ON Semiconductor Corporation (NASDAQ:ON) Credit Suisse 26th Annual Technology Conference Transcript November 29, 2022 1:40 PM ET
Executives
Hassane El-Khoury – Chief Executive Officer
Thad Trent – Chief Financial Officer
Analysts
Unidentified Analyst
[Started Abruptly]
Credit Suisse Semiconductor Analyst. Our next presentation is ON Semiconductor. It’s a home game for you guys, just down the block. With us for ON — from ON is Hassane El-Khoury, CEO; and Thad Trent, CFO. So, gentlemen, thanks for attending.
Hassane El-Khoury
Thank you.
Thad Trent
Thank you.
Hassane El-Khoury
Thank you for having us.
Unidentified Analyst
So, I thought maybe to start and ON’s been a company that’s been in a bit of transition, and thus far, that transition seems like it’s worked out pretty well with how the stock has reacted and how the fundamentals have reacted. So maybe a minute to kind of describe that transformation and how the strategy of the company has changed.
Hassane El-Khoury
Yeah. Look, at a high level, when I walked into the company, I could see from a technology with any semiconductor company, you have to have the value in the baseline technology before you can talk about what do you do for a strategy.
So the company has very solid and broad-based technology components that we were able to take and through a portfolio rationalization, reinvigorate the strategy of auto and industrial, but more importantly, focus on power and sensing as the go-to-market and that allowed us to then tack on to a lot of the megatrends that are in automotive like electrification, allowed us to double down on silicon carbide, you have seen a lot of that investment, whether it’s CapEx or R&D.
We repositioned our R&D investments into those high growth areas. Meaning we reduced the distractions that was part of the restructuring that we have done in the beginning of 2021 and along the way, we had to fix the business.
So as we invest in the future and we over index to the growing megatrends in auto and industrial, we had to fix the baseline through price to value discrepancies, where we have had components or we have had products that were priced below market, even below our own similar products between markets or customers.
Unidentified Analyst
Right.
Hassane El-Khoury
So there were what we call value leakage that we were able to also bridge and close that gap over the last couple of years. And what you have seen is obviously an expansion in our gross margin, which was every quarter record high. Our growth has been sustained with the growth that we are seeing in the electrification of the vehicle and the factory automation and renewable energy.
And really a more sustainable financial model that is, obviously, starting to get exercised as we look into 2023 and that’s, again, the sustainability of the model that we have been working on in two years is to make sure that we have a model that we can get through good or bad times.
Unidentified Analyst
Right. Right. And I mean, right now, and obviously, in the mind of everyone right now is sort of the transition that’s going on in the industry because of the macro, where there’s some areas of weakness, but then some areas which seem like they are pretty rock solid in auto, industrial, and the previous speakers we have had, and of course, through earnings season, it seems to be a consensus view among the companies we cover as those sectors have held up very well. And I guess the pushback from investors we just rolled out coverage recently is that, in every other cycle, it’s just kind of a question of not if it slows, but when and interested in your perspective on that. And both the — if and when and then what ON does if that happens, if industrial should weaken because of macro concerns?
Hassane El-Khoury
Yeah. Look, I don’t look at the market at that level, because if you look at it at that level, you are going to miss a lot of the nuances that are driving the growth. Unless you can peg and put your finger on exactly what is causing the growth. You are going to get sucked into the cycle and the macro which is historical.
I don’t think — I think everybody will agree, we are in no way shape or form going to be pegged on any industrial type or any historical type market, because there are a lot of megatrends. There are a lot of in the road that we have seen and we will see more.
So if you take it on a market-by-market, consumer and compute great last few years, everybody wanted multiple PCs at home. You had a lot of that the softness we started — we started taking down our wafer starts to get ahead of it from an inventory back in the second quarter before anybody was talking about the softness in those markets, because in the backlog. People ask, oh, my God, did you see cancellations and push up? Well, the answer is no. What we saw is a slowing down of layering of new backlog, so almost a second derivative of the backlog.
Unidentified Analyst
Right.
Hassane El-Khoury
Because, look, the backlog is what it is. Do you trust it? Do you not? It’s way above what we can supply, so it doesn’t really matter. So you want to make sure you move your allocation to where you can make an impact on the end demand.
So we started taking that and we start seeing — we continue to see that softness and we are managing through it through making sure we get ahead of it from this inventory is at an all-time low for us. So we are managing stay ahead of that and our utilization is already baked into our number back to the resilience of our model. So we got ahead of all out of that.
You go to the industrial. Industrial is holding up. And again, but you have to look within industrial, what is holding up. Energy storage, renewable energy, energy generation, energy distribution, chargers, solar, wind and energy storage.
Factory automation remains strong, because what drove that strength is the fact that people couldn’t get labor and social distancing, which reduced the throughput. So company started investing and accelerating their CapEx for factory automation, that’s not going to slowdown. Once you get started, you have to go through the whole.
Some areas in industrial, like, for example, the things that are closer to the consumer like power tools and that is going to — that’s softening. That’s expected because it’s stacked to the consumer and the demand.
Unidentified Analyst
Right.
Hassane El-Khoury
So that, again, we are planning for that, and with that, you can see the resilience of our model through that. Automotive is actually remains strong and it’s going to grow into 2023. Now what is that growth driven by? Again, you have to go, you can double click on automotive, you have industrial or you have and you have ICE engines.
So if you look at the three numbers that people need to watch for, you have the 2022 number of vehicles, you have the 2023 demand from OEM and then you have the 2023 supply that semiconductor companies are going to ship and those numbers are stacked that way.
Our ability to supply is not going to match the demand. We are still going to be supply constrained in automotive in 2023. So even if the demand kind of fluctuates, it’s not the supply boundary and that supply that we are — as the semiconductor industry, we are going to be shipping into 2023 is higher than what we shipped in 2022.
So it’s going to be a growth year, even if you are going to see fluctuation on the SAAR. Why? Because no matter what happens, OEMs are going to ship and manufacture electric vehicles, even if it’s at the expense of an ICE engine — ICE car.
If you get one part whether it’s power semiconductor or mixed signal analog, and you only get one, I guarantee you the OEM is going to put it in to make one more EV versus one more ICE car. That is going to fuel the growth, because for us, specifically at onsemi, the content is about a $50 content in an ICE for powertrain going to 750 in an EV when you do the silicon carbide and all the power semiconductors that go with it. That delta is going to fuel the growth net of whatever the SAAR and the units are going to do.
Unidentified Analyst
Right. Right. So that in the constrained environment, the ability to produce EVs is so far below what they want to do, that EV growth will continue.
Hassane El-Khoury
That makes sense.
Unidentified Analyst
That makes sense. What about the fungibility of supply, though, and for your own business, there is some fungibility between what’s happening in some of the consumer-oriented sectors in industrial and automotive. Has that allowed you to reallocate your production to those areas, and of course, you are deemphasizing some of those non-core businesses?
Hassane El-Khoury
Yeah. So both of those obviously played a big role. So we have been on a trajectory for going to a fab-lighter strategy, which is resizing our manufacturing footprint for where we want to be as far as mix. But over the last few years, obviously, with supply constrained, we did prioritize our auto and industrial customers ahead of our non-core markets and that allowed us.
We just reported a 68% auto and industrial as a percent of revenue and that’s been kind of increasing. That of course helped with our mix that was accretive to margin as well. So it’s a double positive where you are now exposed to high growth macro markets and you have a better margin mix.
So we are — we have used the last few years of supply constrained to move more and more supply. Not every — it’s not 100% fungibility. That’s why I mentioned earlier that we took down wafer starts. Those technologies we can’t just move to automotive. But to the extent we can, we have.
But nevertheless, as a company, when I talk about we have to be — have a sustainable financial results in good and bad times, you have to work with utilization versus just build inventory to keep the fab full. That used to be the old ON Semiconductor.
We are not in a fab filler product. We don’t do fab filler. To the matter of fact, we are walking away from a lot of that business. We have more to walk away from. But we will take utilization down before we burn cash on the balance sheet with inventory.
Unidentified Analyst
Right. We pivot a bit to one of the drivers, obviously, a big part of the story is silicon carbide and maybe you could speak to that, and I think you have already kind of spoken to why electric vehicles will continue to grow regardless of what happens with SAAR. What about ON’s own competitive advantage in that space? So what’s your secret sauce in silicon carbide allows you to win?
Hassane El-Khoury
So a couple of things. Obviously, we have been in the power semiconductor for over two decades. We have been — we are a big worldwide player with IGBT, which gave us a very strong pedigree in both technology and packaging.
So when you talk about 300 kilowatts, 400 kilowatts, 500 kilowatts with a die size that is shrinking and shrinking, how are you going to get that heat out. So packaging is actually a very big competitive advantage we have.
When combined with a very good technology from Audi Essence or whatever spec you want to talk about, you have to have both. Because if you have the best device and you put it in a less than optimal package, you are not going to get the efficiency. You end up paying for silicon carbide, which is more and you are not going to get the benefit because the heat is trapped in. So packaging and device are very important. That’s where we win business.
Now what we have done also strategically is we have acquired GTAT in — it’s been a year now. October was the one-year milestone in order to also extend the vertical integration from packaging device all the way to substrate in order to get that supply assurance, which is very critical.
If you look at where the market is going and the ramp and the speed of adoption that we are seeing in automotive and in industrial, that market is going to be constrained for probably the next decade.
So having supply assurance that a customer can visit the site, touch and feel the capacity that’s being installed and get that confidence that as they ramp, we are able to ramp them. There’s no dependency that I have to go and hope that somebody is able to ramp. That goes away.
So that vertical integration translates into supply assurance is another angle of not just why we win, why we win a lot of the majority shares at the big accounts and that translates into the $4 billion of committed revenue under long-term supply agreements that customer has signed up for.
Unidentified Analyst
Right. So as you look at silicon carbide and I think you talked about $1 billion run rate by the end of next year. What’s the constraint? Is it actually a substrate that is constraining your ability of supply, I mean, it doesn’t sound like electric vehicle demand is a constraint?
Hassane El-Khoury
Yeah. It’s definitely not demand.
Unidentified Analyst
Yeah.
Hassane El-Khoury
It’s — at this point, it’s execution. It starts with the substrates. I talked about — since the acquisition of GTAT, our — we have — we will have end of this year, which four weeks left, 5x the number of furnaces installed that will be online.
So from our capacity and our ability to add capacity, we are on track. Like I said, we have four weeks left. I am not worried about it anymore. I don’t sleep on do we have enough furnaces installed. Right now, it’s the ramp, which when you do a 5x ramp in the 12-month period. I can tell you if somebody is doing that and sleeps good at night, they are missing it.
That’s where a lot of my focus is and the teams focus day-to-day is making sure that every issue you have doesn’t become systemic, the blocking and tackling, which again, yeah, it’s silicon carbide, it’s very difficult. But the process of a ramp, we have been doing for decades on ramping fabs and ramping manufacturing even in power.
So from that, we already expanded capacity on wafering and EPI. So once you get the boule you have to be able to make the wafers and put EPI on it. We expanded that capacity that we have and then the fab, we have doubled the capacity in 2022 from last year. We will double that again next year and that the equipment.
Unidentified Analyst
Right.
Hassane El-Khoury
So I want to say it’s all execution, it’s all planned. The question is until everything is in-house and I put my finger on it, I am going to keep managing it day-to-day.
Unidentified Analyst
Right. Right.
Hassane El-Khoury
But it’s execution, but it’s not a demand, which is…
Unidentified Analyst
Right.
Hassane El-Khoury
… when we get to an execution focus, I feel much better because then you have control.
Unidentified Analyst
That’s something in your control.
Hassane El-Khoury
That’s right.
Unidentified Analyst
And so…
Hassane El-Khoury
That’s exactly.
Unidentified Analyst
… the silicon carbide for the next several quarters, year, year and a half, two years, it’s really in your control in terms of your execution and getting the product out?
Hassane El-Khoury
That’s right. Yeah.
Unidentified Analyst
Let me pivot a little bit to pricing, which has been a good story for the industry and for yourselves as well for much of last year. Maybe you could speak to two things with that. One is what’s happening within the non-core segment with pricing and I suppose that’s one of the reasons why you are exiting some of the businesses that you have been talking about exiting for a while. And then, secondly, what about in the core businesses, and if there is price pressure in compute and consumer, does that leak its way into industrial and automotive at some point?
Hassane El-Khoury
Yeah. So let me take it in two sections. So the non-core business, a lot of the revenue or the business that we have said we are going to walk away from. We have walked away from about $270 million at an average of 25% margin in a good pricing environment. So I wouldn’t call a good pricing environment. That is somewhere that I am high flying about it. It’s better than it was, but it’s still dilutive. So we walked away from that.
Where we are today? We talked about another $400 million to $450 million that we are going to exit in 2023. That’s going to be market dependent. If a customer is able to get it somewhere else cheaper, you are welcome, go for it. We are not going to chase it down to kind of single-digit margin that it used to be.
So from that perspective, we don’t see — we are not going to be under any pricing pressure. As a matter of fact, as we lose this business, it’s going to be accretive to margin, because it’s below the corporate average.
Unidentified Analyst
Right.
Hassane El-Khoury
So from that perspective, it’s actually going to be a good thing for us. So softness in that market may accelerate us losing that business. I will be honest with you, by now, I thought we would be done with it. But it’s going slower, because they can’t get it anywhere else.
Unidentified Analyst
Right.
Hassane El-Khoury
We expect that to change. Now on the core business, specifically on auto and industrial, we heard, you heard me talk about LTSAs. Just to remind you, LTSAs are multiyear in nature. We have LTSAs that go four years, five years, some of them are seven years, eight years that have both volume and pricing in it.
So in core businesses where we are investing, there’s not a conversation about pricing. The conversation about pricing has already occurred. Right now it’s just making sure that we ramp, because we have been very consistent and transparent about the fact that we are only adding capacity where we have LTSAs.
So for us now is making sure that the LTSAs are what the customers need and that we are getting ahead of it by adding capacity to support those LTSAs. But call it whatever the demand does, there’s not going to be a pricing conversation.
Unidentified Analyst
Right.
Hassane El-Khoury
It may be a volume conversation, but it’s not going to be a, hey, I can get it somewhere else cheaper, well, at that point, the LTSA is a legally binding agreement.
Unidentified Analyst
Right. And how much of core industrial and auto business is covered by those LTSAs?
Hassane El-Khoury
It depends on the technology. I got to tell you, for example, silicon carbide 100% is…
Unidentified Analyst
Right.
Hassane El-Khoury
…is LTSAs, businesses where we are adding capacity are 100% on LTSA. We are not going to add — we are not going to invest in CapEx unless there’s a signed LTSA. So to a first order between LTSAs and NCR 2023, I mean, we are sold out already.
Unidentified Analyst
Right.
Hassane El-Khoury
So that gives you kind of an idea of the — it’s a big percent in the shorter term and then…
Unidentified Analyst
Right.
Hassane El-Khoury
And we keep layering on top of it.
Unidentified Analyst
And aside from silicon carbide, where else are you looking to add capacity for 2023?
Hassane El-Khoury
So in 2023, our CapEx is going, obviously, silicon carbide, but also a 300-millimeter fab. So we will close the East Fishkill, 300-millimeter fab acquisition end of this year, called December 31st. We will be owners of the fab on January 1st. So that — we are converting that fab into a power discrete and logic fab. So the second CapEx, call it, intensity is going into that fab.
Because as — if you track the story, we have been — I referred to the fab-lighter. We have divested or announced divestiture of four fabs. We closed three of them already. One, we have announced the agreement when we expect to close in the fourth quarter. So by the end of this year, we would have exited four fabs of our fab network.
Our capacity, when we put East Fishkill online, we will actually increase. So, net-net, we are adding capacity, but we are adding capacity at scale and we are divesting the sub-scale fabs. So those are the two, I would say, components that are — where a majority of our CapEx is going.
Question-and-Answer Session
Q – Unidentified Analyst
Great. I will pause for a second and see if there’s any questions from the audience before I continue. Go ahead, Rob?
Unidentified Analyst
Thanks. Appreciate it. I think one point of differentiation on your SiC strategy has been your investment in the air wafer-level burn-in systems. I think your competitors have not been public with such investments. Can you explain how, if at all, this is adding your success in winning kind of SiC business?
Hassane El-Khoury
You are talking about wafer-level burn-in?
Unidentified Analyst
Yeah.
Unidentified Analyst
Yeah.
Hassane El-Khoury
Well, I don’t know what they are doing. I look at it. I don’t think wafer-level burn-in is anything new in the industry. Any new industry — any new technology as you get to maturity and you flush out a lot of the stuff, you have to get a wafer-level burn-in and you have to get out of some burn-in, some technologies will remain. So I can’t comment at that level because that’s not really where competitive advantage comes.
Wafer-level burn-in is a quality in PPM [ph]. It is not — we are not going to win, because we have wafer-level burn-in. I will go back to — you have to have the best devices and you have to have the best packaging. Those are the two key items why a company — why we are winning. I can talk specifically for us. How we manufacture, how you improve all of that stuff, the manufacturing cost and manufacture the baseline has a lot of things between test, the burn-in and all of that.
Unidentified Analyst
Thad, maybe I will direct the next one on you with regard to margins and there are some puts and takes on the gross margins right now, where, again, the — what’s happening with Fishkill, with — what’s happening with silicon carbide. Maybe you can walk us through what the puts and takes are and it’s my perception that the headwinds that you face on gross margins sort of peak toward the end of the year. So maybe you can confirm that and kind of, like, put the roadmap in front of us?
Thad Trent
Yeah. So let me start off by just calibrating where we are on margins. So we started with margins down in the 33% range, right? We pushed them up pretty close to 50%. Now what you are referring to as we are going forward is we have two major headwinds in margins and we have been very clear about these for a long time.
We have got about 100 basis points to 200 basis points of headwind with the silicon carbide ramp. So we have all start-up costs with silicon carbide. That will basically be there for through 2023. We think by the time we exit 2023, we are about at the corporate average on silicon carbide once we ramp. So we have always said that’s about scaling. We don’t exclude the start-up cost out of our non-GAAP numbers. So that’s one element.
The other element is the East Fishkill. So as we take over the fab as this onset, in January, we are going to be providing foundry services to GLOBALFOUNDRIES for three years. So next year, we will have about 40% of capacity and it steps up and as GLOBALFOUNDRIES steps down over three years. So for next year, it’s about 40 basis points to 70 basis points of headwind, which that steps down again over in 2024 and 2025.
So those are the two main elements and then, obviously, depending on what the market does, there may be some underutilization, but that’s going to be macro driven. Now as we go forward to 2024, we have got a couple of tailwinds coming as well. So Hassane talked about the four fabs that we are exiting. There’s about $160 million of annualized fixed costs that come off of the gross margin line as we exit. [Audio Gap] dilutive to…
Unidentified Analyst
Right.
Thad Trent
… our financials. Meaning if we have under loading because of it, then customers are going to have to offset that if they don’t want to take the product. So our goal is not to blindly shove inventory into the customer.
Unidentified Analyst
Right.
Thad Trent
Because you just pushed the problem down the road. So we are not focused on short-term kind of benefit had a long-term impact. We want the long-term stability of our go-to-market and our revenue and our margin.
But it can be margin dilutive, because historically, we are left holding the back, backlog and disappear in 30 days before. Back to that point, we are going to get a call six months in advance when there’s a problem, which gives us a lot more time to manage it as a win-win with the customer.
Unidentified Analyst
Right. And it’s very different than the way the industry has lapped the growth rate…
Thad Trent
Absolutely. Absolutely.
Unidentified Analyst
… for quite some time. I guess one last one, just carrying this back to cash flow. And there’s still some investment. You are still in investment mode right now, particularly in silicon carbide and other. At what point does some of that capacity addition, the spend start to moderate and you start to generate stronger cash flow on some of those investments?
Thad Trent
Yeah. So let’s be clear on our CapEx. Our CapEx is all being put in place to support LTSA revenue.
Unidentified Analyst
Right.
Thad Trent
So this is not a build capacity and hope to fill it, right? So we are not going back to that fab filler strategy where we would be forced to go into. So on the last call, we said that, our CapEx intensity in 2023 would go up into the high-teens, right, from about 12%. That’s all to support the incremental LTSA revenue that we are locking up. Most of that, you can think about is being silicon carbide.
Look, I think, that starts to subside, if it doesn’t, it’s because we have incremental LTSA revenue over the long-term. That’s what would keep that at a higher level, but we do expect it to come back into a normal range.
Unidentified Analyst
Okay. Well, lots to talk about. Unfortunately, we are out of time. So we will continue this conversation. But gentleman, thanks for your time.
Hassane El-Khoury
Absolutely. Thank you.
Thad Trent
Thanks, Chris [ph].
Unidentified Analyst
Thanks, everyone.
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