ON Semiconductor Corporation (ON) Earnings Call Transcript & Summary

Good morning, everybody. Let's get started with the next presentation. We're very pleased to have Hassane El-Khoury, the President and CEO of ON Semiconductor as our next guest. So Hassane, great to see you, unfortunately, still virtually, but it was good to see you live in New York a couple -- well, I guess a month ago roughly at your analyst meeting.

So before diving into some ON-specific dynamics, why don't we just talk a little bit about your choice to join ON. So you've been the CEO now for 9 months, roughly, lots of changes in that time. But a simple question, why did you choose to become the CEO of ON?

You've asked a great question. I -- obviously, after I closed the deal in my prior company, I wasn't planning on taking a break, although I ended up taking one because COVID unfortunately forced everybody to stay put. So of course, during that time, I had some opportunities, but I was looking for something that I will enjoy, let me just put it that way. What does that mean? Some -- if you think about it, I'm a project person. What I wanted is a company that has so much value, but it can help with -- or could again to help with a strategic focus, an investment strategy that supports growth. But all of that, you need fundamental technologies to be able to do all of that. So when ON Semi came about, I -- of course, I was familiar with the company. The company I've seen it on the same board as my prior life. And being on the same board at those accounts, I know the quality, and I know the technology that these customers demand. And having ON Semi be on that same board gave me that comfort and really the confidence that, hey, there's technology and there's value in there. So I did a lot of work on what the company has publicly stated, the plans, really what's working against the company, right. We all know the execution and the performance and the deliverable against our own plans. So it came to -- it has the right assets. It has the right posture. It's in auto and industrial, 2 of the markets that I actually enjoy participating in, but it needed execution. That I can do. Defining a strategy, getting execution and to be honest with you, I love what I do. So I have to have all of these, including the personal one. Otherwise, doing what we do and not enjoying it is not a sustainable goal. But brought everything that I was looking for. And of course, my skill set was also reciprocated by what the board was looking for. So it was a perfect fit. And to be honest with you, how fast we moved so far, and the momentum that we have built shows that I've made the right choice.

So what was the biggest positive and negative surprise you found when you arrived at ON and now got under the covers deeply for the last 9 months or so?

Look, I've always said the biggest positive or -- to be honest with you, the positive surprise that I got walking in and looking under the cover is our portfolio breadth but more importantly, the revenue distribution over the margin profile. My concern walking in was, am I going to inherit $5-plus billion of revenue all at the corporate margin because then what do you do, right? What I found is, one, the revenue distribution. Of course, it has a tail that is below the corporate margin at the time, but it also had much above in order to deliver that mid-30s margin, we had some below and some above. Therefore, I made the portfolio rationalization decision, right? Not a hole, you got a client about it. It's we decide what we want, we decide what we want to focus on, and you start dispositioning that tail of product, what we call the noncore and fixing the value of the product in order to push everything up. And we've been doing that very well and seen it in the results. That's, I would say, one of the biggest things that I was pleasantly surprised with. What I knew we had good technology, but I didn't know exactly where. You hear me talk very bullishly about power and silicon carbide and sensing. There's a lot of technology we have here and putting that technology in a core strategy is a great thing for us because we have the fundamental blocks, and now we're putting the focus on it to execute to it. That was a very positive. From everybody says we have power, and we have this and we have that, but having fundamental technologies that we are able to drive strategically and grow in the market is a huge plus for us. Now I'm not going to say everything was all positive surprises. There were things that I wasn't expecting. But the way I look at it, let me put -- I was expecting to find things that are not so positive. So it wasn't a surprise. However, all I do is I take that, and I create another lever. Everything I found that I got surprised with on the downside, to me, it is a lever that we're going to pull in order to create an offsite, and how we've been doing that is exactly the results you've seen.

Yes. And those results have already been very, very impressive. At the highest levels, the gross margin exceeding 40% in your guidance, operating profitability, the cash flow, all of those. How much of that do you believe is due to some of the structural improvements that you and the team have put into place? And I know they take time versus the beneficiary of very, very good timing in the cyclical strength driving those improvements.

Look, all -- you hear me talk a lot about sustainable gross margin expansion, sustainable financials. So all of them are self-help sustainable results. Now of course, I know there's the other side of the table that says, "Yes, but you're in a great environment, it's easy to say that. Let me tell you what I mean. We already said we're going to be walking away from 15% -- 10% to 15% of our revenue is going to be declining, and it's going to create a drag in the short term. That's how we're going to do it structural. So maybe today, we have some revenue that we adjusted pricing up from a low margin. That margin is still dilutive. And when the market stabilizes and the customers can get that same noncore product for me, somewhere else, they're going to leave. It's not going to have an impact on margin because I'm not going to chase after it anymore. Prior management -- and when you call -- when there's enough supply, we have fabs to fill. How do you fill fabs? You chase after every piece of revenue no matter what the margin profile. I went out and said, we're going to walk away from that 10% to 15%. And walking away from it is, I'm not going to chase revenue at the expense of margin. I was very, very clear from the beginning, I'm ready to walk away from revenue in order to expand margin. And now we put a number on it, that 10% to 15%. That's structural. If I'm sitting here telling you our margin is going to be guided at the 40%, right? But I'm not going to sacrifice any top line, that's when you have to be suspicious. But I already said, I'm going to walk away from that. And therefore, it's not going to be dilutive on the other side. But I do want to make a comment on the cyclicality of it. We are in auto and industrial. And if you look at the content, that's growth. Yes, we're coming off a very strong year and everything, but there's fundamental growth in the markets we serve. Patent is going up 30x for us. So I don't know what a cycle is going to mean in the future, but it's not going to mean what we've all been looking at over the last 20 years. We're in a very different demand environment, and we have to be able to structure the business to support it longer term.

So when you mentioned about, yes, the prices could increase in some aspects now, but you're not banking on that going forward in noncore products. Is the definition of noncore products, something that is just hitting a margin level that is unacceptable to you, and so therefore, you could fix it if pricing was increased at a sustainably higher level? Or is it more of a product-driven, not margin-driven thought process as to how you define core and noncore?

It's market, product and margin in that order. Meaning if it's something in the -- for example, in the consumer market, right, and it's a product I can service in automotive, I'm going to move that product to the automotive market. That's what we call. When you hear me talk about mix shift, I'm moving material or products from a consumer market to an automotive market. Inherently, it's going to be higher margin because the ASP for an automotive wafer is higher than a consumer wafer. So those are market products. That's a mix shift that we are doing. Margin is more on the value of the product. If we do have products, it doesn't matter what the market is, even in automotive, if I have a product that we're not adding value, it's a me-too product. Customers don't care what logos on it, right? They can buy it anywhere else. They can buy it off a catalog. That to me is noncore also because that will end up being a low margin because somebody somewhere is willing to take a low margin for it because they don't put a lot of R&D in it. And that's not what we are doing.

Are you finding products that actually are adding value, but were just simply mispriced and therefore, fixing the pricing lever solves that problem and it won't be a revenue headwind, it will actually be a tailwind?

Yes, because those -- I'll give you an example. What I mentioned, I called the pricing to value discrepancy. If I have -- let me explain, people say, what the heck does that mean, that's like a fancy term of pricing. But there's actually analysis behind it that we looked at. If I have, call it, a low-volume customer buying a product at $0.80. And I have a high-volume strategic customer buying it for $1. You can argue the market value is $1. But somebody somewhere gave $0.80 to close a deal. Well, I'm not going to have it. I'm going to adjust that price to what we believe the market price is based on the distribution of that product across the market. Those are sustainable. So those are values that we didn't capture before for whatever reason. Obviously, we're capturing it now. But more importantly, we're installing a process to prevent that from happening, and that's culture.

So let's dive into a couple of questions from your analyst meeting. I believe the most controversial statement that I heard and that investors ask about is the 7% to 9% revenue growth rate longer term. I know it's going to be slower than that initially because you're walking away from 10% to 15% of the business, then it will be faster, and the average gets you to your target. But what do you believe or what gives you confidence that this company can grow? We've seen long-term growth rate promises from this company of anywhere as low as 2% to 3%, to 5% to 7%, to 4% to 6%. So if it was kind of low to mid-single digits before, how are you going to grow twice as fast as you did prior in this company's history?

Look, it comes back with focus and where we're putting our investments. So let me talk about both. When it comes to focus, we're going to shed the things that are -- back to your point, the cyclical that we don't control. That's one. We're going to walk away from that because that's not a content game. Where we are doubling down is where the mega trends are. Let's talk just automotive for now. Automotive is going to be -- it is our largest business today. And forward-looking is going to be our highest growth segment as well, our highest growth market. And that's going to propel the company at a higher growth than before. The automotive growth specifically, which is underlying that 7% to 9% is growing faster than what historically the company has. And that's because of the content gains that not only we have won and secured and we're going to be ramping over the next few years, but it's more on the content gains that are going to happen in the future as you get more and more EVs being a bigger percent of cars made. So the comment I made at Analyst Day, if the SAAR doesn't change, if the SAAR is flat, and the penetration of EV stays on track, we will still grow. So I don't need the SAAR. I just need the penetration of EVs. So therefore, we say, okay, what confidence do I have? Well, it's the best confidence I can get, given that governments are behind it, OEMs have made public statements about how many models they will have deployed by '25 and '30 and so on. All of that is new content. I don't have to go and gain that content from an incumbent. That's-all new content that we're going to be designing in and ramping that doesn't exist today. That's where the growth is. So when I say we double down on it, we put our R&D in making products that create value through efficiency. That's where the intelligent power and intelligent sensing came from. Then we're going to get that growth that we see in the market. And between those markets, for us, it's a 30x content growth. That's a pretty stellar content growth that I believe we have the execution shops and the technology to go and win.

So as you go from internal combustion or ICE to EVs, is there a substantial substitution effect at all? Or is that 30x content net of the fact that ON might produce some parts that are on the ICE that disappear as you go to EV?

That's net. You're still going to have some power for -- power seats and radio and all that stuff. But the net-net what is going to come in. And let me talk about the 2 segments that are driving this power with EVs. Every new EV brand-new content is not positive to the content that didn't exist in the ICE. And when you talk about ADAS, I don't have to go to Level 4, Level 5, where the world was talking about 4 years -- 4, 5 years ago. Just talk about Level 2 plus that content, you go from 1 camera looking in the rear because that's required for the backup -- let's say, back up 4 cameras, 5 cameras, some companies and some cars have 9 to 11 cameras. That's content that did not exist before that will exist and has started to ramp now. That's all-new contents.

Which one do you think is the bigger driver for ON going forward? I know you love all your kids equally, but between the EV/power side and the ADAS/sensing side, which one is bigger today? And which one do you think is a more important driver for the company over the next 5 to 10 years?

Look, I think the bigger -- as far as percent is going to be on the power. And I say it as it is today on the sensing side, we have a pretty big market share, right? In automotive, we're about 60%, and ADAS we're about 80%. So we have the market share, and we're going to grow as more cars get to that Level 1 to Level 2+ and so on. From a growth percent perspective, power is going to be a big growth driver because that's starting from a smaller base of penetration. And like I said, the EVs are going to be what driving it. And today, EVs are still a much smaller percent of total car productions. As that becomes a higher percent, I talked about 50% of cars will be EVs by '28. That's going to drive a much bigger TAM for us.

And just to wrap up the auto topic and I guess 2 auto related but somewhat disparate questions. These new drivers in automotive, I assume, are accretive to gross margins?

Yes. Yes. No doubt.

And why is the intelligent systems group gross margin, why did that get hit so hard over the last year or so, if that is -- the tailwind from that should be very, very strong right now for all the reasons that you said, and it's a fabulous model. But yes, the gross margin was weaker. So I'm a little confused by that would be as low as it was.

That's a cost conversation. Like you said, it is a fab model, right? So that's a cost structure. It's not primarily a value. And that cost is what we are working both with foundries and internal.

So the last question on automotive is one that's a higher level one. The shortages you see right now, one, how long do you think they persist? Two, do you think there's going to be structural changes in the industry? You and I are both from the Detroit area. We know how slow some of those companies can be to really change their inventory policies, their planning policies, et cetera. Do you think things will change going forward on that front?

Look, I believe so. And so things are going to change. The question for me is, is it going to stick, right? Is short-term memory? I'll tell you why. In 2018, we had a lot of shortages, if you recall. Those different -- MLCC, some memory and so on. But there are a lot of shortages that put customers' lines down. Before that, we had, unfortunately, the Japan earthquake with Renesas that put companies to shut down. So we had disruptions in the past. This one showed that the model is just not sustainable. 2018 just 3 years ago and here we are again. And my view and my conversations with OEMs directly is if you don't like it today, wait till you try to ramp EVs and there's not enough capacity because nobody is building, who's going to put billions of dollars and hope that somebody will design it in. Nobody. And I was very public about this back in April, where I said that just in time and, oh, go ahead, invest only for capital, and then I can cancel 30 days before I have to shift. That model is not going to work. OEMs and Tier 1s are now realizing this. And we are now all at the table talking about what a sustainable supply chain model would be. Where it's not about inventory. It's about longer-term visibility and longer-term commitment. Inventory is how you manage a fast trend before it stabilizes, right? That's more of the second derivative question of demand ramp. It's not about capacity. You can't solve capacity with inventory, so you have to build to that capacity. And those are conversations that we've never had in the past. And the fact that the 3 parties are at the table is very different than the last 2 decades I've been in automotive. So it's different, and I'm hoping it sticks. And for now, everything I see and some of the engagements and some of the long-term agreements that we have tells me that this is here to stay.

That is. I've talked to companies earlier today, it's interesting that it was only 2, 3 years ago that we had a downturn in 2019. Nobody wanted any inventory. But hopefully, the fact that electronics and semiconductors, in general, are so much more important for the building of materials going forward, whether it be EV or ADAS that they get elevated in their importance to these customers. So as part of the automotive side of things, I can ask 1 more question. And it dovetails into your revenue growth rate promise of 7% to 9% and also your M&A strategy. You guys just announced an acquisition 2 weeks ago on the silicon carbide side of things. That dovetails into your power side of things and maybe even into your revenue growth. Talk a little bit about that acquisition? Talk about what it brings for your power aspirations? And is M&A part of the 7% to 9% revenue growth target that you have over time?

Sure. So let me explain a little bit on what our intent has been and we publicly stated that as far as where we are in power, and how I look at M&A. Where we are in power? We're doubling it on power. We are investing our CapEx in that section. We talked about investing CapEx for some East Fishkill, but silicon carbide across the whole supply chain from packaging to wafers to -- across the board. I've also said that we have internal development for substrate or substrate development for silicon carbide. We've also said that we're going to be using M&A to accelerate internal development. So if you look at the GTAT acquisition, it covers all of them. It covers an investment in silicon carbide. It covers an acceleration of an internal development, in this case, our own internal substrate development. But more importantly, it's about what we just talked about. It's about that supply assurance for our customers. I've been bullish and you've seen our growth rates in automotive and power. I'm bullish about these growth rates, and therefore, I need to make sure I secure capacity for my customers as they ramp. So that's how we use the GTAT. It was a strategic acquisition that fits our strategic intent. So it's not a reaction. I've always said we're going to be very disciplined about how we approach M&A. So it wasn't a reaction. It was a very strategic approach is fit the strategic purpose for the company that we talked about. So the 7% to 9% is not based -- it does not have M&A baked into it. So the 7% to 9% is growth rates for the company as it stands. Obviously, M&A deals that bring in revenue synergies or cost synergies and so on may differ from the model accelerated or changed the model, that will deal with when there is an M&A to talk about, but this one will not. So we confirm that GTAT does not change our outlook for our financial model. But more importantly, I'm just trying to make a very important point here because I did get some questions, right? Now the GTAT acquisition also does not change our CapEx intensity model. Because everybody said, are you going to go now and build a fab or because they see some of my peers doing the same when they talk about silicon and CapEx intensity when people say silicon carbide, we don't have to do any of that. I don't need fabs. I don't need clean rooms. I don't need big manufacturing operations that I hope to fill. I already have all that. Today, I'm able to wafer epi, device, package everything. What GTAT brings is the ability to scale for supply assurance are both for our substrate.

It's an interesting advantage that you have. Pulling that in-house, do you believe that, that internal business model internalized from bull all the way to products is the way of the future. Because we've seen different companies go different directions than that, thinking there was a third-party supplier of substrates or bulls now people -- trees doing it itself. STMicro is, now you guys are, do you think that model is the one that's going to persist? And I guess as somewhat ancillary question to that, is GTAT going to also be a supplier to potential competitors of yours? Or are they going to be focused mainly internally for you guys?

Look, I think the model, it depends on the company, because I will tell you CapEx require scale, right? So if you don't have the scale, it will be hard for a company to say I'm going to have everything from cradle to the grave, right? And we've seen that CapEx intensity clearly with Cree, right, but also with us where we said we're going to increase our CapEx in the short term in order to build out that supply chain that we need. So that's going to be there. What GTAT does between now and close is really GTAT. We are 2 separate companies after the announcement as you can understand. So they have contractual obligations that they will service. And those contractual obligations will transfer to us as the acquiring company. So that doesn't change. What we do obviously move forward and strategically, once we close, we'll reassess all this. But there are obligations that we respect and there are obligations that GTAT will respect while they're independent.

So let's pivot over to some of the financial metrics in the last 5 to 10 minutes we have. And you guys gave a very detailed walk through those with fab doing it at your analyst meeting. The most interesting one I saw was when he said that 40% gross margin, which is kind of the long-held ceiling is now going to be the floor going forward. Again, what gives you the confidence in that? And I know the high-level answer is that while our mix is going to improve and we're going to walk away from low-end business. But you still are a scale-related business. Even in your ISG segment, you said you have a cost issue that you need to address. So what gives you the confidence that 40% can be the floor or thereabouts?

So it's got nothing to do with mix. The mix is what's going to drive us forward. What's going to be the floor is what we do on the manufacturing. So the image sensing business will not have an impact there. So let me just put that out there. Because it's foundry yet costs, well, we knew cost reduction, there's always that going up. But what was and has been the drag on margin, prior models, prior execution, whatever the case may be, is if you don't have the fabs full, right, it's going to drive your margin down. It's just financial outlook. So what we've done is -- and I've always said, first, we're going to do the portfolio. And when you walk away from 10% to 15% of revenue, we also have to resize our manufacturing footprint. That's what I said by the -- what that presented as fab lighter. Now why is that important? Because it's back to what I said before. I'm not going to chase that revenue in order to keep my fab full because then I end up with diluting margin and underloading, the double whammy on margin. Now that we have the posture we need for the portfolio, with the margin profile that we need, and we keep working on that. We're not done, of course. We're going to resize our footprint and that said it, we're going to reduce the number of physical locations in order to reduce our fixed cost. And that's what's going to create that floor. Because when we start walking away from that revenue, and I don't have the overhead of manufacturing sites to keep full, my margin is not going to fluctuate already. Does that make sense? That's what's going to create that floor is the manufacturing rationalization, which is reducing fixed costs, by reducing physical footprint. Now people say, "Well, how are you going to grow? That's why we had that third chart, our capacity is actually going to grow because we're going to move the value technologies to scale fabs like East Fishkill at the $300 million. So we're going to get the capacity to grow, but we're not going to have to deal with the subscale fixed costs that we have in some of our manufacturing sites. And it's not just about fabs, by the way.

Does the current tightness in the market accelerate that process or decelerate the process? Because telling a customer you're going to shut down supply and transition it right now, they -- I'm assuming they don't really want to hear that.

That's right. They're not easy conversations. But look, we're very respectful of our customer relationships. So we're not leaving anybody hanging. We've made our intent clear. It's not about when you sell the fab or when you divest the fab or when you do something with the fab. It's not that transaction that gives you a favorability is when you exit the fab. So we have already started transferring technologies to our other fabs. So there's no supply disruptions today. What's making it more difficult is typically when you transfer fab, you have to build some inventory, kind of transition inventory. We just don't have the capacity to build that. Everything we're building goes to demand, right? So what's slowing it down a little bit is that transition. But the work that gives you the margin stability is actually the transferring, qualifying and ramping those technologies in the new location. That's what's going to happen. So we've been doing all of that already. So therefore, when we are able to divest the fabs at the right time or the back end at the right time, it's a seamless transition versus a 2-year transition. But Make no mistake, getting out of fab is a 2 -- is a multiyear process, right? It's not, oh, we decide and next quarter, we're going to be done with it. We know that from the fabs that we have already announced to exit. It's been a few years. And I know that from my prior life when we were -- we divested a fab and it took about that long.

You talked about a lot about raising the floor by rationalizing the footprint. At your analyst meeting, I think you said half of the gross margin increase is from kind of manufacturing efficiencies. Talk a little bit about the positive side of that, not just removing the negative, but as you fill unintended East Fishkill, as you fill that up, how much better are the gross margins just from the superior cost on a 300-millimeter wafer.

That will be -- it depends on the product, but we're talking about probably 20% plus. But more importantly, if you think about it, the products that we are moving to the other fab, forget about just East Fishkill. The products that we move to the other fabs from the subscale fab to at-scale fab, those are going to fill those fabs. And all the products in those fabs, the cost is going to be reduced just because of more efficient manufacturing. Is that -- I like that said, half of our benefit is going to come from rationalizing the manufacturing. So that's why a lot of people say, "Well, what's left to go, given the seller part of gross margin. Well, there's a lot to go. And that takes time. The manufacturing, like I said, is a multiyear process. It's not measured in quarters.

So we're running up against the end of time, so I'll just ask one final question. You gave a bunch of financial targets at your analyst meeting, 7% to 9% revenue CAGR, 45% gross margin, OpEx intensity at 17% and free cash flow targets, I think free cash flow margin, 20% to 25%. Which of those are you most comfortable with and which one takes the most work?

Look, I'm going to say I'm comfortable with all of them because that's -- I'm not going to put something out there that I'm not comfortable execute into. The one that has the most complexity is, of course, the manufacturing, unwinding manufacturing. That's the one where a lot of my focus and my team's focus is on is that, say, that just takes time, and it's complex. It's not difficult. It's just complex. So that's just as a lot of my attention, and I have a pretty solid manufacturing and operations team. I brought in a new Head of Worldwide Manufacturing at the beginning of the year. You're starting to see some of that benefit of the restructuring that he's already started doing and will keep doing over the next few years. Everything else is really an outcome of execution. Growth is -- we're solid where we are. We're going to keep pushing. We're going to keep creating products. We're going to keep pushing those products in the market. So that's going to fuel the growth. But the margin and the manufacturing is the one. The manufacturing side of the margin because product margin mix is going to happen as we grow. One thing I want to make sure everybody understands is there is a nuance in our model also where we disconnected the margin from a revenue level. Prior targets had a margin attainment at a dollar level. So when we talk about sustainable margin, we are not tying it to a revenue level, and that gives you that floor back to your prior question. That's important nuance because that's how we're going to be operating is to maintain that margin expansion at whatever the top line does because we don't -- macro is going to do whatever Mac does, and I want a sustainable margin.

Well, the good news, at least -- complex as it may be in time consuming as it may be, at least the thing that's the most -- that's garnering most of your focus is the thing that's under your control more than anything else as well.

That's exactly.

You guys can work on that. So we're actually right on time, Hassane. So thank you so much for attending the conference. Great to see you again, and we look forward to monitoring ON's progress in the future.

That's great. Thank you. Thanks for the time.

Thank you.