ON Semiconductor Corporation (NASDAQ:ON) J.P. Morgan CES Tech/Auto Forum January 5, 2023 12:00 PM ET
Company Participants
Hassane El-Khoury – President and CEO
Thad Trent – CFO
Conference Call Participants
Harlan Sur – JPMorgan
Question-and-Answer Session
Q – Harlan Sur
Happy New Year. I’m going to kick it off with the first few questions, and I’ll turn it over to the audience to see if they have any questions. The team’s strong revenue margin, free cash flow performance has been driven by a strong foundation of technology, product differentiation, focus on core auto and industrial markets, right? Your design win pipeline has been a great indicator of future growth. In 2021, your design win funnel grew 60%, new product revenues grew 28%. How much did the design win funnel grow last year and what are the areas or product categories within your core auto and industrial that saw the largest gains?
Hassane El-Khoury
Yes. Look, obviously, we’re in the quiet period, so I won’t comment on last year’s result. We’ll talk about those when we do our earnings. But overall, we’ve been investing and focusing on automotive and industrial. So a lot of our design win funnel growth has been in those areas, obviously, to follow our investment thesis that we’ve been putting together.
We don’t see that changing moving forward. If you look at our Analyst Day and even our projections that we’ve had since Analyst Day, where we expect auto and industrial to outgrow the market given our focus on it, but also the content gains that we’re doing. Within these, obviously, there are trends within each of these markets that are holding up and driving the design win funnel and subsequently, the growth in these markets. In the automotive, you have electrification and ADAS. In Industrial, what we call the core industrial, factory automation, energy infrastructure, medical, those are what’s driving a lot of that design funnel and also, obviously, subsequently the revenue projections that we’ve had
Harlan Sur
Demand trends began to decelerate for the team Q2 of last year, driven by consumer-focused markets like PC, smartphones, consumer electronics. With automotive and industrial, roughly two thirds of your revenue exposure remaining quite strong, right? The team took proactive measures in Q2, lowering utilizations, maintaining lean inventories with distribution partners. Q3, you saw weakness compute consumer and consumer-focused areas of your industrial business, right, that was sort of the incremental part.
I know you’re not going to you’re in quiet period. You’re not going to talk about the near term. But looking at full year calendar 23, qualitatively, what areas do you anticipate continuing to grow in segments that will be weak?
Hassane El-Khoury
Yes. Look, our view – our long-term view have not – has not changed. We expect growth in automotive. We expect growth in core industrial. A lot of the things that are more tied to PMI or GTP are just like consumer and compute. We expect those to be dependent on the market. And for us, we’ve set ourselves up, starting in the second quarter of last year, to be able to weather through these.
Now, I’ll remind everybody, we have about $400 million to $450 million in those markets that we have been working on pricing or sales out to the market. So that would accelerate with a softer outlook in the market, which is actually good for us because that business is actually still dilutive to margin even in the pricing environment that we’ve been in for the last couple of years. So as we wind that down and exit that business, it will actually help us overall. So net-net, it’s actually a positive thing of how we’re looking at 2023 as a transformative year to set ourselves up for the ’24 and beyond.
Harlan Sur
Last earnings call, you talked about the continued tight supply dynamics in auto and industrial and with a large percentage of the core industrial and auto business covered by long-term supply agreements. In fact, the team noted between long-term supply agreements and NCNR orders, the team’s capacity is sold out in auto and Industrial for 2023.
Again, I’m not asking about the near term, but more on the 2023 profile, is that still the case that demand still outstrips the team’s ability to supply in core auto and industrial for 2023? And maybe sort of more longer term, the LTAs are great in times of strong demand, tight capacity. As we potentially move into a period of weaker demand, give us the advantages of these LTAs. And maybe more longer term, how the LTAs resulted in stronger long-term strategic partnerships with customers where they’re actually sharing their road maps for the next few years, which is quite different relative to, let’s say, three, four, five years ago,
Hassane El-Khoury
Yes. So look, for the first part of the question, when we talk about the outlook and then 2023, we’ve always said we’re pretty much sold out between the LTSAs and the NCNR where we’re sold out. And given our market exposure, you can say it’s auto and industrial are in that same category.
As far as the LTSAs, look, I’ll start by saying LTSAs for us, our long-term supply agreements are legally binding agreement between us and the customer. And what is included in those agreements is both pricing and volume. People ask about — ask a lot of questions about what are we doing on backlog? How does the backlog? We’re not really at this point, we’re not building to backlog. We’re building to LTSAs because that’s where the customer signed.
And when I say by the customer signed, it’s not — not minimizing the title, but it’s not a director of procurement that’s going to sign. In Europe, it’s a member of the board. In North America, it has to be an officer of the company. For ourselves, it’s me, Thad or our Head of Sales that sign. So they are legally binding agreement, it’s their liability for the customer because they’re take or pay.
Now that’s like you said, that’s all great when everybody makes the parts. Now what happens in moving forward? Okay, look, we’re not here to quote unquote, “shove the inventory”. If the customer has a concern on demand where they say, okay, six months from now, it’s not going to be where I thought it was going to be. That allows us a few things.
One is we can manage our manufacturing. So you don’t have WIP that’s going to end up in inventory. If we do, the customer will have to take it because we’re not going to be left holding the bag. It has to be a win-win. If I can move that capacity elsewhere because we’re oversubscribed, that’s even better for us and the customer. It’s a win-win, again. What we’re not going to have a conversation about is pricing, because that’s usually where everything falls apart in a softer environment.
People say, oh, well, I can find it 10% cheaper somewhere else. That’s not negotiate. That’s where we will execute the extent of the agreement. So that’s the call it, the framework of the LTSA and then our view on how we’re approaching it. We haven’t had to do that because we’re not there yet. And we don’t expect to have that — those a lot of these conversations with our auto and industrial because of the other part of your question, which is the supply and demand.
We’re not able to support the demand that our customers want in 2023. So we’re still supplying below demand. So even if demand fluctuate based on concerns and macro and all of that and demand fluctuates a little bit even with downward pressure, they’ll just get closer to a supply that’s still below it.
So we’re not concerned about what the macro demand environment is going to do to our business with the LTSAs. But the LTSAs do provide a very solid visibility on both of those. On the strategic aspect, though, I’ll give you, call it, backward- looking data that gives you a projection of the front. A few quarters ago, we talked about increasing our LTSAs. Last quarter, Thad talked about, we incrementally added $5 billion to now total $14 billion of LTSA. This is overall in the company. That dynamic is new customer but also existing customers that had an LTSA on maybe three or four parts that were highly constrained in 2021, we signed an LTSA. In ’22, customers came back and said, that’s great. It actually fit what we want. We didn’t have to — we were sleeping good at night for On Semi parts that are on the LTSA. I have 200 parts that I’d worry about. I want to put all of them in.
Some of those LTSAs are eight years in length. So the next question is, well, how does the customer know what part? Well, they know what technology, and we will create the part together. That’s the strategic importance of these where the customer knows, especially when they co-invest with us on a specific technology, and we say, okay, this analogue node, the customer is going to co- invest for capacity. It’s to their benefit to create a road map on that technology with us. So it makes us, one, sticky and way more visibility long term of what our demand and where the market is going.
So net-net, it went from supply assurance to a very strategic document that both us and the customer are engaging with. Why? Because we delivered in the last two years to the essence of the LTSAs where we didn’t take the customer lines now when they haven’t LTSA. So they saw the value, they saw the value for us as a supplier, but they also saw the value of the breadth of technology that we are providing for their core in the automotive, for example, for their core vehicles, and that matters to the customer.
Thad Trent
Yes. And just let me add. Hassane talked about the duration of these. I think the perception sometimes is the short-term duration. These are not just for ’23. Normally, they’re three to four years plus. We’re not doing something short term to solve the short term. And that’s what makes it very strategic. And if we look at the softness that we saw in consumer and compute, the LTSA — LTSAs held up in that process as well. So that’s kind of our proof point that says we can enforce these with win-win situations with our customers.
Harlan Sur
And does the LTSAs and periods of weakness actually motivate your customers to give you more heads up? Not — three, four years ago, you guys would get 30 days notice, right? Yes, I’m not going to need these products. I’m cancelling my orders. And so does the LTA program actually motivate your customers to say, look, we’re looking at the macro environment six months out, like things are looking squishy. Let’s let the ON team know about this.
Hassane El-Khoury
Yes. That’s exactly no, I joke with my team, like if the LTSA do one thing, it’s somebody is going to pick up the bat phone and call me. I remember, in end of 2018 when kind of the backlog like got a 30% haircut, right, if you recall, I didn’t even get a phone call. I just woke up in the morning. I thought it was a computer glitch where a backlog kind of somebody didn’t add it up.
Well, I don’t want that. We were not going to be left holding the bag because, look, we made a lot of investments in order to support that outlook from our customers and therefore, it’s a win-win. And the way they see it, they have to take the part, so it’s a take or pay. But if they let us know six, nine months in advance that, hey, we — this new model is not working out. Look, that’s fine. The conversation is great. We’ll take share on another model that works as long as we utilize the capacity. And the fact that customers, some customers have co-invested with us, they’re more likely to give a share because of their investment from others in a call it, in an environment where they don’t have the full volume materialize. So all of those are win-win for us.
Thad Trent
And what we won’t contemplate is the pricing discussion? That part of the pricing in there. So we won’t have that discussion of I can get it cheaper down the road, right? It the pricings locked. What we can do is create that win-win if we can move that capacity to another customer. Sure, we’ll help that customer but it’s not a pricing discussion and that’s why, on our last call, I was very comfortable saying the ’23 pricing environment is extremely stable to us. But it’s because we have that locked up on LTSA.
Harlan Sur
Before I move on to some of the product and technology, does anybody have any questions? So let’s move to your automotive segment. Back at Analyst Day, the team highlighted 17% full year revenue CAGR, right? That’s your target CAGR of 21% to 25%. Given the strong 2022 performance, you guys are going to be up like 40% year- over year in auto, still implies low double-digit CAGR to meet that 17% target.
Electrification is a big driver. EV production is set to grow 30% CAGR over the next three years. And then on top of that your dollar content in EV can be as high incremental, as much as $700 per car. And then on top of that, ADAS is driving strong content growth for your image sensor and LIDAR products. It seems to us that the 17% growth target is going to prove to be somewhat conservative. Has the design win funnel in auto outperformed your expectations versus two years ago when you set the targets?
Hassane El-Khoury
Look, I think — I think overall, the market has accelerated since we set the targets. Look, our investments match, the outlook the new outlook that we have in the market, what I will tell you is we still expect to outgrow the general automotive market because we are exposed to the mega trends that are driving a lot of that growth, net of the things in auto that in the ICE engine and so on that we don’t play a lot in So we’re very comfortable in our outlook. We’re very comfortable about maintaining our momentum, fuelled by a lot of the design wins, number one, and really the LTSAs that we’ve been talking about.
Harlan Sur
Your silicon carbide power technology and portfolio has been a big driver of the design win pipeline and future revenue growth in your core markets. As with any new emerging technology, there can be a lot of noise out there, right? Noise around yields, reliability, scrappage, parametrics, and I can go on and on, right? But to me, the best way to ask the question that encompasses manufacturability, design, cost, share traction is, is the team tracking doing what they said they were going to do, right? Did the team grow its silicon carbide revenues by 3x in 2022? Is the team still on track to drive $1 billion of silicon carbide revenues this year and exiting this year with silicon carbide gross margins at sort of that corporate average gross margin level?
Hassane El-Khoury
Yes. So I’ll focus on the outlook more importantly. So is the team from I know the fud out there in the yield and I don’t react to it, nor do I spend time on that, because what I measure our team on, including from GTAT to wafer processing, EPI all the way because we are vertically integrated And we have metrics and deliverables in our annual plan last year and moving forward through every step of the way.
So is the team delivering? The answer is yes. Because you never hear me in any form, talk about we plan for perfection and therefore, we’re not on track. This stuff is hard. We have ramped many factories before. Forget about slicon carbide. When you ramp at scale, especially at the scale we are ramping and how fast we’re ramping, there are ramp challenges. So we plan on those, and we have a team of experts that have that are currently running 20 factories for ON Semi worldwide.
So they know how to ramp. They know how to tackle problems. They know how to tackle all these. So that makes me very comfortable because- and I give you one day. We’ve had issues during the ramp. Let’s be realistic and we’ve tackled every single one of them before it becomes systemic. That is the difference between scale manufacturing and a startup. So we’re not in that mode yet.
So a lot of the conversations and so on, I know where it stems from. I’m not worried about it because we are a professional scale manufacturing company also, along with the technology innovator. So both of those puts us in a good position. So moving forward, we’re still on track to deliver to our plans that we’ve talked about, the ’23 plants. We talked about the start-up costs for silicon carbide being 100 basis points to 200 basis points, as we grow out of those tours exiting ’23.
If I take — if I remove that stuff, I will tell you the silicon carbide margin is at or above our corporate margin. So as we grow into that capacity that we had to build ahead of time, you can expect that to be an actual tailwind. So all of these together are going to be helping our margin, but we’re — I would say we are on track to the plans we’ve set for ourselves, whether it’s the plan from the acquisition of GTAT or the plans for the expansion of our Buchon fab, all these plans are being executed to our own plan.
Harlan Sur
One of the things I feel like the market underappreciates is that the team has been in the power semiconductor market for over 30 years, right? And the market does tend to focus on silicon carbide. But ON Semi is a leader in IGBT, ON Semi is a leader in MOSFETs, right? And these two power technologies have been growing. I think, even recently, right, 30% year-over-year. And so these are driving very, very strong growth dynamics. So how much of the competitive advantage that you have on silicon carbide; process, manufacturing module development, understanding your customers’ requirements, how much of this is attributed to your strong position in IGBT and MOSFET?
Hassane El-Khoury
I would say 100%. If you think about a lot of the conversations we’ve had and I’ve had externally, where I talked about one of our differentiation in module development. We have multiple decades of power semiconductor module development, design and manufacturing. That becomes even more important in silicon carbide, wide band gap. We’ve got a lot more power smaller area than silicon if you’re not able to get that heat out in a very innovative package, you’re not going to get the benefit that silicon carbide bring. You’re just going to be paying a premium for the same performance if you think about it.
So being able to do that, now people can say, well, yes, we can get the heat out, yes if you put a big hunk of metal, which adds weight and cost at the system level. So yes, you solved it. At a component level, you just buried the cost at a system level Our approach and our innovative approach for module development, we’re able to do the best silicon carbide device in the best package designed for that device, lower material costs, lower manufacturing costs, better bond, all of these things that actually added up together is a much better efficiency at the system level that translates into either longer range or lower battery volume.
Those are dollar numbers when it comes to the customer So that carried over — that experience that carried over from silicon into silicon carbide is 100% applicable. And when people talk about how — where did ON Semi come from where we were three, four years ago to now; $4 billion of LTSA is proving with our customers that we have the technology and the knowhow to deliver what they need for them to be successful. That’s the win.
Now from a manufacturing perspective, back to why I’m not worried about the ramp as much as a lot of the headlines on the fab out there is we’re moving our IGBT. We have a fab in Korea in South Korea, it’s a large scale power fab, six and eight inch that is doing IGBTs for a very long time. It just pumps, IGBTs, great yield, clean fab, excellent operational performance.
What we’ve done is we moved the IGBTs to East Fishkill. So we moved it to 12-inch. And we’re moving silicon carbide in an existing high-scale power fab. So I don’t have the fab ramp challenges. We’re increasing capacity, of course, but the fab runs power already. Whether it’s silicon or silicon carbide, it’s a power fab. So all of these put together put us in a very competitive position, one to tackle the market with our technology and two, to scale to support those customers
Harlan Sur
One of the other benefits of the 1GBT and MOSFET leadership, right and if I look at that $4 billion pipeline in silicon carbide power products, these engagements, are creating I feel, additional dollar content attach opportunities for your MOSFET and IGBT portfolio, right, gate driver modules, DC to DC converters, IGBT inverter attach for front-wheel drive, just a few examples, right? You probably track this, but what’s ON Semi’s additional power, power management content attached to that $4 billion of silicon carbide revenue indiscernible?
Hassane El-Khoury
Well if you think about it, obviously, it’s not a one-to-one, but you can think about, you got the $4 billion that we’ve talked about, and that’s the three-year LTSA window for silicon carbide but a $15 billion or $14 billion overall. So you can think about a lot of these are with the same customers where the example I gave before, where you may have two or three parts and now the customer says, we’ve had a year now of seeing what is our supply chain for ON Semi, we want to add all of them. So that cross-selling is what we’re looking at.
Now as we look at road maps with customers, and we look at it from the system level design of what is the customer trying to accomplish, because back to having that breadth of technology, especially silicon carbide and IGBT, look at the customer and says, here’s the problem we’re trying to solve. If we’re able to solve it with silicon power we’re going to offer silicon power, I don’t have to kind of corner into I only have silicon carbide. You have to have it.
We’re going to give the best solution for that customer and that matters from a competitive standpoint of being able to provide that the flexibility for both and that goes back to the comment you made where sometimes, it’s a split axel. Front axles IGBT, we were actually set. What we’re able to provide too, they don’t have to go to another supplier. That is important for the customer.
So all of these and the breadth of portfolio is a competitive advantage that we see because the customer can develop a system-level approach with one supplier where trade-offs are being made on the board with one logo, if you think about it. And that gives us the ability forward looking to see, okay, if we had to make these trade-offs, how can we design the next generation to not have these trade-offs? So you already design yourself into the next one because now you’re codeveloping with the customer.
Harlan Sur
Got it on silicon carbide substrate side, what’s the mix of in-sourced versus outsourced supply of substrates today? And where will you be exiting this year and trajectory over the next three years as you sort of grow into the $4 billion revenue pipeline?
Hassane El-Khoury
Yes. Look, obviously, today well, it’s known majority is external. As we ramp our GTAT, we’ve said we will be majority internal exiting ’23. And that will continue to increase as we move forward. Our intent is to be supporting our customer ramps with internal substrate because that’s the one we can depend on.
When we talk about supply assurance, that’s the one we can really commit to our customers. And obviously, we’re going to have a little bit on externally. It’s not going to be 100%, because you need to have the possibility to be able to spring up for certain, like a quarter of a big ramp, we want to be able to spring up. We can either do it by building ahead or by sourcing from the outside. So we’ll do that. And that’s why we have a good pulse on what we call the merchant market, what’s out there. But our goal and our strategy, which has proven the right one already, is to have it internal.
Harlan Sur
Let’s move over to industrial. It’s a large part of your business, obviously, very diversified. Some of the subsegments are there’s multiyear demand drivers, right, like energy, infrastructure, automation. Energy infrastructure, for example, I think last you guys reported was like driving 60% year-over-year growth. Provide us some color on the exposure to the different subsegments within industrial? And which of those subsegments are more resilient, let’s say, in a weaker macro environment? And at a high level, the seams confidence on growing the business this year, should things get weaker from a macro perspective?
Hassane El-Khoury
Yes. Look, in general, you highlighted the trends that are driving the industrial, what we call the core industrial energy infrastructure. That’s a multiyear — multi almost a decade long because it’s going to be lockstep with the electrification. As you get more electric vehicles, you’re going to have a bigger infrastructure that have more energy. What does that mean? The renewable energy from solar wind, but more importantly, is the energy storage with the unfortunate events in — with the conflict in Europe, that accelerated a lot of the energy storage adoption in Europe, but also in North America, given a lot of the climate disruptions that we’ve had with the grid.
So all of these have driven a lot stronger demand on the energy — renewable energy market for us. That is both silicon carbide but also a very big market for IGBTs today. So those are areas that we don’t see that slowing down because it’s part of a larger mega trend.
When let’s say, you have concems about macro in ’23, nobody is going to be like, let’s not put chargers and let’s not do this until ’24. Those are not dependent on that because they’re long-term investments. And the longer you wait, the worse it gets. So those, we don’t see anything. And we’ve talked about how the top 10 energy renewable energy, including storage, have 80% market share: We have LTSAs with eight of the top 10. So that gives you where our growth and how broad our growth is when it comes to that tackling the market.
Factory automation growth is driven by a different. It’s driven by coming out of a two-year of shortage in labor, social distancing, pandemic, where you had to either shut down factories or run with a skeleton crew for social distancing. Well, the way you solve that is automation. That’s driving cameras and analog power for factory automation. That bet will remain because we don’t see maybe the social distancing is getting less but the labor shortage is not. You see what I mean? So those investments remain.
And the last one I would highlight that we’re focusing on is, of course, the medical, where macro or not, you can’t push out medical procedures or medical needs. Those will get always prioritized independent of the macro. So I would say those are the ones that where our growth is coming into, and that’s where our investments are going. So the outlook is positive because of these megatrends underlying industrial.
Harlan Sur
And my last question, because we’re running out of time here, is on the gross margin front. You did mention that there are some potential tailwinds to the gross margins. Obviously, there’s offsets in a weaker macro environment underutilization. You’ve talked about some of the impacts East Fishkill and the start-up of the GTAT and the manufacturing and silicon. But as you mentioned, the team has exited $277 million of noncore revenues and an average gross margin of 25%. You’re planning to exit another $65 million, $70 million in the December quarter. And then as you mentioned, Hassane, $400 million, $450 million remaining in calendar ’23, which I believe has a gross margin profile in the low 40% range. So given the market softness into the first half of this year, should we think that the impact of that roll off of that $400 million, $450 million being more biased in the first half, just given that noncore products are more commodity-like and probably more sensitive to the macro trends? And so or would you expect that roll off to be sort of more linear as we move through the year?
Hassane El-Khoury
So what we’re seeing right now, we’ve always said this is margin dependent, and we actually thought we’d lose this business faster than we have, right? We think we’re going to be out of that business by the end of ’23, given the market dynamics. What we’re seeing right now is it’s fairly linear, but probably more back-end loaded to the second half, if you think about it, kind of what the visibility we have on it today. If the macro gets softer and we lose it faster, that’s good for us because we can reallocate that capacity to something of higher value.
So it’s really market-driven. There’s not a whole lot we can do We’ve already priced ourselves in a position where we think we’ll exit it, and that was all by design.
Harlan Sur
Perfect. Well, we’re looking forward to…
Thad Trent
We’re expecting just one thing on the margin. When you talk about the tailwind, when you look at longer term, just your reminder, we exited four fabs in 2022, and we talked about $160 million of COGS favorability as we fully exit the fabs. We handed the keys to another partner. But as we move these products out of those fabs into our remaining fab network, we’re going to be getting that $160 million. That’s all tailwind above and beyond of where we are today. Of course, that takes time to fully exit fabs, think about two to three years. But that’s still a taiwind that’s yet ahead of incremental to the margin that we’re able to achieve in the shorter term from that window.
Harlan Sur
Absolutely. Absolutely. Looking forward to monitoring the progress and execution the team this year. Hassane, thank you very much for joining us today. We really appreciate it.
Hassane El-Khoury
Thank you.
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