ON Semiconductor Corporation (ON) Earnings Call Transcript & Summary

Great. Thank you, everybody. I'm Joe Moore back again. Very happy to have with us the management team of ON Semi, Hassane El-Khoury, CEO; and Thad Trent, CFO.

So maybe if go off-script breaking news today that you've acquired the Universal Silicon Carbide business from Qorvo. Can you talk a little bit about that? What benefits do you guys see from that?

Sure. So if you think about the strategic rationale, of course, we're a power semiconductor provider, including silicon carbide and wide bandgap, and we've always said that the competitive advantage that we have is the ability to give customers a solution to stay look for their specific needs and or optimized. So how does that -- the acquisition of the silicon carbide JFET business fit into this overall strategy and more appropriately, how does it fit the customer need. With the emergence of AI, the AI trajectory from a power perspective is increasing every generation. And now the AI server going from 40-kilowatt to, call it, hundreds of kilowatts as that transition happens, you start to need more of wide bandgap technology devices rather than just a silicon from an efficiency perspective, but also from a cost and area. Because a rack doesn't get any different. The size of a rack, the XY and height are almost spec-ed. So therefore, real estate is important. So you need a more compact power solution that is able to provide the efficiency when you deploy at scale. That's what the silicon carbide JFET does for us. It's a smaller die. It's a higher efficiency, higher frequency product than this regular -- even silicon carbide. And with our ability to, over time, bring that in, it gives us that also a competitive advantage from an operational side in addition to the strategic side. So more power drives more efficiency requirement, more efficiency requirement make silicon carbide JFET very appropriate for AI. Other markets that we play in, where that becomes very competitive also and more suited, we have a trend in industrial for more solid-state breakers for example, silicon carbide JFET, is suitable for that. It's actually the most ideal solution for that. Fast forward into automotive, with the proliferation of electric vehicles, you have the battery disconnect switch that's going from electromechanical to now a solid state silicon carbide JFET again, is the ideal solution for that. So you can look at it from a strategic rationale, the technology is superior, great team, great technology, now going into markets that are exactly where we go and play with the rest of our portfolio. So that's back to the cross-selling go-to-market that we have been pursuing.

Great. And Qorvo wasn't able to extract this value because they don't have the breadth of power that you guys have is that?

It's the breadth of power, but also it's the customer alignment and the channel alignment. So the Qorvo, the sweet spot of Qorvo is market and they're successful in their markets, it's more on the mobile to RF and so on. And although they have some more diversification in their portfolio. but that business requires a portfolio because sometimes it's silicon carbide FET, sometimes it's a JFET, sometimes it silicon can do it. So you have to be able to give the customer that optionality, number one, but also be able to use our existing sales force in a very efficient go-to-market. For us, our sales force will look at it as now it's another product in our sales bag, for the same customers we actually call on today through the same channel to go to market. So it's a very efficient go-to-market as well for us.

Great. Well, congratulations. It sounds like a great deal for you guys. The other new development was the development of Treo, programmable analog, can you give us an overview of that and how that fits into your long-term...

Yes. So Treo is, again, if you think about how we go-to-market, our focus is adding value to the customer system. And the way we go about it, we solve value through technology. So we've introduced the trail, which is a mixed signal analog product platform which is base on BCD 65. So BCD 65-nanometer BCD, 12-inch internal fab in East Fishkill. What does that do? It's 2 component of competitive advantage. One is the technology component. What BCD 65, as I mentioned, a 65-nanometer, 300-millimeter fab, number one. More importantly, it is a 1-volt to 90-volt monolithic capability of the whole platform. We can go from low voltage all the way to 90 volts at 65-nanometer, which means from a competitive advantage, we are able to provide a single chip solution for a 48-volt rail, as an example, in AI or 48-volt with the zonal architecture and automotive in a single chip combining power and compute in a single platform. So that's what the platform does and the ability to go up to 175 degrees C. So very well suited, auto, industrial and AI for a very broad range of products. What we also said in the announcement is we will start -- actually, we introduced products. We're sampling products in all of these markets. Revenue starts actually in 2025. With a target of [ 2030 ] of $1 billion with a margin of 60% to 70%. Again, when we talk about our portfolio progression over time to get into the higher margin product, higher value and drive the corporate margin to our -- towards the 53% target, that's part of that trajectory. On top of the technology, there's a process and capability that we introduced with the Treo, which is an SoC like go-to-market. What it means at its basics, we have a collection of IP blocks. And based on the product we want to make, we integrate and we consolidate those IP blocks to make a product. That capability, which is very typical in SOC, nobody has done it in the analog domain yet. We've been able to achieve it, which takes us from concept to sample to a customer in 6 to 9 months. That go-to-market in the markets we're playing in, like AI, you have to be able to get that pace when AI generation is, call it, on average, an 18 months kind of beat, 6 to 9 months is half of that. So we're able to do multiple products to proliferate as soon as the architectural decision on the SoC is done. And that's a different value outside of just the technology is that capability.

And can you talk about that with -- you're talking about margins that are the high-performance analog types of gross margins, but you're competing there with companies that have broad catalogs and your -- how does that competition work? Do you have to have the same building blocks that they have to achieve this?

Yes. So our intent is not to go in the general purpose analog mixed signal. It's very targeted to where we as a company provide back to the cross-selling as a go-to market. Let me give you an example. We provide and we're leaders in silicon carbide MOSFET, whether it's JFET or the MOSFET or even IGBT. But let's take the silicon carbide, we're leaders in that market. If we're able to make a driver with compute and a good drive in it, that is designed in conjunction with our silicon carbide FET that together perform better at a system level. Think about it as a chipset for kind of -- if your background is in the digital domain. The chipset always works better together, but they can work separately. So having a driver that makes our MOSFET work much better from a customer perspective, they will buy our driver when they buy our MOSFET. So it's that cross-selling that we're going after from a mixed-signal analog portfolio, not necessarily the general purpose off-the-shelf analog that TI and ADI kind of do. So it's a very targeted go-to-market where we believe we add value in conjunction with the rest of our portfolio. The same goes with the PMIC. The same goes with an AI, for example, we have the best FETs in the industry, integrating the point of load with some discrete or just discrete with controllers and PMIC's and so on, we're able to provide the best performance for our customers because we have the best of both technologies, others do not. So it's a very targeted cross-selling driven go-to-market, not just a blanket analog portfolio.

Yes. Okay. Good stuff. Thank you for that. So maybe moving to the overall industry environment, the #1 debate we get on for ON is gross margin. You've done such a good job. You've got gross margins in the mid-40s with utilization in the mid-60s, can you talk to the sustainability of that? I mean, obviously, it's a sort of a challenging demand environment. Can you sustain the profitability that you have?

Yes. Look, our margin right now is driven by utilization, right? As you said, our utilization is 65% kind of a trough utilization historically for us. And typically, in previous downturns, when we hit this level of utilization our gross margins were high 20s, low 30s. So the fact that we're holding the mid-40 shows that we're structurally a different company. From this point forward, whether utilization goes up or down, that's going to drive the gross margin. Given the outlook that we're seeing right now with the uncertainty, we think for the next several quarters, we're going to be -- we'll be below seasonality for the next few quarters. So we may take utilization back a little bit and margins will move slightly with that. But that's temporary when does utilization comes back on. So for every point of utilization, up or down, it's 15 to 20 basis points of gross margin up and down. So you can kind of do the math there. We peaked out utilization around 83%. So going from 65% to 83%. You can do the math. It's a nice tailwind there. Like I said, in the short term, if we've got to take it down and not build a lot of inventory, that's fine. That's temporary. And when the market recovers, we're going to turn it back on. We've managed our inventory in the channel and on our balance sheet very effectively. If you look at our working inventory, it's 113 days. Our sweet spot is 100 to 120. So whenever this market does rebound, we're in a really good spot to turn the utilization back on quickly. And then there's about a quarter latency for that to hit the P&L, but you start to see that through gross margins very quickly. So it's not like we've got to burn through inventory at the disty and of our balance sheet before we see utilization improve. So you may see some short-term headwinds to utilization and gross margin, but I think that's all temporary. But structurally, we're a different company, and we're positioned well for the market rebound.

And look, the balance you're trying to strike of course, 2025 for us is going to be all about cash flow. We don't control the market environment. We don't control the demand overall. So what we do control is how we manage our business, and managing the business for back to like Thad mentioned, focusing on not building more inventory than we need keeping in that same in that spot will drive more cash flow to the bottom line. And with the CapEx going down a click now gets that cash flow. And you've seen us very active in share buyback, more cash flow generated, good capital return to shareholders. That's kind of what we're managing too in a 2025 environment.

Okay. Great. So to maybe double click on a couple of those. You talked about the 113 days of operating inventory. You also have the strategic reserve, which comes up a lot. So can you just describe the rationale for that?

Yes. So we've really bucketed our inventory into the 2 buckets. One is the base inventory or working inventory that's 113 days. We have another 100 days, which is what we call the strategic inventory. That's for our Fab transitions in the silicon carbide ramp. So just as a reminder, in 2022, we divested 4 fabs. We've been doing the last time builds in those divested fabs and we'll burn through that inventory over time. So as the market rebound happens, that's again another way we're going to create strong free cash flow, turning that inventory into cash. But when we look at truly what's that working inventory, that's in our sweet spot. That other piece is by design. It's just taking a little bit longer to bleed through because the market is softer right now.

Okay. Great. And then in terms of the lower capital intensity, I think you talked about going to a mid-single-digit level of spending. Can you talk about how long you'd operate at that level, what would cause that number to go up or down from here?

Yes. Look, we don't see any change to that number. The big investments are behind us. We made big investments in silicon carbide, big investments in our 300-millimeter capabilities at East Fishkill. And the reason that we were able to take down that intensity level quicker than we anticipated is because silicon carbide yielding very well. We don't need the additional capacity. So it's all internal that we're actually ahead of us. So when you think about our investments over time, they've been brownfield investments which is much more efficient than greenfield. So from this point forward, we think we're going to be running in this mid-single digit. And you can think about it as primarily maintenance. There's a little bit of capacity here and there over a multiyear period, but most of it is maintenance because the big investments are bind us. So like as Hassane said, even in 2025, with uncertainty, we're going to create a lot more free cash flow just year-on-year.

Yes. Yes. Okay. That's great to hear. So you mentioned the demand environment, I guess, it was around this conference last year that you guys started signaling weakness in autos, you were early to see that. I think the same was true in Industrial a year before that. You were the first ones to see that. So where are we now in that process of reducing customer inventories in automotive and obviously, there's good underlying organic growth in those markets, when do you sort of see us returning to that from a semiconductor perspective?

So we're still in an inventory digestion period because that -- the inventory and how long it takes is a factor of end demand. The end demand is not really picking up.

Okay.

And like we mentioned even on our last call -- or on the conference last week, we talked about the next couple of quarters being below seasonality because, look, what happened in the last, call it, 4 to 6 weeks, you've seen a further development in the European market from automotive. Just look at the headlines. So there are challenges here locally that are different and softer than they were when we talked about it in our quarter. Now why are we seeing it? Why am I talking about it? Not just the headline, but from an LTSA perspective, the same comment you made, why we see it early is because we get the phone call because of the LTSAs allow us that phone call. So we're starting to see that come in with concerns, specifically European Tier 1s that are impacted by the European OEMs, and that's why we're looking at kind of the next couple of quarters below seasonality until that works its way through.

And to what extent do you think that European weakness is a function of the success of your customers in China? Because it does seem like that's at least an element is that European luxury cars exported to China seems to be disappointing. And I know you have a good presence with the customers that are...

Yes. Look, that may be from a financial stance that there is a stance when you have -- and depending on the OEMs, if you have 20% share or market share in China and that kind of shrinks, it will impact your financials, top line profitability, depending on the OEM and so on. But there's also an intrinsic issue in general, which is the demand environment. You have a conflict in Europe, you have energy cost. You have fundamental topic. And look, let's be clear, there's also the geopolitical environment, not just in the U.S., but in Europe, you have an election coming up in Germany. So these are things that have to work through wherever it lands, good, better ugly, the comment and what's important for the industry is stability and predictability. And that's what I mean. It's going to work its way out and we anchor on something. Wherever it is, the market will then adjust for it. That's when you start seeing clarity. And from clarity comes consumer confidence, consumer confidence will drive demand.

I mean the shortages that we saw I've done this 30 years, and I have not really seen that before. Two years ago, where every automotive insurance analyst is calling me to figure out when we're going to start building cars again. So like it makes sense to me that there would be a buffer of inventory that got built after that. I guess, what's your visibility into how much may still be there? And when do you think that may start to clear?

So that's a broad -- it's hard to say it like in automotive, there's so many because it's a customer by customer. And to the extent we can, we drill in on a customer-by-customer basis. Inventory in the channel, it's easy for us to do. We have visibility. We know what's in there. The distributors will take more if we ship to them. But we're holding back because we're managing weeks of inventory very tightly. But when it gets to the customer, you have some customers in automotive that are down to a couple of weeks, some that are a little more strategic they talk about 2 to 3 months. But as demand uncertainty happens, those 2 to 3 months, they go, well, maybe we can go with 4 weeks and 5 weeks until the market kind of get better visibility. So that's the moving target that we're seeing, but it's not the same across all customers. And the same is true, by the way, at the OEM. If you look at inventory, car inventory across all the OEMs, it is a very broad range. So you can't look at it as well, it's healthy inventory, plus or minus a few days on an overall. You have to look at it on an OEM-by-OEM basis then the discrepancy and the distribution is much higher. Within the same OEM, different brands have different inventory levels. So we're looking at it at that level. I track inventory at our customers as they -- for the public companies that announced and you can kind of manipulate. So if somebody has a ton of inventory and they're giving me a rosy picture for 2025. I'm going to be very hesitant to take it at face value. So we're doing our due diligence to make sure it doesn't get ahead.

Great. Okay. On silicon carbide, you had some nice proof points with the win with Volkswagen earlier in the year. You've made investments in brownfield kind of local-for-local locations, but it's obviously been kind of a choppier market than you would have anticipated. Can you talk about the outlook of silicon carbide adoption going forward?

Yes. We're seeing silicon carbide -- silicon carbide is a growth vector for us. We also see silicon carbide growth into 2025 because there are 2 factors that are driving silicon carbide growth. You talk about electric vehicles, and what I mean by that is electric vehicles as a percent of total vehicles made. So there's more -- there's going to be more EVs in '25 than there were in '24, even in, let's say, a flat SAAR. So that's the penetration. More importantly, there is a penetration of silicon carbide into EVs. So if I take out the North America -- North America EV leader, if I take them out of the equation, the penetration of silicon carbide in EV is only about 6%. So just silicon carbide getting designed in and ramping within the same EV baseline from a unit perspective is going to grow the silicon carbide specifically. And as OEMs shift to 800-volt silicon carbide becomes the norm for electric vehicles. On the 800-volt with a 1,200-volt silicon carbide device. So that's what's driving the growth. So it's penetration of EVs of total vehicles and penetration of silicon carbide into EVs. Both of those are what we see from a growth perspective. It's going to be lumpy. But Overall, the trend is growth because of these 2 factors.

And in terms of ON's capabilities here, I mean you have vertical integration that nobody else has with your own internal substrates. But we've also seen China substrates starting to become more viable. Can you talk about those dynamics?

Yes. So what our strategy has always been, we're not going to be 100% internal source. We have the capability, which is a very important distinction, having the capability, meaning you can stretch up or down. But we have the capability. We said we're going to be about 70% to 80% internal, 20% to 30% external. Some of it is from China, and we were successful qualifying good substrates from China. So that's a path. There's a geopolitical aspect of it, where having all of your substrates come from the outside or China specifically, but just in general, if you don't control your supply chain in this environment, with the geopolitical uncertainty, that starts becoming a risk for our customers. So our customers look at us back to what you mentioned. They look at us as we have good supply assurance, but more importantly, supply resilience. We're able to get inside, we're able to get outside, and we're able to stretch inside if needed, or reduce inside if needed. Where it's going to land is going to be back to -- we need to look at a stable geopolitical environment. If you can access unconstrained, China substrates, that's one model. If it's kind of in the middle, you have to be able to differentiate between the 2, that's why we're talking about expanding investments in Europe to be able to also provide our European customers more of a supply resilience with a full end-to-end capability of silicon carbide in Europe in addition to our worldwide. So we feel we are in the best place from a supply resilience. And with our device capability, device and package capability and the superior performance of our products, we are very competitive, and that's why we're winning a lot of the designs that are coming up, like you referred to with the VW.

Yes. Okay. Let me see if we have questions from the audience. If not, I can continue.

Great. Thanks. Hassane, just maybe a quick one. It looks as though Chinese platforms are moving a lot quicker. Like every 24 months, we've got a new platform. So help me understand, is this having an effect on your product cycles? And when you look across the peers, who do you think suffers in that sped up cadence?

I'm not going to say who's going to suffer, but the market will tell us. But -- to answer it, yes. The pace of innovation in China is very challenging to a typical design cycle from historical semiconductors. People talk about a 2-year kind of generation to generation, sometimes it's 2 to 3 years depending on it. So it changes the way we approach product development and the way you approach technology development. I gave the example of Treo where I very distinctly talked about, you have the technology and then you have how quickly you create products in a 6- to 9-month that pace is you have to have consideration when you develop the technology. Otherwise, you have technology if it takes you 2 years to develop products, you're kind of going to miss the -- you'll do every other technology at the customer. So you have to rewin your share almost. So we do it very effectively by when we design a technology, we design the go-to-market platform capabilities with it. And that makes us very efficient as far as being able to service the market at a faster beat than the design cycle, which gives us 2 bite of the apple because if you get 2 bite to the Apple, you're going to hit every design cycle and every, what they call an automotive, a facelift, meaning they're not redoing the car, but they're changing a lot in it. So you can get every single one, and that's how your market share starts going up over time because you don't have to wait a 2-year or 3-year to get the next opportunity to get designed in, very, very important distinction. Our ability to move fast, we're able to move at what our customers call it, China speed. And that's why in China, we're capturing a lot of market share, and we're still winning in the market share because we're providing ON Semi performance and efficiency at China speed. And that's the best combination that the customer can expect in China. What we are seeing though is in Europe, it's getting us closer to the OEM, because now we're able to have iterative discussions with the OEM and do samples way ahead, so the OEM can do -- 6 to 9 months of their own work and validate before we even start making the actual projects. So it puts us at a very competitive advantage. Perfect example, VW, again, VW announced an MOU ahead of the win. During that time, we're using simulations. We're using the go-to-market, the fast iteration and then we got the award. Very important in the new world of how you go-to-market, which is directly where the value creation is, which is at the OEM because the efficiency we get at a device level means higher mileage at the OEM, not lower cost than the Tier 1. Very important distinction and that's helping us because we had to get to the China pace which helped everywhere else.

Other questions from the audience? We have a minute half left. Maybe we could close with just any of this weakness drive any change in the pricing environment? And I know you have good LTSA coverage, maybe unique from your competitors? Just how do you see the role of pricing going forward?

Yes. We're not looking at pricing as a lever, because look, if there's a demand environment, a weak demand environment, you would argue there's no -- you shouldn't be any price elasticity. You drop your price. You're not creating more demand. You just brought the market down, you destroyed your own value. So if you believe that you bring value to the customer design, then the pricing is not a conversation. It's the value of the product didn't reduce just because the market environment is soft. It actually is more important because it provides a competitive advantage. How we look at pricing over long term, everybody asked me the question of, are you seeing this annual price reduction? And my point is, I don't believe in that -- this whole or January 1 pricing clicks down for whatever reason. But take the example of BCD 65, you go in, the customer has a solution. We're able to do that solution with a very competitive value-based product. The ASP may be lower, but the margin is 60% to 70% because it's a smaller product, more compact, more advanced nodes, it provides a value to the customer. We're going to capture some of that value. But net-net, we both win. And our margin goes to 60% to 70% on that product. Is that a price reduction? I would argue no. That's a market competitiveness because the technology enables you to do that. You'll see that, but not a same product, same volume or lower volume and you're having negotiations for a year-on-year decline just for existing.

Great. Well, we're out of time there. So we'll wrap it up, but congratulations on navigating all this. So effective.

Thank you.

Thanks Joe.