ON Semiconductor Corporation ($ON)

Good afternoon. Welcome back to this afternoon session at the BofA Global Tech Conference. Really happy to be here with the team from ON Semiconductor. We have Hassane El-Khoury, CEO; and Thad Trent, the Chief Financial Officer. And as usual, I'll go through my questions, but please feel free to raise your hand if you would like to bring something up. Thank you so much, Hassane and Thad, for being at our conference. Really appreciate your time.

Maybe, Hassane, if we could start at the top, I think when you reported the last quarter, you kind of described Q1 as an inflection right point. If you could give us a little more color on what led you to kind of describe the quarter that way. And then more importantly, where are we in this kind of cyclical recovery cycle for ON across your biggest end markets?

Sure. So at a high level, a lot of people, even going through last year is, they kept pressuring of, well, when are you going to call the bottom, or is it the bottom or when is the recovery and so on. And I've always said, I'll call it when we see it. So when we saw, it was in the first quarter, and both Thad and I talked about the signals that we're looking at, and it's not just one signal. You can think about it as a whole slew because they're all interlocked. So from an operational perspective, we started looking at, okay, how backlog is layering in, how far out in time is backlog layering in, meaning the visibility we are getting into a demand signal that is out in time. When maybe 180 days ago or 2 or 3 quarters ago, we were talking about visibility being a quarter. So as you start getting the visibility, then lead times will start extending which is, again, a sign that there's more and more demand layering in on top of that. And then we look at, for example, on the industrial side, PMI has been hovering in 49 to 50 PMI start clicking above 50. So these are all signs, not just operational of our business, which are the KPIs I talk about, but from a PMI perspective, it's more of an industry or a market inflection. So all of these put together, you start seeing a benefit. Now within the end markets, it's also, however, it's a slightly different story depending on the end market. In automotive, overall, we talked about very strong China business because we are the leaders in electric vehicle with our power products over there. So that was very clear. With the energy challenges in the Middle East, we -- you can see the headline of all the export market is very strong. We're with all the exporters. So we are winning with the winners. So that was very clear of why the business is doing well. Industrial, again, we have the AI halo effect, a lot of our energy storage system, a lot of the microgrid that infrastructure that is supporting the data center doing well. And of course, the AI data center business itself is doing well. And from a general market, automotive, we've been undershipping demand. So automotive just going from undershipping to shipping to demand looks like up, but it's not a recovery yet. So outside of automotive, I would say it's overall, and that's a healthy environment to be in.

Got it.

So looking forward, you have the replenishment. You still have the tailwinds that are yet to come. But where we are today, that's where the bottom is there, but we're not off to the races as yet, which is fine because there's still headroom.

Got it. And how is the bookings momentum, right, to the best extent that you can describe it? And I asked that question in the context of the last 2 or 3 years, where -- and the analog industry has usually had a very strong first half and for all kinds of geopolitical other tariff or other reasons. In hindsight, there was a level of pull-in. And then second half, right, there was kind of muted growth. But I think this time around, you actually described the second half to actually outgrow, right, the first half. So what is different about this year versus what we saw in the last year?

So. So you mentioned the difference from the analog names. I just want to make sure, last year, we said the second half is going to be better than the first half. So we have always called and managed our business to the extent we see the signals rather than the signals we would love to see. So that has been very consistent. And we're under that same umbrella or guiding principle this year as well. So now what we see and why we again call the second half better than the first half is the program ramps that we have started in the first quarter are going to continue throughout the year. To give you an example, our AI data center business did 2x better than what we expected walking into the quarter. So there's strength there that will continue. That has nothing to do with potential pull-ins or not because there's none of that. So these are healthy demand signals that we can correlate to the end units being built. I mentioned about the EV I see the end units being built. So those are all tangible signals that we see that will continue to grow. Designs that are ramping now, when they start ramping in a quarter, you're going to get full quarters moving forward. So those are ramps that tangibly, we are ramping, whether they ramp in March, and they will -- now you have full quarters or they're ramping in the second quarter, we'll get a full second half. Those are tangible signals of design wins we've done, design wins we started ramping. And on top of that, we have the recovery that we talked about where we believe the renewable energy side of it, the microgrid and the ESS will resume growth in the second half. And that, again, is based on the outlook that we have in the backlog. So you layer all of these on top of each other, you would get a better half mathematically, a better half second half than the first half based on what we already saw of a ramp in the first quarter.

Yes. And if you take all of that and you put some data to it, if we look out to Q3 and Q4 today, we're better booked out in those quarters than we were last year or the previous year. So while we keep looking to make sure we're not going to see a head fake. Everything Hassane described, customers are actually layering in the backlog further out than they have in the past. That gives us that confidence the market's recovered. The auto hasn't gone through replenish, but things are improving compared to where they have been in the last couple of years.

That's right. Got it. Because you have a better mix of secular and the cyclical auto recovery, is that a reasonable way to look?

Well, I wouldn't say we have seen the cyclical recovery. So the talk -- we talked about is, we have ship to end demand now from an under-shipping to burn inventory to end demand. We haven't seen the automotive recovery. What we're seeing in auto is 2 things. One is the click up to natural demand and the content. Every EV that we ramp is more content than a non-EV. So the content for us has outgrown SAAR by high single digit consistently. And we talked about Treo on the call. We talked about 10BASE-T1S Ethernet, which is the new backbone of automotive connectivity within the vehicle. All those are content we didn't have two years ago. So although we've delivered the content growth on top of SAAR over the last 5 years, looking forward, our new products and the investments we've made in the downturn are generating more content for us in automotive moving forward that we haven't seen yet. So that's the secular and cyclical that were combined are where we outgrow the market.

Got it. Now we'll talk about autos, and then get to the data center. I think whenever people hear about ON Semiconductor's automotive business, right? Investors are immediately reminded of silicon carbide that had a very strong cycle, and then in hindsight, right, there was overinvestment right in this space. And just this morning, I saw some headlines that there's a number of substrate suppliers in China that are struggling right with some excess capacity. Hassane help us understand what silicon carbide means to ON, which parts of that supply chain are commoditized, and there's potential for versus what is your kind of more durable and differentiable moat in the industry?

Sure. So we started the silicon carbide journey, I would say, 5 years ago. And we've been very consistent about one thing is nobody is going to win because the word substrate. Nobody talks about silicon substrates. They all talk about what product do you put on the silicon. Why? Because everybody's got the same silicon. There's one way to do silicon. Silicon carbide is the same thing. Yes, you can get wafers in China, that's not new. And I'm glad that there is enough supply, so we get a favorable pricing environment for it. That's all fine. Now we don't sell wafers in the market. We also make our own wafers internally for a supply assurance. So it's not to differentiate based on the technology of the substrate, it is to differentiate on the supply assurance for our customers and supply resilience. So we have a hybrid model. But where China competes and people talk about, oh, there's so much capacity in China is the substrate, the lowest common denominator of silicon carbide, where there is 0 differentiation. What you put on it is the device. We have consistently had the best devices generation after generation in silicon carbide. That's what we win due to, and where are we? In North America, we are the largest share gainer in North America. That's a fact. China, I report on the China auto show every year. We're about 50% last year market share. We're over 50%, this year. With the exporters, we're much higher percent. We made the announcement with Geely. We made the announcement with NEO. We have engagements. Of course, we've made other announcements prior to that with every single of the top OEM. And these are all the OEMs that are winning the export with the whole -- you go to Southeast Asia, all China EV, Australia, all China EV, the Arab Peninsula, all Chinese EVs. Europe, Chinese EVs. So we're winning with the winners that are exporting. Why are we winning? That's the differentiation of the device. So you mentioned China, you can get substrate, yes. So why are we winning in China because they can't make the devices that we make. That's the differentiation. That's why it's sustainable. We're 2 to 3 generations ahead. People say, "Well, can they figure it out? Yes, if we stand still, but we're not. And that's where we put our R&D to work to create the next generation to win. And one thing on the silicon carbide specifically, silicon carbide is no longer an automotive story, right? AI data center is moving to 800 volts. Everything I said about our success in automotive is all 800 volts. So the AI data center just came into our competitive domain. So we're winning in automotive because of technology at 800 volt. That is exactly the same reason we are winning the transition to 800 volts because our products are the superior products. That's the beauty of having that breadth of portfolio of power conversion.

Got it. Since you stole my question on the data center, I'll ask it a little later. But let's -- just on the topic of autos, outside of silicon carbide and the powertrain, what else is on really good at where you see content growth kind of coming back? Because I think everyone is nervous about automotive units because of all kinds of geopolitical, inflationary and other pressures. And at the same time, there seems to be kind of a shortage of supply that can hit some of the trailing edge, and there's a lot of talk of pricing. So let's just first talk about outside of silicon carbide. What are the other areas in automotive where you're seeing the recovery? And then I had a question on pricing.

So overall, we see -- again, outside of the China EV, the strength on the export and so on, there's EV in North America where we see strength due to share gain, not necessarily, of course, any volume strength there is a tailwind for us, but we've been increasing that share. So that's favorable. But that's on the power. 53% of our revenue is automotive. So the rest of it is content. Let me give you a few examples of where the world is going. You've all heard about automotive going to a zonal architecture. So zonal architecture, what that creates is an opportunity for companies, and we're one of those leading companies to create a differentiation in how do you get to the zone. Think about boxes distributed in the car. Instead of having a box for the headlight and a box for the -- you have a left front box, the zone. We do the communication to that zone, and we do the power distribution to that zone. The only thing that goes to that zone is power and communication, and we do both. When we talked about in the last call that we're ramping 10 based E1s, that's the Ethernet communication in automotive in the second half of this year, that's content we didn't have last year. That's new content. We're #1 in ultrasonic sensing or in automotive and you fast forward in robotics, ultrasonic sensing is obstacle detection. We're #1 in the world today. We're #1 in the world in inductive position sensing. Why is that important, brake by wire, accelerated by wire, steer by wire and what has a ton of positions, humanoids and robots. So that even transitions to that. So these are content we didn't have a few years ago. We're #1 in these markets. That's what's going to drive the content growth in a flat SAAR.

Got it. One last thing, just on auto and silicon carbide was. I think there was a time when the industry was very tight and was able to ship at very, very high ASPs. And I think the industry then went through kind of a period of readjustment right, towards more device-type sales rather than module inverter-type sales. Are we kind of past that transition? So now what we see is actually truly representative of industry growth?

Yes. So you're right. We -- and I've talked about this. So it wasn't a surprise for us that we had to go through this transition or rebalancing. That's primarily behind us. Now if I look at the underlying data, which I normalize to devices, like you said, we have continuously shipped more devices per year than the year before. So when I talk about share gain, that's going to sustain growth in the long term, although it wasn't visible in the top line because of the mix of ASPs from a unit number of devices shipped, which is really the determinism for market share, that's been increasing every year. So when I say we've been a share gainer, the data on a device is showing the share gain continuously moving forward. What I also want to say, however, it's not a one-size-fits-all. It's not like the market is moving to devices. It went from a 100% modules to a rebalancing of module devices, but also, we announced a program, the VW SSP program last year, that actually went the other way. Instead of shipping three modules for an inverter, we'll be shipping three modules in the power box. So a vertical integration the other way. So that's what I mean by rebalancing. It's not like, oh my God, everything is going to device. We're still differentiate on device. It's not a margin hit for us because we extract the same value on the device than it is on the module, but it's an ASP delta, but we have some customers that are going the other way also because they value the packaging and the cooling technologies we provide. So we're able to differentiate at a system level.

Got it. Now let's talk about the data center. I think well expected that as the power consumption of these accelerators goes up, right, that the move towards wideband gap becomes very, very important. Right now, I think you've described AI as kind of in the mid-single digit or so of sales. It grew very nicely, right, year-on-year. How do you see the path forward, Hassane? And have -- do you already have specific design wins? Or do you have the capability and now you have to go and win specific designs to have that multiyear visibility of growth?

So both. So the -- obviously, the growth, and we talked about we're doubling the revenue in AI data center this year. And just for a clarification. What we define as the AI data center is within the walls of the data center because we do have a large opportunity also outside the data center with the microgrid and the energy storage. But for this conversation, we're talking about within the walls. So we talked about doubling. That's devices and wins we already have that started to ramp and will continue to ramp this year. But we also have the capability to sustain the design and momentum and so on moving forward. You heard me talk about JFT, that is as you start getting to more and more power, that's where that starts to play a role. You heard me talk about vertical GaN. As we get more into 800 volts and more density, power density vertical GaN is the solution of choice and so on. So those are all capabilities we've developed, capabilities we've had, and that will continue to proliferate and the opportunity for us moving forward on top of what we have today is the content when we start looking at 800-volt racks is an outsized dollar content than today for the high voltage it.

Got it.

And that, to me, from a dollar content, so to put it in perspective, we talk about today, we talk about the ON Semi opportunity in a rack about $15,000, 1-5-0-0-0 dollars. About 30% of it is high voltage, 70% is low voltage. Think about SPS and so on, just for easy math, 5,000 of high voltage. 800-volt rack, think about 600 to 1 megawatt. There's a $115,000 of content for ON Semi. Half of it is going to be high voltage, right? So half of it, 55,000. So now you're going 5,000 to 55,000. That jump is an opportunity forward-looking of capabilities we have today back to my comment on 800 volts, we have it. So it's not like we have to go make it and so on. We have to -- we're designing it in. We're deploying it, and we're working with customers, and that delta is what we're capturing on top of what we have today, just on the high voltage. That's the opportunity ahead.

Got it. How do you get visibility and confidence about the certain market share, right? Because from the outside, we look at many analog vendors who have this capability, right? We have our products that all sound similar. And there's only a handful of 2 or 3 vendors who can really lead this transition. So how do you kind of get the comfort, Hassane that you will have your fair share?

I can give you one vendor. I don't know who the other two are that you're referring to. You want 2 or 3, I can give you one. Look, without getting into a lot of segments. So when you're talking about power conversion, you are solving a multiphysics problem. Anybody who's in the power domain knows electrical is one, thermal is one, magnetic is the other. Three big components. High voltage, high conversion, high conversion gap going from 800 to 6. Actually, the biggest chunk, physical chunk on the board is magnetics. How do you solve magnetics, you increase frequency. How do you increase frequency? You use GaN. How do we compete because you'll say, well, others have GaN? Nobody in the world has GaN that can do 800-volt in a single chip. You need vertical GaN 1,200 volt. We are the only company that does that. So you may be able to solve the frequency problem, but you're solving it with 2x the size that ON Semi does. And if anybody knows AI data center, the real estate on a data center rack is more expensive than real estate in San Francisco. So if you save on power density and you make it smaller, 2x, you win, not because on the product itself, on what the product does to the physical density. So when I say we differentiate, I'm not talking about we differentiate, oh, who's got better resistance and who's got a better system footprint at a performance that is superior than everybody else. That's how you win the conversion. Because if somebody says, yes, I can give you the conversion on a box this big. And I say, I'll give you the same conversion this big. Who do you think is going to win? Who do you think the customer will pay more for, which is back to the margin. There's value, not in the conversion only and how effective the physical real estate you use for that same conversion. So when I talk about differentiation and I talk about us winning because of technology and capabilities we have, I'm not talking about electrical capabilities only because that's now the easy thing.

Where do you see data center as a percentage of mix in the next 2, 3, 4 years? Do you think you get to like double digit sooner rather -- like do you have that kind of conceptual visibility or?

Yes, you got to come to our Analyst Day later this year.

It's going to grow as a percentage of the pie. But the other 2 are going to grow as well. Now it's going to grow at a faster rate, but it's not like the other 2 segments, industrial and auto, are going to stay flat, right? So it will become a larger piece of the pie, but it's assuming the others are growing as well.

My favorite question to ask any CFO is how are you feeling about gross margins, right? So Thad, how are you feeling about that?

I feel great. I felt great about gross margins. Look, there is a ton of operating leverage in our model. Through the downturn, we didn't sit still, right? We continue to execute on our fab right initiatives. We invested through the downturn in terms of OpEx, right? So if you look at our OpEx today, we've got to grow back into that OpEx. On the gross margin side, we've done a lot of work. We've created these differentiated products through those investments. The big capital investments are behind us, right? We've invested in silicon carbide. We invested in our 300-millimeter fab. So on the gross margin side, today, it's primarily that the headwind is underutilization, right? So we're at 77% utilized. As the market continues to rebound in revenue growth, that's all a noncash charge that goes right to the gross margin line and falls all the way through to the operating margin line. If you think about some of the other self-help things that we've done, we have more fab right initiatives that we're doing, right? So it's about another 200 basis points. I think over time, there's going to be another 200 basis points of mix shift that's going to be positive, everything that Hassane talked about, these differentiated products. And then we divested 4 fabs a few years ago. Once we start manufacturing that inside of our footprint, you get another 200 basis points. So it's why on the last call, I talked about I expect margin growth, gross margin expansion through the remainder of this year, for sure. But over a multiyear period, I feel really good about it. I mean there's just a ton of leverage. And a lot of this is because it's what we've done to set the company up for this rebound, right? I mean if you look at our free cash flow margin today, 24% in a downturn, right, that's what it was last year. So that shows the structural changes inside the company, that the dollar per wafer that we get is much larger, much higher than what it has been historically. So now it's just a market expansion and then us doing more self-help. So really good about it.

And at a high level, I think about like if I you think about the trajectory and what enabled it is a fundamental change in the company, where ON Semi historically or ON Semiconductor historically has been a manufacturing company. ON Semi today is a product company that happens to manufacture differentiated product inside and outside. But in the -- and that fundamental shift in mindset of manufacturing to product is what had allowed us to get through the downturn with the free cash flow margin that Thad is talking about. Historically, the company would be filling fabs, which burns cash and the grades margin and destroys value because once you crash your pricing to fill the fab, it doesn't always happen that you can raise pricing. So that fundamental belief got us through the downturn, investing in the differentiated product and setting ourselves up for a much better recovery than the company has ever done. And that's the exciting part.

The other thing is -- from a pricing standpoint, right, we've had a lot of our input costs go up. We're raising pricing to offset that, right? So we raised pricing effective April 1. That will start to really have an impact on the P&L in the second half, where the input cost is kind of already hitting us on the P&L, right? So that's why I feel really good about even when I rattled off there, you got a pricing tailwind of what's going on in the market as well.

Got it. You stole my next question also. When your gross margins were in the high 40s, it was easier to visualize getting to your kind of low 50s target, when gross margins are now in the high 30s, then it gets a little bit you have to take a little more leap. So are you still comfortable with kind of the gross margin expectation?

The math I just gave you gets to a 5 handle very quickly, right? Now we need a market backdrop to improve, which it's doing, right, which is getting there. I mean just look at last quarter, we took our utilization up from 68% to 77% in 1 quarter, right? Every point of utilization is 25 to 30 basis points of gross margin improvement, 2 quarters later. So that's coming out.

When I look at where kind of consensus expectations, I know you have not given a specific right, top line you've given a long-term model. People are thinking on is a low double-digit kind of sales growth company for the next 2, 3 years. Do you think if you are successful in the data center, Hassane, as you described, that there is potential for upside to that kind of growth rate? Or do you think that is kind of a natural growth rate for ON even when one includes the data center business?

Yes. Look, I don't want to give you a different growth rate because that's the you have to show up to hear at an Analyst Day, but let me give you the business today, the business we are in today. If you take out the if you give credit for the exits we've had which we're done with, but just do annualized last few years on the exits, we have consistently outgrown the market. Even in '26, if you think about, if you put back the exits, the $300 million exits, and then we've outgrown the market in '26 with no recovery in our primary markets. The -- so when you fast forward, assuming a recovery and a healthy growth in this and normalization and the secular growth that we talked about and so on, I feel very good about what we've done over the last few years structurally in the company to set ourselves up to benefit from the upturn, higher than what we had to slug through the downturn because we did the work, and the work hasn't shown up yet. That's the leverage that Thad is talking about. That's forward-looking. Not just -- the market top line is going to do what the top line is going to do. We have the technology. We have the capability. We have the leverage in the model and everything on top is going to fall through. OpEx is not going to grow anywhere close to the top line growth. There's only positive leverage in the model. That's what excites me.

Got it. Final question, use of cash. The stock has had a pretty good move, right, along with the sector. Is buyback still the best kind of use of cash? And is it still -- what you intend to do with that $6 billion buyback?

Yes, we had a $6 billion authorization. We've been buying back shares, right? We've said our stated policy is we'd return 100% of our free cash flow, right? If you go through the priorities on capital allocation, invest in the business, right? We've just talked about we've been huge invest, right? It's that flexibility on the balance sheet, if there's M&A, checkmark on that one. Third is return capital to shareholders. If you go back to Q1, we stretched up. We saw a dislocation in the market, right? Our average share price that we're buying back was just over $60. I think that was a good use of cash.

Good CFO. How about at $130. Is it...

We still like it.

Okay. With that, thank you so much, Hassane.

Thank you.

Really appreciate your time.