ON Semiconductor Corporation (ON) Earnings Call Transcript & Summary

Welcome, everyone, and good afternoon. Welcome to this session with the management team from ON Semiconductor. I'm Vivek Arya, I cover semiconductors at BofA Securities. I'm really delighted to have Hassane El-Khoury, CEO; and Thad Trent, CFO from onsemi. I'll go through a list of my questions, but please feel free to raise your hand if you would like to bring anything up, and we'll make sure we get a mic to you. But a very warm welcome.

Thank you.

Thank you.

Really appreciate you being here.

We'll go through the kind of the near to medium term, but Hassane, I was hoping you could just maybe -- let's take a step back, right? I mean both yourself and Thad have been there for roughly about 3.5 years, right, or so. And I think we have essentially seen a transformation of the company from what used to be kind of a deep cyclical to now more of a cyclical growth with multiple product cycles. And another right aspect of that transformation has been this fab like strategy. But I was hoping to tell us way onsemi's in that journey, how much more is still ahead of you?

Yes. So we've made a lot of progress over the last, call it, 3 years or so, but we're not done. These things take time. Obviously, we've made a ton of progress. I'll highlight some of the things. But this period where we're in today is a testament to what we've done already to build confidence in what's yet to come. So if you think about it, what you said is true, the company's story has been deeply cyclical. Does okay in good times and then I would call it creators in bad time. So how is that different than today? Over the last few years, we talked about the structural changes we're doing. The structural changes we've done on the product portfolio. We walked away from $475 million of high volatility business in a downturn. So that gave us more sustainable and predictable results as we sit here today. We've divested 4 fabs to give us more of a floor on when there's underutilization to get those fixed costs out. So net-net, and we redirected the company into high-growth areas that even in the period we're in today, those areas still showing growth, maybe not as strong as we expected, like silicon carbide EV, but still growth, nevertheless. So if you put all of these together, the company is going from -- if I take apples-to-apples, we're at 65% utilization today from a manufacturing footprint as it stands today. And in -- at the beginning of COVID, we were at 65%. In the financial crisis, we're about 65%, in the last inventory correction, call it, -- 2018, 2019, right around there. The difference is, structurally, our margin floor is 45% today. At that same utilization rate in those prior scenarios, I mentioned, the gross margin used to be low 31% -- 29% to 31%. So apples-to-apples from an impact of the softness reflected in utilization, we are a very different company. That's what the work we've done, led us to hold that mid-40s floor. Moving forward, however, there's still a lot of opportunity because to remind everybody, our long-term margin target is 53%. So how do we get from here to there, given that now we've established that baseline, that new baseline of a structurally predictable -- financially predictable company and that's with a lot of the growth. So utilization, we'll start with that given that's where we are, 65%. Our sweet spot utilization is call it, 80% to 83%. Every point of utilization between 65% and that, call it, 80% is 15 to 20 basis points of margin. So market recovers, utilization goes up, all that go up. Revenue goes up with it. The growth goes up. We backfill or we utilize our silicon carbide capacity with EV. Silicon carbide margin become accretive to the corporate. And I mentioned, we divested 4 fabs. There's about $160 million of benefit from those divestitures that we will benefit in the '25-'26 time frame as we fully exit the fabs. What does that mean? We sold the fab, we handed the keys to somebody else, but we still buy those wafers from those foundries. As we bring those wafers in, we benefit from our cost that's about $160 million that will be over next year. That's without even talking about mix with our new products. So if you add all this stuff up together, you're already within spitting distance from our long-term target. That's what's yet to come.

Got it. And also as part of that kind of the fab right strategy, what is the progress of the East Fishkill fab, right? How does that kind of fit in your journey towards this 53% gross margin?

Yes, part of the mix and how have we been able to grow the company, change the product footprint, yet divest 4 fabs, which we divested 4 fabs in the height of the shortages. So how you do that is by what we call the fab right that you referred to, which is having that footprint there, how do we partition the products. And how do we partition it to minimize and optimize the CapEx deployment to get a better ROIC. So to give you a simple example, we ramped our silicon carbide 4x from '22 to '23, $200 million to about $800 million. But our CapEx, we didn't build the new fab. So how do we do that? We took our IGBT, our silicon power from our Korea fab. We put it in East Fishkill and in that transition went from 8 to 12 inch. So you get a fab utilization on East Fishkill, you have an 8 to 12, so capacity increases based on output, and then we move silicon carbide into our existing power fab in South Korea, and we ran silicon carbide. We did not buy a shovel, nor build a new shovel. Yet we entered a market, quadrupled our revenue to $800 million, meaningfully quadruple. It's not like $1 million to $4 million. It's $200 million to over $800 million and we didn't build a new shovel. That's the CapEx light that comes with our brownfield investment, that's going to expand that concept to the fab right, which is where is the best place to deliver and build our products that minimizes CapEx, improves cost and gets us time to market much faster. So a brownfield versus greenfield strategy for expansion, 40% cheaper and about 2 years faster time to market. That's the reason we capitalize on the silicon carbide market as a "newcomer" back in '21.

And let me give you a little more color on the East Fishkill as well. When we closed that acquisition 1.5 years ago, the dilutive impact at that time was a surprise to us. So it was 250 basis points. And at that time, we said, look, it's blocking and tackling. We know how to run fabs that have right strategy, and we just had to get the cost structure, right? On our last earnings call, we talked about, we now have parity in the wafer cost with their other fabs. So we've taken that cost out, right? We've improved the cost structure, improved the cycle times. We've now taken the cost out, we're at parity. The next step is it's a 300-millimeter fab, so we got to get better than that, which we'll do it. We're on the curve to get there. But today, the dilutive impact is the foundry business that we're doing for GLOBALFOUNDRIES. So that's 100 basis points for the remainder of this year. That rolls off next year as well. So in addition to what Hassane was talking about the utilization, you have that 100 basis points gross margin improvement that you'll see in '25. So the market recovers, a couple of these other things, and we've got margin expansion coming in the future between '25 and '26.

Got it. Does that change that -- the underutilization or the utilization of that path if GF moves out of there?

Sure. We've got to fill that up, but that's in that 15 to 20 basis points improvement.

And the way we're filling it, obviously, as we move IGBT. We have some of our new products from the image sensor that we already are running in there. Our first new product is sampling out of that fab. And we have the medium voltage [ fats ] already there. And in our last Analyst Day, we talked about our new push in the analog mixed signal. New products that Sudhir talked about or the power tree for automotive, industrial and cloud. Those are all going into East Fishkill. So as we wind down the GLOBALFOUNDRIES, low-margin foundry business, we're actually replacing it with new products at 60% to 70% gross margin. So you lose a dilutive impact, but you're replacing it with a much better swing on margin, and that's what's going to get that trajectory. That's the margin expansions on the new product.

So I wanted to talk about the two big parts of the business. So let's start with industrial, then we'll get to a lot more exciting step in automotive. So maybe industrial, help us unpack what is in your industrial business right now? Kind of what are the big applications there? And then where are those big ones in their state of inventory adjustments?

So what's in industrial, everything that doesn't fit anywhere else. So industrial is pretty much the breadth of it. But representative of industrial, I look at our industrial business as really two sections. You got the traditional industrial and you've got the secular industrial. Traditional industrial is what I referred to when I first called the softness in industrial power tool is more, everything in industrial that's closer to the consumer. It's more spend-driven, power tools, more closer to the consumer side of...

[ White ] goods.

White goods, all of that, that's driven by market, that's driven by GDP, that's consumer confidence. Then you have the secular growth, which are mega trend driven. You have the renewable energy, energy storage, factory automation, those are trajectories of growth. So if you split the two and I comment on both of them, the traditional started, we started seeing that softness in Q4 of '22. So we were one of the first that call the softness in what I called in the consumer side of industrial, again, back in Q4 of '22. And there are reasons for that is we have the LTSAs. I've always said, if the LTSAs don't get us anything, they're going to get us a phone call. Well, we got the phone calls. So we really started taking utilization down and we adjusted for it, that was still strength in the -- there's the build-out of the energy infrastructure and so on. So that started getting softer later. So that's where it is. Now where we are today, there's stabilization. So the traditional part of industrial is stable. There's some green shoots in there, but it's stable. It's not -- the rate -- if I look at KPIs, rates of cancellation, pushout and so on, it's has slowed down and stabilized. Again, like I said, some green shoots, medical has been a growth for us in our analog business. And then the other one is still having some softness, but again, slowing down from a softness perspective, I would call that stabilization. So that is kind of how we look at the industrial business. So when people say now, well, your industrial quarter-on-quarter didn't go as much as some of our peers, but you got to -- for us, you got to go back to like Q4 '22, Q1 '23 and measure from that. Because we started taking it down, and we decided to take utilization down way ahead of everybody else.

All right. Some of your industrial and analog peers have suggested sort of a -- I wouldn't call it a hard bottom or at least some bottoming and some recovery over the next several quarters. I think you have been more conservative, Hassane, if I'm right about calling for a bottom in that market. What is preventing you from calling for some bottom if you're seeing some of these KPIs start to improve?

Simple, I don't like to be wrong. At the end of the day, the people that are calling a bottom are the same view I call the growth in 2024 and the end of '23. Guess what? '24 wasn't. Now they're saying, well, yes, but the second half. Look, there's two things before -- for me to call the bottom. I need to see two things. One, I need to see the demand pickup. And the order patterns picking up. That is the first signal for us to say, okay, there is now ordering coming up. Therefore, it's an indication. But the second and more important thing for us to call a recovery, which is market-driven is you ship to your customer, they have to ship through. The end demand, consumer purchasing demand has to recover for us to call a recovery. Does that make sense? Otherwise, we'll see the orders, I ship them out, get a good quarter, inventory sits at the customer, then they reduced their order patterns again. Okay, that's one great quarter. I don't measure in quarters. I measure in long-term view, which is how we run the business is not on a quarter-to-quarter, we manage it on the health and the sustainability of a result that we want to achieve. So therefore, it needs longer time, so those green shoots has to play out on end demand versus just sitting in inventory. We're not there yet. That's why I say it's too early to tell. But as we -- that market develops, if stability is sustained, and by definition, you'll start getting kind of that market demand picking up. But I have to see both before I call the bottom. And by then, I'll be on the other side on top.

Any specific parts of industrial, where you think things are still pretty bad and where do you think those...

I don't think there are parts of industrial that are bad, I would say. I mean...

Alternative energy is still soft, right?

Soft. We don't play in the residential side of it. So for us, it's -- there are areas that are soft, like that said. But there's not an area that's kind of like it was when it first started, whereas like a steep decline, pig to trough, we ended up about 30% or so. So that -- I don't think there's that. There's more of a tapering off.

Let's talk about automotive. So last year, auto production was up 9%. You obviously grew better than that. This year, auto production from what we are hearing is either side of Platt, it's not really. So what does that tell you about how your auto business can do this year?

So auto business overall, I think you can say, call it, flattish depending on where we end. But with -- if you take the -- where the Street has us, just take that and project with the percent, now you have a growth in silicon carbide. So I know there's a lot of headlines about EV, no matter what you think about EV. EV is going to grow. Just a different rate than what everybody thought, depending on what you thought walking in the year. So if you take that growth that we talked about and where the Street has us, the rest of the non-SEC business is down mid- to high single digits, about. So that's kind of where you can think about it. I feel right given where a lot of our peers are, it depends.

Why is that content helping you on the non-SEC side?

Because it's not -- remember, it's not the content inside. It's -- how much of it was in inventory depletion. So it's not a one-to-one to what the content is, there's an inventory digestion period, which is you're undershipping basically, you're not a one-to-one until you get to that level. So that's the dislocation that we have in '24. And that has to work its way out before you start getting to a SAAR plus or content.

Got it. Do you have a -- if you set aside silicon carbide, Hassane? Do you have a greater sense of comfort in automotive versus industrial because you have worked in the automotive industry. Do you think you are getting dependable signals for them? Or you think we should be prepared for another leg down in overall automotive depend?

I hope not. Look, I think from the patterns and so on. I think both our customers, the OEMs and ourselves, we have a pretty good handle on the ordering patterns. And it's not what I see in the backlog -- is the dialogue we've been having with customers, where -- when we're talking about engagement and remember the LTSAs are legally binding unless we both come to an agreement to change -- Having to go through that agreement is where the alignment comes in, where we have to feel comfortable that whatever the win-win is, it's sustainable. So what does that look like? Design and activity is still healthy. Every OEM that had intent on launching a new platform for EV is launching it and launching it when they expected. So none of that thing, which -- that leads me to believe it's temporary. That correction or that inventory digestion or even the contraction in growth in EV is temporary because no plans have changed. I would be more worried if people say, we're canceling 3 platforms, Okay? That's a different approach. But no OEM has backed off on their EV strategy. Some said, "We're not going to be 100% by 2030. It's going to take us longer." Not a problem. We never bet on a 2030 as a black and white date. I've always said, we'll be maybe half penetrated by the end of the decade, give or take a few years. Well, today, it's taken a few years. It's -- the lumpiness is always part of our plan. So nothing that has happened has changed that. And from a customer perspective, nothing has changed from -- I was at the Beijing Auto Show. It's all EV and most of it went to 800 volts. So the trajectory that we're going with our road map at 1,200 volts supports exactly where every OEM is. So again, no OEM has changed the strategic intent on EV. That tells me that this is temporary, and it's market-driven.

All right. How fast do you think the silicon carbide market can grow this year?

Well, I'd tell you we're going to grow 2x whatever that number is.

What is x?

I'm not going to call the x. Because, again, I have to see what the end -- what the denominator is.

But if you're saying, nobody is canceling orders, everyone in the EV side.

True. But you don't know yet is how much you're going to sell through, back to my demand question. I mean it's -- I know what we're shipping. I know the platforms we're in. I can see the cars in the showroom. How much is it getting to sell through? That's depending. The denominator is what is really, really needed here. I know what we're shipping. And I need to make sure that it will be sustainable.

Then how do you know it's 2x?

How do I know it's 2x is based on the sockets position. If there are 100 cars we built, we're in 50. If the market is down, we're still in 50 of 100. You see -- But if that's 50 units or 100 units, we're still going to get 25 or 50 of them. That's the 2x. You see what I mean? So that's where we know we're gaining share. We know what designs we've captured. We know who the OEMs. Remember, in Q4, I said that the second half of this year is going to be driven by the growth in European models, back in our earnings in Q4. Those are going to start ramping. We're in what in the models that will drive 2x market. The question is, what is the number that is going to go, not the penetration rate. So that's what the 2x is based on.

All right. Makes sense. Medium to longer term, are you concerned about the amount of silicon carbide capacity and the competition because we have Wolfspeed who is ramping a lot of capacity, they are expecting to get big grants from CHIPS Act, right? I think STMicro announced more fabs, I'm sure that [indiscernible] is also ramping and there's, of course, like a whole bunch of people in China. So are you not concerned that there is -- there could be overcapacity and a glut of silicon carbide over the next few years?

Look, I'm not concerned enough to change what we're doing. And let me explain why. First off, building the fab doesn't mean that you have something good that goes in it. We've been winning today, not because there's constraint or not. We're winning because our technology is better. Customers make decisions on who to design in based on the evaluation on the bench because they want cars that are winning in the market, right? So maintaining that as long as we're able to support our customers and have advanced technology that's better than all of our peers, we're going to keep winning. I don't care how big fab. The only difference is they're going to have an empty fab and we won't. That's the -- and they'll have a bigger empty fab than we don't. Overcapacity only worse in commodity. The fear of overcapacity only works in a commodity business where the more you make you use pricing and you just flood the market. We're not there yet. Silicon carbide is a proprietary value-driven product, not a volume-driven product. When volumes go up, price doesn't go down because the more percent efficiency that we offer to customers, they can monetize it on the battery side. To give you an example, if our silicon carbide is more expensive, but it provides a 10% better efficiency, the customer will say, drop in the bucket. I'll pay you more, give me the 10% efficiency. I'll go save that 10% is worth way more in dollars, if I take it out the battery than your silicon carbide. You see what I mean? So from a system level, when you want to talk about low-cost EV, it's not about giving a bonus to your procurement guy because they got 5% of the silicon carbide die. It's -- you got $5,000 off the battery because you overpaid for a silicon carbide module. That's the economics of low-cost EV. It's not optimizing nickel and diming. That didn't work out for the auto industry, overall. So they have to look at it from a more dramatic approach, which is what is the BOM of the car versus the BOM at the local. That's why our engagement with OEM is more important now than it has ever been because those decisions are made on an OEM level, not at a Tier 1 level, and that's where we're winning.

And Vivek, I think everybody gets hung up on EV growth rates, right? What is getting overlooked is the penetration rate of silicon carbide in the EVs. So if you look at the market today of what's in production, it's about 25% penetrated in silicon carbide in EVs. If you take out the #1 player in the world, it's 10% penetration. So the opportunity is not only the growth rate in EVs, but the penetration rate within the EV. That's a huge opportunity. And when we look at the design wins, silicon carbide is outstripping silicon. Low-end cars would be silicon, but anything medium-high have some time -- some form of silicon carbide on them. So you can think about those trajectories. The other piece that everybody is overlooking is that penetration.

There is stock of low-priced EVs coming to the market. How is On position with that? Because what I find unique about you guys is the right you have access to both as Thad you mentioned, both the silicon side with IGBTs and silicon carbide. So you can mix and match combinations depending on market requirements?

Yes. We're -- if you recall at Analyst Day, Simon showed the pyramid -- the penetration pyramid with technology. We work from the ultra premium. It's 100% silicon carbide for independent wheels, all the way down to full IGBT, 1 motor to IGBT and silicon carbide hybrid module and anything in between. So being able to provide the technologies we're agnostic, versus a pure-play silicon carbide, where they have to go on an account and they have to sell silicon carbide, right? In certain areas, silicon carbide cost is a disadvantage for the performance. If you don't need the performance, IGBT is fine. So why sell silicon carbide in? We are able to provide a cost optimized performance premium based on the cost that -- based on the vehicle because whether I sell silicon carbide or IGBT, same for me.

One area that On hasn't spoken about as much as the AI and the data center, right? We have to talk about AI and [indiscernible] What is On's exposure? Is this a market of interest? Is it a big enough market for you to go after? Like can you do it organically, something inorganic might be needed?

Yes. If you look at again, a couple of years ago or in May, actually, as early as May, we talked about the power tree for auto, industrial and cloud, right? And we talked about where we play. Our strategy is, first, we're walking in today, we announced a silicon carbide bet for the cloud. At 650 volts now you're talking about the power rail coming in, and a T10 Trench Fed or the internal power tree. So our approach for this market is it's very good adjacency from auto and industrial, where auto is 800, 1,200 volts. That's a 650 volt, still benefit from all of the technology and efficiencies that we have to provide in the car. Now we're able to provide that in the car, which is as important when you talk about efficiency, there's not enough power coming into these servers. So the efficiency matters because you have smaller size, smaller footprint and more efficiency from a power conversion. So we've introduced our new generation silicon and silicon carbide that tailored dose. As you look forward on the road map, what is yet to come is the analog mixed signal that we talked about from controllers and drivers that go in. But once you have the power switch, then adding that cross-selling to it through the controllers and the drivers and everything else becomes a cross-selling opportunity versus a penetration opportunity. Same play we've done in auto and industrial.

Do you think this segment becomes interesting enough that you actually start to break it out and not just put it in other?

It's going to be -- it's interesting enough from a strategic perspective. But from a scale, automotive, you're talking about platforms when you talk about LTSAs and auto, the numbers are in Bs, every single one of them is in $1 billion over life. So we'll see how big that market becomes before we start breaking it out because we also don't want to lose the focus on the auto. The value creation forward looking from the auto and industrial strategy that we've outlined. So we're going to be able to strategically address all 3. But what we talk about in the level of detail like we have been with auto and industrial, that we'll have to decide on.

Got it. And then finally, in closing, Hassane, any -- as we look at the second half, everyone is interested and excited. I think you're taking a little more measured view of second half recovery. How are you feeling about second half recovery right now?

I don't know. Every day I wake up, I feel differently.

How are you feeling today?

At the end of the day, it's what I said on the call. We're running the company in a -- or an L-shape when people like it. We came up with that on the call because to me, it's down. We expect it to be flat. And why do I feel comfortable with that? So yes, I feel comfortable with that because it is the most balanced of, if things don't recover, we are in the best position to get through it. Our inventory, 109 days, very low. Utilization is 65%. Our balance sheet is healthy. All financial metrics and inventory metrics are how we've been managing. If I'm wrong, and there's a recovery, utilization goes up, margin goes up, revenue goes up, inventory burns. It's all tailwind. I'd rather have be wrong and the cost of it is all tailwinds financial rather than plan for a recovery. And if it doesn't happen, now I have to burn inventory. I still have to take utilization down. It's all negative. Our balanced approach puts us in a much better position to very quickly react favorably across all financial and operational metrics should the recovery happen versus plan for it and [ other ] happen. That puts me in a much more comfortable position as it relates to the uncertainty in the second half.

Makes a lot of sense. Thank you so much, Hassane. Thank you, Thad. Thank you.