ON Semiconductor Corp (ON) — Q3 2015 Earnings Call Transcript

Good morning and thank you for dialing into Fairchild's third 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 Morgan Stanley Semiconductor and Semicap Equipment Corporate Access Day on November 9, and the Raymond James Technology Investors Conference on December 9 in New York City, as well as the Credit Suisse TMT conference on December 2 in Scottsdale. I also want to point out that we've improved our tracking of sales by end market segments that we publish on our Investor Relations website every quarter. You will note some changes in the data, as well as a new category titled enterprise computing and telecom that replaces the computing category and better reflects the primary applications for our products. We'll start today's call with Mark Frey, who will review our third quarter financial results and discuss the current status of fourth-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 reports 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 feel 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'll find our 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 discussion 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 third quarter of 2015, Fairchild reported sales of $342 million, down 4% sequentially and 10% from the third quarter of 2014. Distribution sell-through was weaker than seasonal, and we reduced our shipments into the channel accordingly, which was the primary cause of our sales decline in the third quarter. Adjusted gross margin was up 90 basis points from the prior quarter to 34.1%, due primarily to lower manufacturing costs and improved product mix. R&D and SG&A expenses were $88 million, down 12% from the prior quarter, due to spending controls, seasonal factors, and the impact of the expense reduction program we announced in the quarter. Roughly $2 million of the sequential reduction was due to a one-time bonus and equity compensation accrual reversal for the employees impacted by our workforce reductions. Recall that we forecast completing the previously-announced actions to reduce operating expense by the middle of this quarter. Third-quarter adjusted net income was $23 million, and adjusted EPS was $0.20. The adjusted tax expense was $4 million for the quarter. Now, I'd like to review our third-quarter sales and gross margin performance for our two major business segments. Sales were up 7% from the prior quarter for our Analog, Power and Signal Solutions segment, or APSS, due to higher mobile demand and modestly higher consumer sales. APSS adjusted gross margin increased to 43%, due primarily to lower manufacturing costs, higher sales, and a more favorable product mix. In our Switching Power Solutions segment, or SPS, revenue was 8% lower sequentially, as seasonally lower sales in the appliance and auto markets, plus incremental weakness in China, were partially offset by stronger demand from the enterprise computing and telecom sectors. Adjusted gross margin decreased to 31%, due primarily to lower factory loadings and sales. Turning to our balance sheet, internal inventory increased by 5% sequentially to 123 days, as we reduced our shipments planned late in the quarter, and built inventory to support expected higher mobile demand in the fourth quarter. We expect to reduce our internal inventory in the fourth quarter, which along with lower demand, will impact factory utilization. We forecast this to have an unfavorable impact on gross margin in the fourth quarter, as well as the first quarter of 2016. Days of sales outstanding or DSOs increased to 42 days, and payables increased to 49 days. Free cash flow was a negative $9 million for the third quarter, due to cash restructuring expenses of $33 million, and the increase in internal inventory. In the fourth quarter, we expect to spend approximately $25 million in remaining cash restructuring expenses, including severance costs for the recently-announced OpEx reduction program. We repurchased 2.4 million shares of our stock for $35 million during the quarter, and reduced our share count by 5% from the year-ago quarter. We ended the third quarter with total cash and securities exceeding our debt by $47 million. Turning now to forward guidance, we expect sales to be in the range of $320 million to $335 million for the fourth quarter. We expect adjusted gross margin to be 32.5% to 33.5%, due primarily to lower factory utilization and sales, partially offset by improved manufacturing costs. We anticipate R&D and SG&A spending to be $88 million to $90 million, due primarily to normal seasonality, and the impact of the previously-announced operating expense reduction program. 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 fourth-quarter results. Now, I'll turn the call over to Mark Thompson.

Thank you, Mark, and good morning, everyone. We increased sales for our mobile, enterprise computing, and telecom products during the quarter while reducing our distribution channel inventory dollars sequentially. Demand was in line with our revised forecast during the third quarter, reflecting weakness from Asia and especially China in the industrial, appliance, and consumer markets. Sales for our automotive products were seasonally lower in the third quarter, but are tracking for another year of solid growth. We completed the remaining factory closures during the third quarter to improve our manufacturing cost structure. We also announced that we streamlined our leadership structure, which will significantly reduce operating expenses. These are structural cost reductions and are designed to improve profitability and cash flow at current revenue levels. I will begin today with a review of the current demand environment, and our perspective on the fourth quarter. I'll wrap up with a discussion of how we're managing the business in the current environment. Let's begin by looking at the demand environment. We grew third-quarter sales of our mobile products in support of new model launches by leading customers. We also benefited from increasing content for a variety of battery charging, voltage regulation, and signal path solutions on these new models. We expect mobile sales to continue growing sequentially in the fourth quarter as we ramp our shipments to support these new phones. Looking forward, we believe Fairchild is very well positioned to increase content and drive higher sales in the mobile market in 2016. Sales into the enterprise computing and telecom end markets were also sequentially higher in the third quarter. We are benefiting from the ramp in server production, driven by the latest Intel architecture. Fairchild is also gaining content in a number of telecom applications, with high performance discrete and integrated power management solutions. We expect to steadily grow this business, as these markets drive for greater power efficiency. Turning to the automotive market, demand was seasonally lower in the third quarter, but is expected to strengthen in the fourth and is on track for good sales growth in 2015. We are a leader in providing power management solutions that enable advanced ignition, fuel injection, and electronic power steering technologies which increase fuel efficiency while improving the cost of ownership. We expect continued strong sales growth for this business in 2016. Sales into the industrial and appliance end markets were sequentially lower in the third quarter, due to normal seasonality, coupled with lower demand from China. Demand in the US and Europe remains strong. We expect the weakness in China to persist through the fourth quarter, as customers remain cautious and in turn further reduce inventory. Putting this all together, let me explain how we're managing in the current environment. Given the economic uncertainty, we're focused on managing the elements of the business we can control, such as keeping lead times short and inventories well positioned to better support our customers. Our ability to book and turn new orders is excellent, and allows us to be very responsive. We were able to rapidly respond to orders late in Q3, and are even better positioned this quarter. Distribution sell-through or point of sale decreased by about 2% sequentially in the third quarter, which is below the typical seasonal growth of about 2% positive. In China, if we exclude a few one-time new program events, POS was down 5% from the prior quarter. This is far below normal seasonality. We have worked closely with our distribution partners to tightly control inventory, and ended the third quarter with a reduction in channel inventory dollars. This keeps our channel quite lean and positions us well to benefit quickly from any improvement in demand. Finally, we're improving the cost structure of the Company. During the third quarter, we completed the last steps of our factory consolidation project, and are down to a small crew of employees at the closed sites working to decommission the facilities and prepare them for sale. We also announced a significant streamlining of our leadership structure that is expected to result in annual OpEx savings of $30 million to $34 million per year. Our third-quarter results and fourth-quarter guidance reflect partial benefits of these programs, and we expect the full impact to be apparent in early 2016. In closing, while we are currently managing through a period of economic uncertainty, I am confident that the actions we've taken this year will position Fairchild to excel in the future. We expect to emerge from 2015 as a substantially leaner, more focused Company able to generate higher earnings and cash flow, even at current revenue levels. We're well-positioned to grow our sales into mobile, automotive, enterprise computing, and telecom end markets in 2016. When the Chinese economic environment stabilizes, we also expect to see continued growth for our products, serving the appliance and industrial end markets.

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. Thanks, and let's take the first question, please.

Hi, guys. Thanks a lot. May I ask the question? I guess the first one is a little bit separate from the quarter itself, but there were some news reports yesterday about M&A potential that may or may not involve you. I'm wondering if you had any comments, either specifically or in a more general sense, on the quite active M&A market in semis right now.

Sure, Ross. Thanks for letting us get this out up front. So as you know, no company ever comments on this stuff, and we're not going to today. We're here to talk about Q3 and our current business.

Okay. That's kind of what I expected. So let's get onto the Q3 and the current business, then. I guess talking about the gross margin, and as far as it's related to inventory, can you talk a little bit about the magnitude of how much you expect to bring the inventory down, and how long that lower utilization is likely to weigh on the gross margin? People are excited about the cost cuts that you put into place, but it seems like we're not really seeing them come through, due to the revenue environment. So I'm wondering when we're actually going to start to see those.

Sure. First of all, the cost reductions do come through. Unfortunately, they're on a lower business base than when we originally presented their projections. But we expect to, over time, get the inventory back into the 100 day, 110 day range, over the fourth and first quarter. I think we'll probably still be modestly reducing the costs next year, simply because a component of the build ahead were parts related to the factory close-down, and we allowed ourselves about a four-quarter runway for those. But they also tend to be parts that are made externally, so they wouldn't have the kind of income statement leverage that you would normally think of, when a company reduces inventory.

Ross, let me add a few more points to Mark's statements. Currently, we are significantly under-building, and we expect the largest increase to occur in the fourth quarter, which is reflected in our current projections. By the first quarter, we need to return to building according to consumption. The impact of this is usually seen spread relatively evenly across the fourth and first quarters. The advantages of the full model will be evident when the plants operate at consumption levels and also when there are transitional effects associated with these changes. These do not happen instantaneously as period expenses. You can anticipate a similar effect in the first quarter as in the fourth, with a complete resolution by the end of the first quarter.

So pretty much a 1 point drop again in 1Q and then what you're building in 1Q will help 2Q, the utilization?

No, think – I think a good approximation, obviously it's an approximation, is we would expect Q1 to be similar to Q4.

Good morning. Thanks for taking my questions. So normal POS in Q3 is up 2%. I think the team planned for flat. It came down 2% sequentially. What are your POS historical trends for the fourth quarter, and what's embedded in your guidance? I'm just trying to gauge the level of conservatism in the team's outlook here.

So the normal POS in the fourth quarter is down 2% to 3%. And so we have reflected a seasonal drop to POS in the fourth quarter.

Got it. Okay. Great. And then auto, looks like auto was down about 4% sequentially in Q3, which I think is maybe a bit more than seasonal. Any geographic trends you can talk about? Obviously, there's been a lot of concern around the China automotive segment, and auto does tend to take a step down seasonally in Q4. But it seems like the team is guiding up for the fourth quarter, so if you can just help us understand some of the dynamics that are driving this?

I don't have the numbers in front of me, but I believe the decline in the third quarter was around 2%. This was mainly due to some timing issues that were initially expected to occur at the end of the third quarter but ended up happening at the beginning of the fourth quarter. That really reflects the situation—just some localized timing effects of certain programs. So far, we haven't noticed any impact from the softness in China on our overall automotive business.

Yes, good morning. Just a general question on overall business conditions. Based on your commentary, it looked like the biggest area of incremental weakness as you go into the fourth quarter is the industrial and appliance business. I guess if you could talk to us about how you'd characterize that business, do you see that business still getting incrementally worse, and therefore, kind of hard to call stability there? And then with regard to the rest of the business, if you characterize that as stable, improving, getting worse, or maybe you just don't have visibility right now.

The way I would characterize it is that the industrial and appliance businesses is normal all around the world, except for the combination of Korea and China, which are very closely coupled, as I think you know well. And that was quite weak in the third quarter, and we're expecting another similar kind of weakness in the fourth quarter. One of the things we pay close attention to is, so it's weak, but we know that customers and distributors are taking down inventory, right? So people are producing below consumption, and that gives me some confidence. Again, I can't predict the China economy, but it's always a good sign when people are taking inventory out as opposed to the business is down, and inventory is remaining unchanged. So that's why, based on that, we think the most likely scenario, assuming there's not another leg down on the China economy, which most people don't think is the likely case, is that this will be a two-quarter phenomenon. And that most of the inventory correction will be done by the fourth quarter, and then you'll start to see life come back second half of Q1, after Chinese New Year.

Okay. Just a follow-up with regard to the OpEx, any OpEx cuts. You mentioned that some of the cuts were already reflected in the fourth-quarter guidance. You talked about reversing some bonus accruals there. Taking the full impact of the annual reduction in OpEx for next year, I guess it runs an average something around $8 million a quarter, how much of that is already reflected in the Q4 numbers, and then what should we be taking out of our prior estimates for next year?

What we can expect is that Q1 OpEx will be quite similar to Q4 OpEx. The main part of the OpEx reduction programs was initiated by the end of the third quarter, with about two-thirds triggered then. There's a longer timeline for additional triggers throughout the fourth quarter as certain programs are concluded. Thus, a significant amount of the OpEx improvement in Q3 came from spending control and accrual relief. The benefits seen in Q4 are due to expense control and a much improved, yet not fully reflected, cost structure. Typically, in Q1, we experience a slight seasonal increase due to seasonal taxes and other factors, such as the reactivation of FICA. However, by the end of the fourth quarter, we will be at the new run rate with all costs fully accounted for. Therefore, we anticipate Q1 OpEx to remain relatively flat compared to Q4 OpEx.

Thanks. Following up on some of the restructuring cost initiatives, Mark, could you provide some context regarding the industry's slowdown in growth beyond cyclical influences? How are you determining the most appropriate spending levels, and what impact does this have on your position as businesses begin to recover?

If you examine the structural initiatives we implemented, which we believed were solid investments with measurable returns over time, we fully retained them. This includes areas such as our datacom power management, server power management, leading customer mobile power management solutions, and automotive power management solutions, all of which were kept intact throughout this process. We focused on achieving our own economies of scale within our discrete business. Previously, we operated as a set of specialty discrete businesses that often pursued cost reductions ineffectively. Hence, we significantly elevated our cost reduction efforts. We reduced the number of such initiatives on those devices and consolidated our process technology R&D into a single organization. Consequently, we now have one large discrete organization that manages everything from the lowest to the highest voltage solutions, overseen by Marion Limmer, who has been instrumental in establishing our presence in the automotive sector and is an exceptional P&L manager. This restructuring spans about two-thirds of our business and is where we have realized scale and efficiencies.

Helpful. Thanks. And then maybe just shifting gears to growth. You mentioned some optimism around 2016 growth drivers. I know you've had some momentum recently in the data center side, certainly some parts of mobile. Anything you could add to that in terms of anecdotes, or just your visibility into the design pipeline that gives you confidence that you can sustain some of those growth drivers?

Yes, these programs are typically long-term. We have good visibility into automotive programs, though not as much with appliances, but we do with industrial programs. The key mobile customers in the US and China have very ambitious roadmaps, with Type-C becoming widespread. Recently, we've been affected by a significant decline from a major competitor where we had strong market presence, but that impact seems to have diminished as we approach 2016.

Got you. Just a quick follow-up on the data center side, in particular, as you mentioned, it's a long cycle, but just how you're positioned in that particular segment?

We really like our position across both the standard server implementation, which is a big part of the market, as well as the custom data center server of the Googles and the Facebooks, and so forth. So we have a footprint in both places.

Thank you for the question. Looking at the year-over-year results, your revenues have decreased by less than $10 million, but your gross margins have only increased by 60 basis points, even with the ongoing restructuring. Additionally, the APS segment is quite varied and shows higher gross margins. I'm puzzled as to why the increase is limited to just 60 basis points. Is there something we might be missing? Could there be a pricing issue, especially in SPS? I'm trying to make sense of the situation.

We began the year in the first quarter slightly below 32%, which reflected the inventory reductions we implemented in the fourth quarter. During a year with factory closures, we have incurred significant restructuring expenses, yet many expenses not categorized as restructuring are affecting our operating results. For instance, the Salt Lake facility was only half operational in the second quarter, which limited its profitability. Moving forward, our footprint is now cleaner. We still have staff at both locations handling decommissioning, but they will be completely gone by early next year, marking the beginning of a more straightforward period. In response to your question, there are some areas of pricing in SPS, especially in appliances, but overall, I don't anticipate significant changes in pricing across most of the business.

Okay. Maybe we can talk about the gross margin progression from here, then. Is there anything left from the restructuring that we have, and is gross margin pretty much dependent now on revenue level and product mix? Are there any other levers that you can pull on gross margin?

The basic restructuring program is concluded. So we won't have any leftover costs when we go into next year. And we think that we still expect to see favorable mix improvement. We always have cost reductions, so as we consolidate with our subcons, we will work on pricing negotiations, et cetera. In Bucheon, where we're running new parts, you get a learning effect, which deals with yield and throughput, et cetera. So when you net all that, if we're operating at these kind of low 330 range, we think that would translate based on the cost progress to a 33% to 34% profile. When we get back up to the 350 or so, we think that drives a 35% plus.

Hi, good morning. Given that a lot of your peers did not preannounce, my assumption is that you were just more responsive than a lot of other companies adjusting POS in the face of point of sales weaker than expected. If this is true, and assuming that you're not losing market share, what do you think the inventory increase is in the channel from your peers that haven't preannounce, that are reporting on a sell-in basis? Are you seeing a lot of inventory increase at this piece as a result?

Tristan, that's a challenging question for me to answer, as I don't have access to our competitors' data. However, I can share what our situation would have looked like with a different approach. In the third quarter, we reduced channel inventory by $5 million to $10 million. If we hadn’t restricted shipments, we would have been at the lower end of our guidance, but we would have also significantly increased our channel inventory by at least $10 million. Therefore, it could have been worse. My belief is that this situation is largely influenced by China. Companies with greater exposure to the Chinese market are likely more affected by this trend. If you have a substantial part of your business in China and chose to stick to your original guidance while facing a decline in point of sale, the resulting channel increase could have been between $10 million and $20 million. We took a more aggressive approach, which means our recovery time will be shorter than if we had not acted decisively. So, if you consider this, you could potentially apply it to other companies to arrive at an estimate.

Okay. That's actually very useful. Also, in the Q&A, I think I've heard you mention that from a gross margin perspective, we should expect Q1 to be similar with Q4, and you did mention that there was some decommissioning expenses in Q4 that won't be recurring in Q1. So that gross margin flat assumption, what type of seasonal decline, or are you expecting a below seasonal decline, given that you will be under shipping real demand in Q1 at the top line?

Tristan, you highlighted the main issue, which is that the most significant factor isn’t the revenue expectation. It’s the amount of inventory adjustment we still need to make. Currently, we are producing about $20 million less per quarter than necessary. We anticipate that the typical revenue pattern we've seen in recent years will remain stable in Q1 compared to Q4, so that's not a major concern. If the market in China continues to be weak at the start of next year, we may decide to further reduce our inventory. However, if we see indications that the inventory adjustments will conclude in the fourth quarter, we can ramp up production to meet demand. That's a decision we are not ready to make just yet, nor is it necessary for us to determine at this time.

I think, Tristan, there's a number of puts and takes as you go from any quarter and that's one of them. When we say, think roughly flat, it's the net of a number of things. Because remember, some things go against us, like in the US, we have to start paying FICA taxes for employees, people go on vacation less often, et cetera. So I wouldn't put the decommissioning at a status that's different than any of the other puts and takes.

Hey, good morning, guys. Thanks for letting me ask the question. I guess, Mark Thompson, a little bit curious you how you're thinking about mobile beyond the December quarter. Because clearly despite the growth headwinds in the industrial and the implied space you've got sequential growth in September, you said in the prepared comments you expect it to be up again in December. I'm wondering how much of that do you think is just timing of builds of new products, new flagship launches, and we should expect some seasonality into the March quarter? And how much of that is just you think more structural, you're gaining content, share, that's a little bit more sustainable than just a two-quarter period.

So I think there's both elements are present. Certainly, there is one leading customer that's doing a big build in the fourth quarter. We would expect them to pull back some in Q1. That's normal seasonality. On the other hand, the China Mobile component has gotten more significant for us, and their Q1 is the US's Q4. If you look at the way that typically plays out, smartphones are typically a Chinese New Year gift, and so forth. So I think the seasonality will be less muted, but I think - and also, somewhat offset by continued gains, especially places like Type-C and adaptive charging we see continuing to put increasing content. So I don't think we're going to see like a big bubble and then a pullback for mobile. We feel pretty confident, at least looking across 2016, that at the players, one big US, two big China, are pretty well positioned to keep their share, and the big correction we've taken in one other player is fairly well complete. So I'm expecting it to be fairly steady and strong across 2016, if you net all that out.

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. Thanks, and let's take the first question, please.

Hi, guys. Thanks a lot. May I ask the question?

Sure, Ross. Thanks for letting us get this out up front.

Okay. That's kind of what I expected. So let's get onto the Q3 and the current business, then.

Yes. First of all, the cost reductions do come through.

Sure. We are currently significantly under-building.

Good morning. Thanks for taking my questions.

So the normal POS in the fourth quarter is down 2% to 3%. I don't have the numbers in front of me.

Yes, good morning. Just a general question on overall business conditions.

The way I would characterize it is that the industrial and appliance businesses is normal all around the world.

Okay. Just a follow-up with regard to the OpEx, any OpEx cuts.

So what I think you can comfortably do is, if you look at Q1, Q1 OpEx will be pretty similar to Q4 OpEx.

Thanks. Following up on some of the restructuring cost initiatives.

So if you look at the structural things that we did.

Helpful. Thanks.

So yes, I mean, they tend to be longer term programs. We really like our position across both the standard server implementation.

Hey, guys, thanks for the question.

So a few things. The basic restructuring program is concluded.

Got you. Just a quick follow-up on the data center side.

So probably the spot that's clearest to analyze and understand.

Yes, thanks for letting me ask the follow-up. Hey, good morning, guys. Thanks for letting me ask the question.

So I'm expecting it to be fairly steady and strong across 2016, if you net all that out.

Thanks, Mark.

Yes, thanks for letting me ask the follow-up.