ON Semiconductor Corporation (ON) Earnings Call Transcript & Summary

Great. Good afternoon, everyone. Thanks for sticking with us on this absolutely [ gorgeous day ] in New York. Next up is ON Semi, by the way, I want to point out that I get a lot of questions and people completely freaked out that ON's margins have dipped to the high 30s. I just want to point out that this was the previous peak gross margins for Hassane and Thad got there. So it's been an amazing turnaround. You've seen a concomitant increase in the multiple and basically a tripling of earnings since the dream team showed up. So without further ado, we've got Hassane El-Khoury, CEO, Thad Trent, CFO extraordinaire. So I'm...

We're done.

I'll go home now. Okay. So you guys are basically the latest in a long line of analog companies today, and we've got opinions everywhere. We've got things are good. We've got things are bad. We've got things are getting better. We've got things are getting worse. We've got China is good. China is bad, auto this, auto that. We've got dogs and cats living together. So for the Oracle of Austin, what the heck is going on out there, Hassane what's your take on what's happening in the analog space because we've been pulled all over like saltwater tapping man?

So here's the difference between that -- and what we've been saying or what we've been seeing and what I've been talking about. The 1 thing I've always said, and we've been consistent with is I will say what I can see and I will call what I see, not what I hope to see that has been consistent since the first quarter. It's actually been consistent for the last 3 years, where first off, we started the year when everybody is hyperventilating about second half recovery said I have no reason to believe there's a second half recovery. Therefore, we're going to be managing to what we can see, which is stabilization at best. Then walk into the year, first quarter, we said things are stabilizing Q1 is going to hit bottom and Q2 is going to be the bottom in automotive. And the second half is going to be higher than the first half. We are here today, the last earnings call we had exactly the same -- I say terminology, just so people don't confuse stabilization with the recovery. I have not talked about recovery. I talk about stabilization in the environment today as a positive development from where we were. The second half of the year is still higher than the first half. Automotive is up in Q3 from hitting bottom in Q2. So what I would say versus a lot of the chatter that's out there, we've been more right than wrong and we've been the most consistent of all of our peers because our focus is on delivering what we can control and manage to and that we've done very well, whether it's on the margin and more importantly, in a downturn like this on the free cash flow. Cash is king when there's a lot of that uncertainty, and we're using cash to buy back shares returning value to shareholders through buyback, while we execute to what we can control.

Got it. So not getting ahead of your skis. We like that. Just in terms of the, I guess, stability, recovery, whatever you want to call it, I mean this is essentially, like you said, started a few months ago into the second half. What do you think has been the catalyst for that? Is it inventory replenishment? Is it demand is getting better, something else going on out there? What are you seeing as for...

So I think from a -- anyway, if you think about phases of the path to a recovery, whenever that recovery happens. There are multiple path -- first, coming off of the inventory, like you said, there's the inventory drain, when you get the inventory drain, then you start shipping to natural demand from under shipping to shipping to natural demand, then you're going to have a replenishment cycle, which -- you have to be careful there not to be a false positive of oh my God, the recovery is happening now that there's going to be replenishment cycle. And then you have the demand recovery. I think where we are today with the uncertainty related to the geopolitical environment and the whole tariff, no tariff kind of development, the replenishment cycle is not yet -- we're not in a replenishment cycle. Nobody is replenishing inventory until they see certainty in the end demand. What we are seeing now is a stabilization post inventory depletion. So we're now shipping closer to natural demand. It differs by market. Industrial, I think we're shipping to natural demand now because remember, industrial inventory depletion started much earlier than Auto. Auto, I think by the end of the year, we'll be done with it with the inventory adjustment. Today, there are some accounts that already have achieved it. They're actually too low. You can think about 2 weeks of inventory is too low for an automotive Tier 1. Some are still working on it. By the end of the year, automotive should be back to it. So when I talk about the second half is better than the first half, 1 is shipping closer to a natural demand. And 2, we do have company-specific positives that we've had. Our medical business in the industrial side is -- has been positive Aerospace and Defense has been positive. We expect a small kind of uptick in the renewable energy. That's on the industrial side. The automotive side, we talked about our ramps and our market share gains in China from an EV into automotive, that's driving the growth in China. So outside of just shipping to natural demand, we do have company-specific ramps and share gains that we've been posting that are delivering results in the second half.

Okay. Just to parse through the stability versus recovery because I think that's causing some of the confusion today. So you would define things as stable now? And is that essentially like normal seasonality or close to seasonality? And then would you define recovery as a little above seasonality with some like inventory replenishment driving that? I'm just trying to...

I think at a high level, I would categorize it that way. Stabilization I chuckle on when you say normal seasonality. I don't think anything about anything we're doing is normal these days. So -- and the reason I say this also is normal seasonality for us from 4 years ago, when things were kind of more stable, like the anchor point from 4 years ago, we're a different company with a different mix. So we're not even at our normal seasonality pre-covid, so we have to go through the whole cycle to kind of get back to that seasonality. There is, however, an element of seasonality on the ramps. China automotive ramps after the auto show. Q1 is typically down in general. So right now, we're looking at standard, I would say, standard seasonality. But to characterize it the way you did, that's the stabilization. Recovery would be more replenishment and really end demand going up.

Yes. okay. Great. And just for the nervous nellies out there, we're definitely past the bottom in terms of revenue, correct?

Yes.

Great. From your lips to [indiscernible]. How about -- maybe talk about the linearity of bookings over the last couple of quarters. Do you see your like backlog increasing or staying flat or the bookings getting better, stable or still some fluctuation? How has that trended over the last...

Do you want me to take that. Yes. Look, I think entering this quarter, we entered more booked than we have been in the previous 2 quarters, which is a good sign. So the turns that we need within the quarter are less this quarter than what we've needed in the previous quarters. That's what gives us that kind of comfort that stabilization is better and that the second half is going to outperform the first half. That's really when -- back to your question about have we hit the bottom? I think quarter or half on half. Yes, the second half is going to perform better than the first half.

Great. And so it sounds like maybe visibility, at least in the near term, if there's less turns, there's a little better than it was like 3 to 6.

That's right. That's right.

How about like the backlog going out 6, 9 months? Has that changed? Or is the lead time short enough to where it's...

Lead times are short, and customers are cautious, right? Customers are going to order just in time right now given the short lead times and given the uncertainty in the market and the tariffs, right? So we get a forecast from our customers, but backlog is what we really build to. That -- when we talk about visibility, that's what we talk about is that backlog. That visibility is still not great.

Yes. And so we've been asking the rounds of companies this sort of tariff question, and you brought it up. How big of a factor is like the tariff boogeyman out there on demand or inventory management or maybe both from what you guys can see?

So let me take a difference. So what we know today, and I have to put that disclaimer because things do change. Based on what we know about tariffs today, there's minimal to no impact for us as a company. I think the impact, what we call the secondary impact is what Thad referred to as the hesitation from the customer. Customer kind of frozen. Yes, they're not ordering unless they absolutely need it for a build that is happening immediately. That goes back to the replenishment cycle. Typically, when you get through the inventory, you have the replenishment cycle for customers to put parts and so on, on the shelf, they make units for their end customers and they put it on the shelf. We're not seeing any of that. And that's the uncertainty that's driving the short lead time. Some of my peers talked about, "oh, we were getting short lead time." That's like a positive sign of recovery. I looked at it and I said, yes, we're getting short lead time. It's actually a sign of uncertainty. Typically, it's a sign of recovery, short lead time. But in this case, it's -- customers are placing blast minutes. So that's back to my comment of I believe we're shipping to end demand now because of that behavioral change. I don't think that's going to be persistent, but that's based on the uncertainty.

What would be your sort of best guess or estimate of your inventory in the channel out there? Do you think that because of all this uncertainty, it's just kept at a bare minimum and when folks start to feel better about things, they start to take it up a little bit? Or I mean, is it possible it could go any lower? It sounds like it's pretty low if lead times at bottom.

So first off. I just want to correct 1 thing. You mentioned the channel for us is distribution that we know exactly what's there. It's that 9 to 11. So that I'm not worried about. We have full visibility, and we manage it. I think what you're referring to is can it go lower and go through another depletion kind of cycle at the end customer. I think it's pretty low. That's why we're at the -- I think it's actually lower than what customers should feel comfortable about. When you have 2 weeks of inventory on the shelf, if you're a Tier 1 automotive, you are 1 order away from those 2 weeks, turning into 2 days. If you have an uptick, I'm not saying a huge recovery of V-shape or whatever shape you want. But if you have an increase in a sudden increase in demand, 2 weeks we turn it to 2 days, now you're in the lines now situation. It's that's dangerously low. But look, I don't run their companies. I can just advise them that that's way too low. But when you have the uncertainty, they're going to tell you, well, what are you going to base it on to add more. So that's the replenishment that we're not getting there yet.

Okay. Since we've seen the stability, how have you guys seen pricing trend. Has that gotten any better? Has it gotten any worse? Is it not really changing? What's your take on sort of price?

I don't think pricing is stable. I don't think pricing is changing. I think it's what I would call normalized, meaning we offset any price differences in the normal course of running the business that we do, which is taking cost out of our products, so that's what semiconductor company has been doing for decades. That's the same. And you see that with even our margin profile.

Yes. I remember when we met up earlier this year, you said that pricing was getting more aggressive in certain competitors, we're going to sort of follow the pricing down and you guys were choosing to we're not going to participate in that same stance. Has that price.

That's the same. Yes, same stance. And by the way, that's no different than when we outlined our strategy 4 years ago, we talked about a portion of our non-core business that is exactly that price sensitivity and we said we were going to exit it we really exited only half of it so far or a little bit more than half if you include 2025 exits. And that behavior is what I was referring to earlier in the year that, that behavior is what we're seeing our competitors do. Now their margin profile is way lower than ours.

And going lower. Can I say that?

They're willing to take it and our strategy is very clear. We will keep supporting those customers as long as the margin is favorable. It doesn't have to be accretive to where we are, but it can be dilutive. And based on where the pricing trend for that portion, non-core is, we called it last quarter and we said we're going to exit that business. So we're not expecting it to repeat in 2026. So that's the decision we're just executing to our strategy that we outlined 4 years ago. But -- so outside of that pricing the rest is where we expect it.

Great. And what's your take on pull-ins out there? There's been a lot of companies say, we have some pull-ins, some are saying there's still some left. Some are saying that it's all gone. What's the sort of the on view on that?

We don't have any -- we haven't seen any signs of pull-ins. And of course, the next valid question people always ask me, well, how do you know? Because if I look at where, for example, the upside -- the benefit is China. We talked about China automotive seeing growth. Well, 2 quarters ago, in April, I said I was in the China Shanghai Auto Show, and I said exactly what models, we are designed in. Those models got deployed. I sit and watch how much the NAV registration in China happen on the models we're in and I compare it to what we ship. As long as they're correlating, there's no pull-in. So that's how you modulate your pull-in and your profile is are you shipping to what the customer is manufacturing and the answer is, yes. So we don't have pull-ins. So that I can comfortably say.

Okay. And given all that, how is on managing its own inventory? I think you guys are trying to take it a little bit lower. And what does that mean for your own utilization rates?

Yes. So look, if you look at the inventory on our balance sheet, we have 2 buckets, right? We have what I call our working inventory or base inventory. That's right in our sweet spot. It's 121 days. We've been managing that kind of in that range for a while now. We have a strategic bucket with our fab transitions and silicon carbide ramp, and that's going to bleed out over time. So if I think about our utilization and how that utilization will get impacted or improve over time is it will closely match whatever the market recovery starts to look like. So we don't need to burn through inventory through the channel, the distribution channel first and then inventory on our balance sheet, both are right in our sweet spots. And so whatever that shape of that recovery looks like, our utilization will match that. So -- and then you'll see that hit the P&L roughly 2 quarters later in terms of the improvement in gross margin. But the #1 driver for us in gross margin in the short term is utilization, and we'll match that to our recovery. So we're in a really good spot inventory-wise and from a manufacturing footprint wise to take advantage of that recovery, whatever that shape looks like.

Okay. And will your utilization rates essentially match your like revenue forecast for a growth?

Yes. To our first order, it will match very closely.

Yes. And but the other thing is most not all of our inventory is in die bank, so people ask, okay, but isn't that too dangerous that if there's a recovery, you're going to miss it. And my point is we're a few weeks away from turning into finished goods. So we have the inventory stage in the best spot you could in the most fungible spot to be able to address any demand. So I believe the work we've done throughout this downturn on not just operational efficiencies, but the posture of the company, puts us in a much better spot to -- for an upside in recovery better than we were positioned even 2 years ago.

Yes. You guys have changed some things around consolidated stuff on manufacturing restructuring. Maybe reset the table on that, give us an update. Anything left to do?

Yes. Yes, there's definitely more to do. We announced a restructuring and an impairment of our capacity in Q1. We took 12% of our capacity, our front-end capacity offline in Q1. With what we announced, we've done about 2/3 of what we announced. It just takes time. So there's more coming here. So -- and when we think about where we're going with these exits, it gives us a spot where today, the number of units that we're shipping is much lower than what it has been historically. So if you think about it at a similar revenue level, we need fewer wafers, right? The dollar per wafer is much higher than what it has been historically because we've been moving to this higher-value product over time. And so that will allow us to continue over time to take capacity offline. That will help with the margin as well.

Now will this restructuring benefit your gross margins at a later date even if the revenue stays like flat to slightly up? And then what would be the timing for something like that?

Yes. So again, you got to think through -- you got to burn through inventory that you get manufactured at a higher price, right? But you can think about as we do that, it's, again, about a 2-quarter lag for it really hit the P&L. So even in a flat year, over time, you'll see improvement because utilization will improve.

Sure. So I guess let's just run down the gross margin drivers since we talk about most of them. You've got utilization rates, you've got restructuring. Obviously, there's some mix component. Am I missing anything? And then could you rank the gross margin drivers as well?

Yes. So the utilization, where we're running today, at 68% utilized. There's 900 basis points of underutilization, right, a headwind to utilization, all noncash, right, that's hitting us today. So if you think about with revenue growth, that comes off. You've got a couple of hundred basis points of more fab right, that's taking cost out in the manufacturing footprint. You got the mix, as you talked about. And then the other component is we divested 4 fabs in '22. As we bring that inside, that's roughly another 200 basis points. So you start adding all that up and you're getting up into the 50% range.