ON Semiconductor Corp (ON) — Q1 2015 Earnings Call Transcript

Good morning and thank you for dialing into Fairchild's first quarter 2015 financial results conference call. With me today is Mark Thompson, Fairchild's Chairman, President and CEO; and Mark Frey, our Executive Vice President and CFO. Let me begin by mentioning that we'll be attending the Robert Baird Growth Conference on May 06 in Chicago, the Deutsche Bank Semiconductor One-on-One Day in San Francisco on May 12, and the JP Morgan Tech, Media, and Telecom Conference on May 18 in Boston. We'll start today's call with Mark Frey, who will review our first quarter financial results and discuss the current status of second quarter business. Mark Thompson will then discuss our product line results, end markets and operational performance in more detail. Finally, we'll reserve time for questions-and-answers. This call is scheduled to last approximately 60 minutes and is being simultaneously webcast from the Investor Relations section of our website at fairchildsemi.com. The replay for this call will be publicly available for approximately 30 days. Fairchild management will be making forward-looking statements in this conference call. These statements, including all statements about future results and performance, are made based on assumptions and estimates that involve risk and uncertainty. Many factors could cause actual results to differ materially from those expressed in forward-looking statements. A discussion of these risk factors is provided in the quarterly and annual report we file with the SEC. In addition, during this call, we may refer to adjusted or other financial measures that are not prepared according to generally accepted accounting principles. We use non-GAAP measures because we believe they provide useful information about the operating performance of our businesses that should be considered by investors in conjunction with the GAAP measures that we also provide. You can find a reconciliation of non-GAAP to comparable GAAP measures at the Investor Relations section of our website at investor.fairchildsemi.com. The website also contains a variety of useful information for investors, including an extensive financial section to facilitate your investment analysis. Now, I'll turn the call over to Mark Frey.

Thanks, Dan. Good morning and thank you for joining us. I'm sure most of you have had a chance to review our earnings press release, so I'll focus on just the key points in my comments. For the first quarter of 2015, Fairchild reported sales of $356 million, up 6% sequentially and 3% from the first quarter of 2014. Adjusted gross margin was down 80 basis points to 31.6%, due primarily to higher inventory unit costs attributable to lower factory loadings in the prior quarter. R&D and SG&A expenses were $94 million, which were up 3% from the prior quarter but at the low end of our guidance range due to higher payroll related expenses, partially offset by ongoing cost controls and lower equity compensation. First quarter adjusted net income was $13 million and adjusted EPS was $0.11. The adjusted tax expense was $4 million for the quarter. Now, I would like to review our first quarter sales and gross margin performance for our two major business segments. We changed our reporting segments effective at the start of this year to better reflect the way we manage the business. The new analog power and signal solutions segment or APSS contains our mobile, power conversion, and motion tracking product lines. This business focuses on developing innovative analog solutions including power management sensor and signal path applications. The switch and power solution segment or SPS contains our low, medium, and high voltage switch product lines, integrated power modules, as well as our automotive and cloud product lines. This business provides a wide range of highly efficient discrete and integrated power management solutions across a broad range of end markets. Finally, our standard products group or SPG includes a broad portfolio of standard, discrete, analog, logic, and optoelectronic products. We will provide five years of historic financial data for these new reporting segments on our investor relations website. Sales were up 2% from the prior quarter for our APSS business driven by higher power conversion demand, especially in lighting and battery charger applications. APSS’ adjusted gross margin was down slightly from the prior quarter to 38% due primarily to higher inventory unit costs attributable to lower factory loadings in the prior quarter. In our SPS business, sales were up 8% sequentially due to normal seasonality, continued strong growth in our automotive business, and market share gains for industrial and appliance applications. Adjusted gross margin was down nearly 2 points sequentially to 30% due primarily to higher inventory unit costs attributable to lower factory loadings in the prior quarter. Turning to our balance sheet, we held internal inventory dollars roughly flat to the prior quarter as we offset the inventory build to support our manufacturing consolidation with reductions in other areas. This coupled with higher sales caused a 6-day sequential decrease to 100 days of inventory. We expect to complete the bridge inventory build in Q2, then gradually deplete this inventory to exit the year at roughly 90 days of inventory level. Days of sales outstanding or DSOs increased to 41 days and payables decreased to 40 days, which is in line with normal seasonality. Free cash flow was a negative $29 million for the first quarter due to normal year-end cash compensation expenses paid in the first quarter and the increase in DSOs. We repurchased 2.3 million shares of our stock for $39 million in the first quarter and ended the quarter with total cash and securities exceeding our debt by $80 million. Turning now to forward guidance, we expect sales to be in the range of $360 million to $380 million for the second quarter. We expect adjusted gross margin to be 33.5% to 34.5% due primarily to higher factory loadings in the prior quarter and improved product mix. We anticipate R&D and SG&A spending to be $97 million to $99 million due primarily to the annual merit increase, higher variable compensation, and temporarily higher legal spending in connection with upcoming patent trials. The adjusted tax rate is forecast at 12% plus or minus 3 percentage points for the quarter. Consistent with our usual practices, we are not assuming any obligation to update this information, although we may choose to do so before we announce second quarter results. Now, I will turn the call over to Mark Thompson.

Thank you, Mark, and good morning everyone. We grew sales in the first quarter at the high end of our expectations while maintaining flat distribution channel inventory. We expect to build on this momentum in the second quarter as we benefit from design wins and market share gains coupled with normal seasonal demand strength. We are also on schedule to deliver significant cost reductions in the second half of this year once the manufacturing footprint consolidation is completed. I’ll begin with a brief review of the demand environment and some of the areas that are contributing to our sales growth. I’ll wrap up by discussing some current quarter results and our perspective on the second quarter. Let’s begin by looking at the current demand environment. Bookings significantly exceeded shipments in Q1 and that pattern continues into Q2 giving us a better backlog position at this point a quarter ago. Nearly 60% of our sales now come from the industrial appliance and automotive end markets which are seasonally higher in the first half. We also gained market share in the appliance market and benefited from strong sales growth into the auto sector. Sales of our products into the mobile end-market were sequentially lower in Q1, but we saw improvement as the quarter progressed due to the ramp of new smartphones at leading customers. We are also benefiting from higher content in the latest models. As we talked with investors last quarter, we had questions about impact from changes in currency we might be having on the end-market demand. Given the strong order rates we are seeing, there does not appear to be a material impact on our demand. The largest change in currency has been in the euro zone, where we sell primarily into industrial and automotive sectors, which are some of the more stable markets that we serve. In aggregate, a stronger U.S. dollar is a positive for our results as we have more cost and revenue in currencies other than the dollar. Let’s turn now to some of the specific areas that Fairchild is driving sales growth. Our automotive business once again reported robust growth to achieve record quarterly sales in Q1. Fairchild is a leader in delivering innovative power management solutions that enable greater fuel efficiency and lower cost of ownership. We expect continued strong growth in this market as the adoption rates of semiconductor control solutions within the automotive powertrain accelerates. The industrial and appliance markets posted strong sequential growth due to normal seasonal trends coupled with market share gains at some leading appliance makers. We also won new designs in a number of LED lighting, industrial fan, and pump applications, as well as solar inverters. We expect continued solid growth in this business for Q2. In the mobile market, demand is picking up as customers start building their new models. We have secured higher content in a number of leading new smartphone models, which we expect will drive solid sales growth as we progress through the year. Fairchild is winning content with our full line of battery charging solutions, voltage regulators, and analog switches. Fairchild’s fast charging technology that enables the battery charger to vary its output to significantly reduce charge times is prominently featured on leading customer’s flagship smartphone. Fairchild is leading the revolution in creating intelligent adaptive battery chargers that allow smartphone users to be truly mobile instead of routinely searching for a power outlet. Our sales into the computing end-markets are off to a good start in the first quarter as we gain market share at a number of large server customers. Fairchild has a growing portfolio of integrated power stage solutions that provide superior performance and efficiency to this demanding market. We also launched a full line of extended temperature power management solutions that have been well received by the market. Given our content gains in server, storage, and cloud applications coupled with our very low exposure to consumer notebooks, we expect steady growth from this business through 2015. Turning now to the first quarter results and our perspectives onto Q2, we maintain distribution inventory flat sequentially as our sales into the channel roughly matched the increase in point-of-sale. Weeks of inventory in the channel remained at a lean nine weeks. Lead times increased during the quarter, but still remain short with most of our businesses in the seven- to nine-week range. Looking forward to the second quarter, given our higher starting backlog and order momentum, we are guiding for another quarter of solid sales growth. We have many changes happening this quarter as we wind down production at three manufacturing sites and ramp activity at other internal and external factories. We expect margins to rebound strongly in the second quarter as we set the stage for this major transformation in our manufacturing cost structure in the second half. In closing, Fairchild is off to a great start and we look forward to an exciting 2015. We have a strong pipeline of design wins and our new product launches that we anticipate will accelerate our sales growth in 2015. Our manufacturing consolidation is on schedule and we expect to significantly reduce our cost structure beginning in the third quarter of this year. All these improvements are designed to drive higher earnings and higher cash flow. We repurchased 2% of our outstanding shares in the first quarter as we continue to drive higher shareholder value through effective capital allocation. Thank you, and I will turn the call back to Dan.

Thanks, Mark. We'll now open the call to questions. I would ask that, in order to allow more of you to ask questions, we limit each person to one question and one follow-up, please. Thanks, and let's take the first question.

Hi, guys. Congrats on the solid quarter and guidance. I guess my first question for Mark Thompson is on the channel side of the equation. You mentioned that you are not seeing any signs of macro volatility, but can you walk through how the quarter stayed flat sequentially in the channel where I think you expected the channel inventory to actually rise a bit, and then what sort of channel inventory assumptions are embedded in your second quarter guidance?

So, Ross, we were never expecting a huge replenishment of the channel. So, while it was at the low-end of expectation, it wasn't out of bounds. And I think normally it’s a little bit hard, especially towards the end of Q1 to exactly match point-of-sale because things are slow for Chinese New Year and then there is a bit of a catch-up. So getting exactly matching fill for the point-of-sale, it’s always a little bit challenging. And so, that’s really the reason why it wound up at the low-end of ship into the channel versus low-end of our range, but not out of range. If you look at the assumptions for the second quarter, it would keep the channel roughly flat.

And is that on a dollars or days basis in both the flat first quarter as well as the flat second quarter that you just talked about?

That would be in days. We had nine weeks as of the low-end of the range we want to run. So we seek to exit the quarter in the nine plus week range.

And I guess as my follow-up for Mark Frey, on the gross margin side of things, I know you guys only guide one quarter out, but given the volatility around what’s going to start to occur in the third quarter, just assuming the restructuring impact alone, think about loadings or anything associated with demand, can you give us any sort of quantifiable framework on how we should think about the pluses and minuses of the fab closures and what that means to the third quarter and maybe even fourth quarter gross margin please?

Sure. The biggest plus is the elimination of fixed expenses after we closed the plants in June and early July, and just think of that as about 200 basis points as we've guided in the past. In the short-term, it will get a little longer in the longer term. What we don’t know is how efficiently the new processes ramp up both externally and internally, so it’s harder to put a crystal ball on that, but we see this playing out pretty much the way we’ve been modeling and presenting to the investors up to this point.

So all else being equal, the gross margin would grow 200 basis points sequentially in the third quarter?

Yeah.

Good morning. Great job on the quarterly execution. Post Chinese New Year, just wondering if the demand pull and inventory replenishment you saw was in line with expectations or were there any areas, sub-segments where there was a bit of incremental weakness or incremental strengths relative to your expectations?

I would say it roughly followed our expectations, so nothing out of balance in terms of overwhelmingly negative or positive. Broad-based health in demand is the way I would characterize it.

Great, thanks for that. And then on the mobile side, good to see the traction and content gains with your solutions – battery charging, voltage regulation, switching. You talked about – can you just roughly quantify, let’s say, on some of the upcoming flagship smartphones, what the rough dollar content increase is versus the same models last year?

So, what I will say is that across-the-board, there are content gains. Until they go into production, it’s always difficult a little bit to quantify them because normally there will be two suppliers for a share, and so the exact balances aren’t usually known until they go into production. But they range from kind of 50% to 75% increases in content for most of the handsets that we are looking at across-the-board if we get kind of expected middle-range share.

Great. And then just real quickly, I think you touched upon it, but what percentage of your COGS in OpEx are denominated in foreign currencies?

I don’t have a clean percent. The two currencies that have been harmful have been the euro and the yen, and we look at that as how much revenue is denominated in the currency relative to the cost. And euro, for example, only about 25% of our revenue in Europe net of expenses is actually exposed to currency. Then we have a very large cost base in Korean Won, and I don’t have that as a percent, but if you net the impact of the Euro and Yen to the Won and the Malaysian Ringgit, you get a slight favorable overall impact.

Great. Thanks for the insights guys.

Thank you, good morning. The first question is regarding seasonality and obviously you want to guide for the second half right now, but given the increasing mix of your business towards industrial and automotive, should we be changing our expectations with regard to the typical seasonality we see in your business as we look into the third quarter and the fourth quarter?

So Chris, it’s a little hard to answer that question. As I said, it’s sitting about 60:40 today. So, a 60:40 profile would give relatively muted seasonality given that the 60 is first half strength and the 40 is second half strength. I think somewhat confusing that this year is there are some significant program ramps in the second half in mobile, and so if all of the things being equal, we might expect in aggregate stronger first half and second half, but I think that’s likely to not be the case this year given the program ramps.

Okay, well, I was going to follow-on with regard to the expectations in mobile and you know I guess that makes it difficult, you know to talk about mobile with regard to the product ramps as well, but your commentary said that you had seen some better performance in mobile, late part of Q1, I assume that’s carrying into Q2 with the flagship ramp. I guess the question is, as we see there’s two factors, one being the hand off between the two customers in the first half and the second half. And then the second factor would be the new platform ramps, how do we balance all of those together to get an expectation for the mobile business as the year progresses?

So, Q2 better than Q1, Q3 better than Q2, Q4 better than Q3.

Yes, thanks for Mark Thompson. If I look at the computing segment for you guys, it is one that relative to the other segment seems to be kind of under the radar a bit and just want to get your sense in terms particularly for the data center what you are talking about, is this Greenfield opportunity for Fairchild, is it market share gain opportunities and you know relative to some of the other segments how would you put the growth in computing kind of mid-to-longer term?

So, I guess it depends on how you define Greenfield. So, there is sort of two classes of server out there. There is the custom server for the big data center guys like Google and so forth, where we are definitely seeing share gains and they of course do their own designs and that’s where really primarily where we are concentrated on the custom server portion of it. We do some of the standard server for sure, but the biggest incremental focus areas are on the custom server side. One other thing I would add Craig to that is that we have seen the recent consolidation of two significant players, suppliers in the space, Infineon and IR, has created incremental opportunity because their combined share is more than some people prefer and so that’s freeing up some share that we are also accessing. So, it’s a mix of sort of pure design win and incremental share.

Hi guys, congrats on the quarter and nice to see that execution. So, for Mark Thompson, at the end of your prepared remarks you mentioned strong pipeline of design wins were those just the mobile program ramps that you were talking about or where there other needle moving wins and perhaps you can describe what the make-up of that pipeline looks like.

Certainly the biggest for us is on the mobile side in terms of concentrated dollars, but the server one, the server will move more slowly, but we have some significant design wins and power stages in server. We have some very attractive content gains that we expect in automotive as well.

Hi, good morning. You talked about earlier in your call about a sequential 200 basis point in gross margin benefit in Q3. Could you remind us whether this means that your manufacturing consolidation is going to be cut neutral by then versus the beginning of that consolidation or is it still going to be a drag on gross margin? And also if you could talk about some of the gross margin benefits that you expect beyond Q3 and I understand that some of this is unquantified at this point.

Yeah. We certainly do expect to be favorable in the second half because just think of our product set as X billions of units going out at a certain price prior to – or the second quarter and before, we were running seven full facilities and starting in the second half we were running kind of 4.5 full facilities. So as we said earlier, about $50 million of fixed overheads are eliminated and that same product set is now either being concentrated in the remaining internal sites or being manufactured by subcons or foundries who have given us very good pricing on those moves. And so you wrap that altogether and you get better gross margin profile. Is that what you are getting at Tristan?

Yes. That is very useful. And then I guess directionally any sense as to what the continued improvement might look like beyond Q3 or is that pretty much done?

Well, no, as I said yields ramp up rates, the fullness of our dual sourcing. So we don’t on day one have everything qualified to go everywhere. There will be another year or two to really work into the carry on efficiencies of the new supply chain. And I think the number one influence or once we are past that stage is the level of growth on its own and the mix up. So if we continue to grow our 50% gross margin applications faster than our 30% applications, then that would be a further tailwind which we expect to see.

So just on the biggest incremental cost we’ll peel off in Q3, there is another increment. I mean there is a lot of spend on decommissioning and so forth that will continue as a tail in Q4, but some of that will then peel off in Q4 and then we expect a very clean Q1. But we certainly expect it’s a little bit like that gross margin in Q3 will be better than Q2, Mark size that in 200-ish basis points. We would expect Q4 to be better than Q3 and we’d expect Q1 of ‘16 to be better than Q4. And obviously as we get closer to it and know all the puts and takes on that, we will obviously quantify a better than that, and then basically mixed driving in 2016.

Great, that sounded good. That’s very useful. And then could you talk about the initial outlook for the second half that you’re getting from your large customers. Would you say that the forecast is kind of similar to what they’ve seen in prior years or do you sense that people are either more bearish or more bullish on the second half outlook and then if you could talk about your utilization rate expectation for Q2? Thank you.

So it’s really hard to call in a broad basis second-half at this juncture. But they’ve probably the best proxy we have for it is incoming order rate although we are only a few weeks in, so that’s largely mapping. It’s about half mapping into Q3, half mapping into Q2 but that is ahead of shipment rate right, so a book-to-bill above 1%. And so that would say that there is certainly decent confidence in demand at least into the third quarter, but there is really no visibility into what the fourth quarter would look like at this juncture, virtually nothing is booking into there and people’s forecast are, they typically don’t give forecast to go that far. So I just can’t offer much other than the incoming order rate. If you look at the utilization, the plants that are closing are running flat out right now and so – but the new BKA plant is not yet fully utilized because there is a lot of engineering work that’s still going on. And then our Portland, Maine facility is running at least average or slightly better than average utilization which would put it well into the 80s right. So that’s kind of the picture.

Thank you for taking my question and for providing all the historical data on the new segments. The question for Mark Thompson, how should I think about the right growth trajectory for Fairchild? I think your Q2 outlook suggests roughly flattish year-on-year growth. What do you think is the right sustainable growth rate for Fairchild and what would be the trigger to consider boosting that growth rate through M&A?

So in the segments that we operate in, we would expect to roughly grow with whatever the market happens to be and so which we think will allow us to, basically we think there is more financial model progress available in gross margin than in top line. And so what we do is basically seek to grow with the markets, then we can produce more selective about the business that we take consistent with our gross margin improvement model. And so if you aggregated the growth rates in the sort of big areas that we play in appliance, automotive, server, and mobile plus industrial, then that would be a reasonable model to use. So some number in the mid-single digit kind of thing is where we think the sustainable model will land.

Got it. And one specific question, Mark, on the end markets, could you remind us what your exposure is to the China smartphone OEMs and what you are seeing there in terms of trends?

They are doing well. There are two players in particular in China that are getting a disproportionate share. The way we look at the market is, a third of it a big American company, a third of it is a big Korean company, and a third of it are a pair of leading Chinese players. And so we’ve – our strategy has been to have strong distinguished content in those three categories.

Got it. Any concern, I think in Q1 there were some concerns about slowdown or excess inventories and so forth and perhaps slower start into Q2, have you seen any of that or do you think those concerns have passed us and then it’s now seasonal growth over the next few quarters?

I think in aggregate seasonal growth is reasonable. The mobile market is always going to be a little choppy right. Some handsets do really well, some don’t do really well, there is inventory correction, there are shortages, but overall I think there is certainly lots of data out there on expected growth rates for the total handset of the big three categories that I gave and everything we see is roughly consistent with the prognosticators.

Yeah, good morning guys. Thanks for letting me ask the question. Mark, I guess I am going to try to ask the key two guide question a little bit differently. Clearly we’ve had some mixed data points in the semis space outside of you, but in an earlier call I referenced you guys have company specific. I am just kind of curious as you look at the sequential growth you are guiding to in the June quarter, to what extent should I think about this as being sort of core business seasonal to below seasonal, anything that’s above that is sort of content growth for the company. How would I think about kind of those two buckets for the June quarter guide specifically?

Sure, John. Historically, our Q2 growth is in the mid-4% range. So we are really guiding somewhat consistent with that. And I don’t think the drivers of it individually are any different than the drivers that have historically generated kind of the mid-4%. I don’t think there is one overpowering driver that’s accounting for it.

But if it’s just seasonal kind of goes against the argument that you guys are gaining content, I kind of guess what my question is, is that you guys sort of giving a cautious kind of seasonal to below seasonal in the core business, but you’ve got this content growth and that’s why you are guiding the way you are? Yet another way to kind of ask the question is whether or not some of the noise that we’ve been hearing from other companies is embedded in your guidance or not?

Well, we are trying to be cautious. We do have content that’s incorporated in it, but most of the real content impact is second half, it’s just beginning in Q2.

But, John, if I were to answer your question little bit of a different, I mean, I know you’re trying to parse specific program from seasonal, but it’s really almost impossible to do that because there is never a true base case that you could analyze. But if you look at some quarters you head into and you say you are more worried about demand, some quarters you head into you are more worried about supply, rarely is there a perfect equilibrium of the two. I’m more worried about supply in Q2 than demand.

Great. Thanks a lot and congratulations on the nice quarter and guidance. Just to go back to clarification on the new segments, under the APS’, you have power conversion, is that strictly AC to DC power conversion or does that include DC to DC, I’m just trying to understand that versus what might show up in cloud and SPS?

Yes, the power conversion is AC to DC. There is DC to DC, but that’s in the mobile part, but it’s still within the APS’ segment. Generally speaking ICs and sensors and ASICs, whereas the SPS has most of our MOSFETs, rectifiers, IGBTs, and of course a big module content which then gets into driver ICs and some controllers, et cetera. But by and large, that’s the way to think about it. Today, it’s mostly power stage, so some combination of driver and FET. So, I think there are two focus categories for us in mobile. So, we are maintaining the interface solutions, but that’s not where we are investing our R&D dollars, so that’s still an important business, it remains. Especially, if you look at, for example, the big Korean guys have been very, very focused on integration, which has tended to be bad for some of the interface solutions. On the other hand, the China makers have actually not been focused on integration. So there is a sort of a different – you almost have to get specific to the architecture to figure out, which is – what things are more important than other things. But if you look at the functions where we are spending our R&D dollars, which is probably the best descriptor of strategy, it is in the full end-to-end – we call it wall-to-battery for a reason, right. It’s from the adapter all the way to the battery interface, but all the pieces how to work together in order to make that work. So everything between the plug and the wall and the battery itself is a focus area for us. The second thing are specific regulation solutions. I mentioned pay solutions, for example, which are distinct and separate. Those also have some distinct regulation requirements. Typically, they’re run straight off the battery and so have some very –. So those are the two classes of things that we are most heavily focused on in mobile and are more in a harvest mode on the interface solutions although they are still important.

Thanks, Mark. We'll now open the call to questions. I would ask that in order to allow more of you to ask questions, we limit each person to one question and one follow-up please. Thanks, and let's take the first question. Thanks, and I'll turn the call back to you for any additional or closing remarks.

Great, well, thank you very much. That will conclude our call today. We appreciate your interest in Fairchild.