy, which is margin expansion and growth, we're going to disposition of it. I don't know what that means yet because, again, it's a wide portfolio. Some of it will be just -- we're not going to invest in it anymore. We're going to focus on cost structure, et cetera. So there's a lot of work to be done to unwind that thing. But the focus on customer-driven creation, value creation is definitely part of our strategy.

Great. Well, let's focus on 2021. I mean, as we look into this year, off of a pretty weak 2020, I mean, global GDP is looking to grow 5%. Auto production is expected to grow about 15%; cloud spending, growing 20%; 5G base station deployments, growing 35%. The Street has the ON team growing about 10%, 11% revenue-wise. How does the team see 2021 playing out from a growth perspective? And what are going to be the areas of outsized growth for the team?

So our -- obviously, our -- we do see growth in 2021. There's going to be, I would call it, reallocation of growth, meaning it's going to be from one product line to the next because part of portfolio rationalization is going to be more focused or less focused on product lines. But overall, we do see the growth that you mentioned because of the macro where we are. The excitement about it is the automotive side of it, where automotive is growing. Our exposure to automotive puts us in the driver's seat to outgrow that market. Because back to the comment I made earlier, the content story is going to get us outgrowing the SAAR. Now is the SAAR going to be 5 or 3 or -- we're still in month 1 of the year. Indications are all positive, but time will tell. But whatever that ends up being, we are going to outgrow whatever number the SAAR is going to be because of the content. And we're still well positioned to do that. The backseat function that we are going to be focusing on, while we do that and deliver on that, is how do we do that by also expanding our gross margin. And that's the progress we're working on, on what does that look like and what is the timing for that. That's going to be kind of front and center in my tenure here because we have to expand our gross margin, and it's something we've done at Cypress while we grew. So I don't want to outline the -- well, it's this or that. It's not what I'm saying because we've proven or are proving at Cypress we're able to do both. Now I don't know how it's going to be step-by-step here. But I will tell you, from the short time I've been here, I see the opportunity to be able to do all of that.

Got it. Near term, the team came into the December quarter with a strong backlog. You were seeing accelerating bookings and a view that even into the first [ half ] of this year, the team could be driving above seasonal shipment trends. And it does appear, based on some of the commentary from your peers, that demand has remained strong in auto, industrial, cloud. Has the order and backlog trends that you observed coming into Q4 continued to accelerate? And what areas are you seeing kind of the strongest demand pull?

We -- obviously, I have to balance. We are in the quiet period. So we'll be able to give more color when we do our earnings. But I will tell you, the momentum is still there. The momentum on demand is still there. So nothing causes me to believe that it was kind of a blip. It's there. Where it will normalize, that is going to be a couple more quarters to figure out where it normalizes. But right now, we're managing through kind of the blip, coming out of a really depressed year as far as inventories. So how much of it is replenishment of inventory and how much of it is true end demand sell through, we have to look at. Obviously, we have all the metrics in place to look at inventory versus true demand and so on. So we're not going to fall into that whole of a fake demand outlook. We're looking at all of these. But even with that, I'm happy with where the market and the industry is going.

We've heard of industry-wide capacity constraints on wafers, on packaging, on assembly and test capacity. 2/3 -- roughly 2/3 of ON's manufacturing is in-house. Has the team been able to keep up with the strong demand trends? Are you constrained as well? And is the team holding or taking up pricing as costs are rising and demand remains strong? For example, we had the microchip team report this morning. And as a result of some of their manufacturing costs are rising, they're taking prices up come mid of -- middle of this month. I'm just wondering if you guys are seeing the same things.

Yes. We're looking at everything. So we are seeing obviously a change. Now back to your question, though. Are we able to keep up? The answer is yes. Obviously, that's, I would call it, to a first order. There are pockets, of course, where we are managing demand and managing supply. We're much, much more closer with our customers. But we're keeping up, meaning we're not the tallest pole in the tent. So we're trying to make sure that our customers get what they need from us in order to ship what they have. Now whether or not they will be constrained on something else that prevents them from shipping the final product, that's not in my control. So we're working on what we are able to control as far as demand and supply to match. As far as pricing, obviously, that's an ongoing thing. I don't want to say one way or another because obviously, there are decisions that have been made. We are working on deploying such decisions. And until we do that in a -- with the impacted parties, i.e., customers or partners, I don't want to throw it out here in this forum.

The team had entered Q4 with the target to keep your front-end utilizations relatively flattish, I believe, at about 70%. But just given the sustained strong demand pull by customers, did the team actually start to increase utilizations in the December quarter and maybe a sense of where they might be today?

Bernard, [ do you know where they are today ]?

So utilization, indeed, we did have a focus on the balance sheet to make sure we drive inventories, internal inventories down. And that was one of the reasons for managing the utilization. As we expect and see momentum, as Hassane said earlier in going into Q1, that will definitely help us start showing increased utilization on our manufacturing footprint.

Yes. In the shorter term, obviously, we have a focus on generating working capital through inventory drains, which is the right thing to do. If you have the products sitting here, we have to flush them out.

And then on the supplies on the channel side, the team had anticipated keeping disty inventories relatively flattish sequentially into Q4. But again, given the strong demand trends, I'm sure you're just seeing strong demand pull from your disties. Did disty inventories actually come down again? And is it now below your target range?

We'll talk about the actual performance in that -- when we announce the results. But I'll give you -- we are managing the inventory at the disty to make sure that -- because of the constraint in the overall market, what we don't want is support a disty demand that's going to sit on a shelf at a distributor versus prioritizing a different customer or a different distributor that is able to ship it through because of strong demand at the end customer. So that's the balance we're looking at. So we're not looking at it as an absolute level. We're really on, call it, tackle mode. If there's an order, whether it's disty or a direct customer, we will validate that it's going to an end product in this case. So call it, it's going to be sell-in and sell-through much quicker than you otherwise would have. But we are, of course, monitoring the disty inventory because we don't want them to drop too low. So we're managing the 2. We are in this, like I said, the transition of supply and demand. So we have to have a much granular approach to disty inventory than we otherwise would have.

Hassane, a question for you. This is more of a high-level strategic question from an investor. So is growth in top line revenue an objective? Or is -- are you willing to shrink, maybe grow at a slower pace as a part of maybe potential portfolio rationalization and maybe more focus on margin improvement?

Yes. That is a approach that's on the table. What I want is -- what I do want is a growth value company, and value is reflected in gross margin and stability and quality of the earnings that are generated by it. Which means that if we have to kind of streamline the portfolio and have a still growth, but a muted growth, we may consider that. But we're not at that decision yet. So I don't want to portray that we are. But it's going to be the balance of the whole financial model starting from the top line. Because if you increase the margin, you're still generating the earnings that you need without the complexity of the top line. So we're going to -- we're looking at everything. There are no sacred path that we are not looking at. And when we come out with what we are going to do, it's going to be the most aggressive but most balanced approach to strategic planning.

Average lead times for the ON team has been somewhere in that sort of 13- to 15-week range. Again, given the strong demand trends, have lead times started to extend beyond that range?

Again, I don't think we're going to talk about specifics of our earnings call. But as we have said, we do have a good manufacturing footprint, and our utilization was low enough that we have room within that. But having said that, there is always pockets of stuff that goes on.

Yes. Yes.

Any updates on the sale of your Belgium and Japan fabs? And on the closure of the Rochester fab, is the team still on track to realize the $15 million in annualized cost savings starting this quarter, Q1?

Correct. Rochester is a done deal. It's water under the bridge, and we should start seeing the benefits of that immediately at the beginning of the year. At this stage, no additional comments on Belgium and Niigata. It's still in process.

Perfect. Let's focus on more of the product areas. Automotive, obviously, I know it's very near and dear to Hassane's focus. It was a big focus at his tenure at Cypress. So the ON team, obviously, very strong pipeline of wins in ADAS, EV, several other areas like motor control, lighting. Team has outperformed auto SAARs by double-digit percentage points on average, looking back over the past 5 years. You kind of tracked towards 500 to 800 basis points of outperformance versus SAARs even in the big downturn in last year. According to third-party research guys like IHS, which are focusing kind of low -- casting kind of low to mid-teens percentage year-over-year growth in 2021 for automotive production light vehicle, what are your expectations for your auto segment? And can you sustain this level of outperformance on a go-forward basis?

Yes. We're going to see the growth as a, call it, a positive multiple of SAAR, right? So I'm not -- based on a lot of the data that I've looked at and where our funnel is and so on, we do see -- because nothing changed from before I joined to after I joined as far as what the team's approach is and the team's performance is, as far as pushing content into the automotive segment. And like you said, that's a market that I care for deeply. I think it's a critical market for us and our future. That will remain part of our strategy. Now are there going to be different approaches or potentially different focus on the submarkets in automotive? What are we going to double down on? What do we want to accelerate? What do we want to be lead in versus just a fast follower? That's part of the strategic deployment that we are working on real time with the team, but it's not going to change the overall approach to automotive that you stated.

High-level question again for you, Hassane, from an investor. For the 30 days that you've been with the team and obviously, you've interacted with them before that, what kind of corporate culture do you find from ON?

It's a good culture of execution and data-driven analysis, which is kind of -- if you think about everything we need to be doing, that's the baseline. That's the table stakes that you need to have is, do we make decisions based on data? And once we have a strategy, are we able to execute against that strategy? And I see both of those in the culture of ON, which makes obviously my job much easier. Now the question is, what are we going to ask the teams to execute? That's part of the strategy. And how are we going to measure it? And that's part of the credibility in the data. And whatever I measure it internally, you'll be sure that you're going to see some of those metrics externally because that's how I'm going to be asking our shareholders to judge us on. And like I said, you and I have a history. You've seen how we operated at Cypress. I'm very open and transparent about what we do, what the opportunities are and what the challenges are. And you're going to expect the same thing from me.

And then as you've looked at the auto business, and I'm thinking about looking out over the next 1 to 2 years, what are going to be the areas that are going to be driving the strongest growth in the automotive franchise? I mean, obviously, your sensor business, we're seeing strong growth as obviously cars become more intelligent. Electric vehicle, its dollar content for your power solution, drives a significant increase in dollar content versus conventional internal combustion engines. I mean what are going to be like the top 3 sort of areas of strength in the automotive business looking out over the next couple of years?

Yes. Those are what -- the top 2 that you mentioned are going to be the biggest drivers for us in that order, meaning we have engagements on all of them today. But if I look at sensing, that's already -- it's not a standard, but there's more and more content because of it. Whether it's Level 2 or Level 3, 4, 5 and beyond, Level 2 is already there, and it uses a lot of that content, and we're very well positioned for that. Then you follow the EV, where we have a position and a competitive advantage in the EV market. That's more of an adoption, right? As more and more electric vehicles go up, that's how our content is going to go. The beauty of that as well is per car, there's more content per car when it turns EV than there is content for a internal combustion. And that, again, builds up on our content story.

Yes. We were just -- the big talk of CES was the rollout of China Tesla, right, NIO, and their new ET7 car, right? I think it has something like 33 sensors around the car, double digits number of image sensors, a bunch of radar, ultrasonic, and I think they have 1 LiDAR sensor. But I think that's a great example of the explosion of the sensor technology as these cars become more intelligent. In the industrial segment, it's another large part of the business, 26%, 28% of revenue. It's very diversified. You guys deal with power, motor control, power transistors, image sensor solutions. Maybe highlight some of the strengths and weaknesses within the different subsegments in industrial. And how are you positioned as you look at the demand outlook for industrial here in 2021?

Yes. I mean the thing that -- from a technology perspective, the technologies you mentioned are how we are tackling the industrial market because it is a broad and very fragmented market. But where are the opportunities in that? Well, obviously, renewable energy, that requires the power -- components and the power solutions that we have. That's from the renewable energy. But if you look at factory automation where you get more of the factory efficiency, whether it's robotics or sensing, that's going to be, again, part of where our -- some of our growth is going to come from. But industrial, like I said, it's a very fragmented market. The work that we have to do right now is what do we want to double down on and focus on and do a, like we referred to earlier, a system-level approach where we have leverage and we can put -- consolidate some of our content in order to solve a complex problem for our customers. Because if you are able to solve a complex problem, the adoption is faster than having the customer give them a bunch of parts and say, "You try and solve it." And that's one of the approach to market -- to addressing certain markets we are doing.

Maybe -- this is a question from an investor. Can you give us an update on the GaN and silicon carbide power portfolio? You guys have been talking about the growing portfolio and design win pipeline of next-generation SiC- and GaN-based power solutions in automotive and industrial applications. As a leader in the power and power transistor market, kind of talk about how you see these new technologies driving growth over the next few years.

Yes. I mean it's premature to say where we are on it because I do need -- this is a segment where I'm happy that we are active, and we have development in those areas, me as a CEO. But I haven't dug into where we are, how fast we're going to be there and what the competitive landscape is going to be. I mean, obviously, I know it at a high level. That's one of the growth areas or the strategic areas that I looked at walking in the door. I looked at the progress. I'm happy with the funnel that we have. We do have products. I'm happy with the funnel that those products are generating. And the question I ask the team is, "What more can we do?" Now that's a longer-term growth area. But if you want to play to win, you have to be the winner now. So when the market does turn and the crossover between the IGBT and the SiC happens, you want to be the company that gets the lion's share of that.

Yes. Absolutely. On the financials front, Bernard, so on your gross margins, targeting 43% gross margins at $7 billion in revenues. Kind of near term, though, you've got the cost savings from the closure of Rochester. Pricing environment is probably better than you anticipated 90 days ago, and you're ramping utilizations just given the strong demand environment. Given all of this, can we maybe anticipate better than 50% incremental gross margin fall through on incremental revenue growth over the next few quarters?

It's a dynamic environment. There is different pluses and minuses. But I believe that with all of the reviews and all the focus we're having on gross margin, that is a possibility. We will be -- as was mentioned earlier, we will be having a Analyst Day, and we'll be coming out with when we are going to do that at the upcoming earnings call. At which point of time, we'll be able to share in much more detail what our strategic plans is and what the financial -- the resulting financial model of that.

We're going to be -- yes, margin is going to be a driving effort for us, not just the reporting. We're going to be driving to a target, not only reporting on it. And you're going to see a different move in the different levers on margin than you have historically seen here.

Great. Well, we'll be looking forward to the Analyst Day. We'll talk to you guys at upcoming earnings. We're out of time. Hassane, Bernard, thank you for joining us today. Best of luck in 2021, should be a very strong year for the ON team. So thank you very much.

Thank you.

Thanks.

Thank you.