ON Semiconductor Corp (ON) — Q3 2016 Earnings Call Transcript

Thank you, Terrence. Good morning and thank you for joining ON Semiconductor Corporation's third quarter 2016 quarterly results conference call. I'm joined today by Keith Jackson, our President and CEO; and Bernard Gutmann, our CFO. This call is being webcast on the Investor Relations section of our website at www.onsemi.com. A replay will be available on our website approximately one hour following this live broadcast and will continue to be available for approximately 30 days following this conference call, along with our earnings release for the third quarter of 2016. The script for today's call and the additional information related to our end markets, business segments, geographies, channels, and share count are also posted on our website. Our earnings release and this presentation includes certain non-GAAP financial measures. Reconciliations of these non-GAAP financial measures to the most directly comparable measures under GAAP are in our earnings release, which is posted separately on our website in the Investor Relations section. During the course of this conference call, we will make projections or other forward-looking statements regarding future events or future financial performance of the company. The words believe, estimate, project, anticipate, intend, may, expect, will, plan, should, or similar expressions are intended to identify forward-looking statements. We wish to caution that such statements are subject to risks and uncertainties that could cause actual events or results to differ materially from projections. Important factors, which can affect our business, including factors that could cause actual results to differ from our forward-looking statements, are described in our Form 10-Ks, Form 10-Qs, and other filings with the Securities and Exchange Commission. Additional factors are described in our earnings release for the third quarter of 2016. Our estimates may change and the company assumes no obligation to update forward-looking statements to reflect actual results, changed assumptions, or other factors, except as required by law. We will be holding our 2017 Analyst Day on March 10 in Scottsdale, Arizona, and we will be sending out invitations and additional details of the event in the coming days. During the fourth quarter, we will be attending the Credit Suisse Technology, Media, Telecom Conference on November 30. Now, let me turn over to Bernard Gutmann, who will provide an overview of third quarter 2016 results. Bernard?

Thank you, Parag, and thank you everyone for joining us today. Let me start by updating you on recent directives from the Securities and Exchange Commission on the disclosure of non-GAAP financial measures. Due to new and revised Compliance and Disclosure Interpretations on the use of non-GAAP financial metrics by U.S.-listed companies from the U.S. Securities and Exchange Commission, we are revising our practices with respect to guidance and use of non-GAAP measures. Please see the earnings release for additional information. Now, let me provide you details on our third quarter 2016 results. ON Semiconductor today announced that total revenue for the third quarter of 2016 was approximately $951 million, an increase of approximately 8% as compared to the second quarter of 2016. Third quarter revenue included a contribution of approximately $53 million from our acquisition of Fairchild Semiconductor, which closed on September 19, 2016. The incremental contribution from Fairchild was partially offset by approximately $5 million of revenue we didn't see this quarter due to the divestiture of our Ignition IGBT, TVS diodes, and Thyristor product lines. GAAP net income for the third quarter was $0.02 per diluted share. GAAP income before income tax for the third quarter was approximately $87.3 million. Non-GAAP income before income tax for the third quarter was approximately $107.3 million. Net cash paid for taxes in the third quarter was approximately $6.5 million and diluted shares outstanding were approximately 420 million. GAAP gross margin for the third quarter was 34.6% and non-GAAP gross margin for the third quarter was 35.9%. GAAP and non-GAAP gross margin for the second quarter of 2016 was 35.1%. GAAP operating margin for the third quarter of 2016 was approximately 4.9% as compared to approximately 8.6% in the prior quarter. Our non-GAAP operating margin for the third quarter was 12.9% as compared to 12.3% in the prior quarter. GAAP operating expenses for the third quarter were approximately $282 million as compared to approximately $233 million for the second quarter of 2016. Non-GAAP operating expenses for the third quarter were approximately $218 million as compared to approximately $200 million in the second quarter. The sequential increase in operating expenses was driven by the inclusion of Fairchild in our third quarter results; annual merit increases, which became effective in the third quarter of every year; costs related to the Fairchild integration; and increases in legal and tax consulting fees. We had stronger operating cash flow performance in the third quarter. I'm very excited about the cash flow potential of ON Semiconductor, and with the addition of Fairchild, we should see meaningfully improved cash flow performance in 2017. Operating cash flow for the third quarter was approximately $133 million as compared to approximately $104 million in the second quarter. Operating cash flow for the third quarter was negatively impacted by approximately $26 million related to the modification of our Term Loan B financing. During the third quarter, we spent approximately $36 million of cash for the purchase of capital equipment and we obtained approximately $104 million from the divestiture of our Ignition IGBT TVS diodes and Thyristor product lines. We exited the third quarter of 2016 with cash, cash equivalents and short-term investments of approximately $880 million as compared to approximately $588 million in the second quarter. At the end of the third quarter of 2016, days of inventory on hand, adjusted for 11 days of revenue contribution from Fairchild and the fair market value step-up, were 113 days. ON Semiconductor days of inventory in the second quarter were 120 days. In the third quarter of 2016, distribution inventory days increased marginally compared to the second quarter, primarily due to the inclusion of Fairchild. For the third quarter of 2016, our lead times were up quarter-over-quarter. Our global factory utilization for the third quarter was slightly up sequentially. Now, let me provide you an update on the performance of our business units, starting with the Power Solutions Group or PSG. Revenue for PSG was approximately $408 million. Revenue for our Analog Products Group for the third quarter of 2016 was approximately $363 million. Revenue for the Image Sensor Group was approximately $180 million. Now, I would like to turn the call over to Keith Jackson for additional comments on the business environment. Keith?

Thanks, Bernard. I will start with an update on the progress we have made thus far on the integration of Fairchild, and then I will provide commentary on current business trends and on various end markets. We are pleased with our acquisition of Fairchild and also with the progress we have made thus far in the integration process. As of now, we are tracking significantly ahead of our announced synergy targets. Recall that at the close of the transaction, we announced that we were targeting to achieve an annual synergy run rate of $75 million six months after the close of the transaction. We have already exceeded our six months post-close target and we plan to implement further actions in the current quarter to realize additional synergies. We expect to start to see the impact of these measures on our operating costs in early next year. Let me now provide additional detail on the action we've taken to realize synergies in various functional areas. On the R&D front, we have identified redundant or uneconomical programs and are in the process of eliminating many of these programs. A sizable portion of R&D program rationalization will likely be achieved in the current quarter. As we previously mentioned, although ON Semiconductor and Fairchild have very complementary product portfolios, both companies were investing to grow in similar areas. In sales and marketing, we took actions on the first day after the close of the transaction to effectively integrate the sales team. Redundancies in account management were eliminated and customer accounts were allocated immediately after the close of the transaction. Based on inputs from our customers, we retained the best talent between the sales forces of the two companies. With the addition of Fairchild's portfolio, ON Semiconductor has significantly improved its presence in the distribution channel. We intend to leverage our expanded presence to drive higher sales through the distribution channel. In general and administrative, we are rationalizing corporate functions such as finance, IT, legal, and human resources. As we integrate the systems of the two companies, we should see meaningful savings on the G&A front. The departure of Fairchild management team has contributed to savings on the G&A front. On the operations front, planning is well underway and we are beginning to execute on synergies. Our initial assessment indicates that Fairchild's facilities are in good condition and we intend to increase loading at most of these facilities through insourcing and production transfers to drive higher margins. Fairchild's operations planning systems are very similar to ours, and we expect a seamless integration of operations of the two companies. Our initial assessment fully validates our financial and strategic rationale behind the acquisition. The acquisition is highly complementary, and the overlap and redundancies in products and customers of the two companies are lower than previously expected. Fairchild has a very strong product portfolio, and with our scale and execution rigor, we are confident that we can generate significant value from Fairchild's portfolio. As we have indicated earlier, Fairchild's expertise in mid- and high-voltage power management is highly complementary to our strength in low-voltage power management. Customer reception to the transaction has been very positive. Customers realize the combined strength of the two companies and they are willing to engage with us in an even more meaningful manner than before. We've seen increased interest from automotive, industrial, and communication customers in our combined portfolio. Fairchild has also added a list of marquee customers in the network and industrial end markets and we are pleased to be working with these customers. As we had indicated earlier, the combination of ON Semiconductor and Fairchild creates a new leader in discrete power management market. Given our scale, execution history, and relationships, customers now have a very credible alternative to traditional market players for discrete power management solutions. Customers across end markets and geographies intensified their engagement with us from mid- to high-voltage power management solutions. We will provide further updates on the financial and strategic impact of the acquisition at our Analyst Day on March 10, 2017. Let me now comment on the business trends in the third quarter. During the third quarter, demand trends were stable and the bookings were generally steady across most end markets and geographies. End market trends were generally in line with expectations. Recent commentary from customers points to a steady demand environment. Despite a stable macro environment and generally benign demand environment, we continue to manage our business in a prudent manner. We continue to execute on our strategy of focusing on automotive, industrial, and communications end markets, and with the acquisition of Fairchild, we are well positioned to increase our presence in these markets in a meaningful manner. We expect that our investments should start showing concrete results in 2017 and beyond. Now, I'll provide details of the progress in our various end markets. With the inclusion of Fairchild's results for part of the third quarter, the normal quarter-over-quarter comparison that we have historically provided is not quite as meaningful. Therefore, I'll limit my remarks to qualitative summary and limited quantitative data. The automotive end market contributed revenue of approximately $319 million and represented approximately 33% of our revenue in the third quarter. Third quarter automotive revenue was negatively impacted by the divestiture of the Ignition IGBT business, TVS diodes, and Thyristor product lines. Our automotive design funnel remains robust as semiconductor growth in light vehicles continues to outpace production. We continue to see strong demand for image sensors for ADAS applications. We've secured wins on marquee platforms, and we are well positioned to drive strong growth in our automotive image sensors. Other applications driving growth in automotive include advanced front lighting, park assist, and DC-to-DC conversion. With the addition of Fairchild, we are now very well positioned to benefit from the fast-growing EV/HEV market. The industrial end market, which includes military, aerospace, and medical, contributed revenue of approximately $212 million and represented approximately 22% of our revenue in the third quarter. Key drivers for growth in the industrial markets remain intact. In the medical market, we continue to maintain our leadership in the hearing health market and we are preparing to launch new products in the fourth quarter. In the machine vision market, we are seeing strong demand for our CMOS and CCD image sensors. The communications end market, which includes both networking and wireless, contributed revenue of approximately $192 million and represented approximately 20% of our revenue in the third quarter. Our momentum in the smartphone market remains strong and our presence with global OEMs and China-based OEMs continues to grow. We continue to increase our content on marquee platforms by virtue of our innovative power management solutions. Fairchild further improves our position with key global and China-based OEMs with its wall-to-battery solutions, converters, audio switches, power switches, and other analog switches. The computing end market contributed revenue of approximately $116 million and represented approximately 12% of our revenue in the third quarter. We noticed a slowdown in the computing market due to inventory adjustment. The consumer end market contributed revenue of approximately $113 million and represented approximately 12% of our revenue in the third quarter. We noticed greater-than-seasonal strength in the consumer business, primarily due to gaming consoles and white goods. Now, I'd like to turn it back over to Bernard for forward-looking guidance.

Thank you, Keith. Based on product booking trends, backlog levels, and estimated turns levels, we anticipate that total ON Semiconductor revenues will be approximately $1.19 billion to $1.24 billion in the fourth quarter of 2016. Backlog levels for the fourth quarter of 2016 represent approximately 80% to 85% of our anticipated fourth quarter revenues. Our guidance for the fourth quarter is in line with normal seasonality, with our organic business down approximately 2% at midpoint and Fairchild down approximately 7% at midpoint. We expect inventory distributors to be flat quarter-over-quarter on a dollar basis. We expect total capital expenditures of approximately $40 million to $50 million in the fourth quarter of 2016. For the fourth quarter of 2016, we expect GAAP gross margin in the range of 27.4% to 29.5% and non-GAAP gross margin in the range of approximately 33.6% to 35.6%. Factory utilization in the fourth quarter is likely to be down sequentially. We expect total GAAP operating expenses of approximately $327 million to $359 million. Our GAAP operating expenses include the amortization of intangibles, restructuring, asset impairments, and other charges, which are expected to be approximately $54 million to $72 million. We expect total non-GAAP operating expenses of approximately $273 million to $287 million. We anticipate GAAP net other income and expense, including interest expense, will be approximately $40 million to $43 million for the fourth quarter of 2016, which includes non-cash interest expense of approximately $6 million to $7 million. We anticipate our non-GAAP net other income and expense, including interest expense, will be approximately $34 million to $36 million. Cash paid for income taxes is expected to be approximately $7 million to $11 million. We also expect share-based compensation of approximately $13 million to $15 million in the fourth quarter of 2016, of which approximately $2 million is expected to be in the cost of goods sold and the remaining amount is expected to be in operating expenses. This expense is included in our non-GAAP financial measures. Our diluted share count for the fourth quarter of 2016 is expected to be approximately 424 million shares, based on the current stock price. Further details on share count and earnings per share calculations are provided regularly in our quarterly and annual reports on Form 10-Q and Form 10-K. With that, I would like to start the Q&A session. Thank you and, Terrence, please open the line for questions.

Hi, guys. Thanks for letting me ask a question. I guess the first one, heading into the fourth quarter and then potentially into the first quarter, can you just talk a little bit about the demand patterns you're seeing by sub-segments? And I realize sequential math is a little skewed by the full fourth quarter of Fairchild. But just trying to get into what normal seasonality will be for the full company for the first quarter and then what the pluses and minuses are that get you to your revenue guide for the fourth quarter itself.

Okay. Well, it's a good time to address some of the differences between the Fairchild patterns and ON. ON normally would be down 2% to 3% in the fourth quarter and then down another couple of percent in Q1. Fairchild had a very different pattern. They were down like 7% or 8% in the fourth quarter and then up 1% or 2% in the first quarter. So the net of that is a little more smoothing of the transitions on a quarterly basis. Primary drivers were really the mix of business that the two companies had and what you see is a pronounced impact on the Fairchild side from the communications or handset market, which had the stronger patterns. So, right now, we're seeing things a little better than seasonality going into the fourth quarter and with the backlog patterns going into the first quarter for both companies, which basically says computing's down a bit, the handset's down a bit, automotive down a bit, and basically across all the markets, they're going to be down a little bit from Q3. There's really no strengthening in Q4 over Q3 market-wise. Q1 should see a strengthening in industrial and automotive, and the other markets should be approximately flat.

Great. And I guess as my follow-up one for Bernard, can you just walk us through your expectations sequentially and then kind of going into next year on the synergy side and specifically, on the OpEx line? How should it trend from that $280 million mark that you are guiding to in the fourth quarter?

So, as we mentioned in the written remarks, we are ahead of schedule on the savings and ergo, our midpoint of our guidance is $280 million. In general terms, we expect those numbers to be flat to down. We expect the first quarter to still show some improvement over that. And then, as you go into the back half of the year, we should expect still some small reductions, but it will be partially offset with our normal merit increases. But in general terms, we expect that our OpEx to move towards the 22% of revenue towards the end of the year.

Hey. Thanks, guys. Just a clarification on end markets. So I think you said in the comments and prepared remarks that there was a slowdown from the PC market. Was that the reason that you came up a little short with the Q3 revenue? Maybe talk about how the slowdown in the PC market is impacting Q4 and then any impact from the Note 7 problems as well.

So primary difference in Q3 was not computing; it was actually the divestiture of the business we mentioned for the Ignition IGBTs and the Thyristor businesses. So that difference was basically made up for the entire gap. On the computing side, our comments were we did start to see some inventory corrections through the computing side. I believe we see them a little earlier than others, but I think you're going to see that in Q4. But in general, there was not a big change Q3 over Q2 or Q4 over Q3 for our market, basically due to the increased Skylake content.

Okay. Great. And then for my follow-up, can you just maybe talk about where you're finding these additional synergies? Is it more on the COGS or the OpEx side?

It's both. On the OpEx side, we're identifying continued opportunities as we understand the investment profiles in more detail and just getting rid of redundancies there. That's opened up some new doors for us. And on the COGS side, we now have enough data to do the analysis on insourcing and that should provide some earlier-than-expected opportunities in 2017.

Yes. Thank you. Good morning. I guess the first question, if you could clarify what the Fairchild revenue was for the full quarter. In addition, Fairchild had a sell-in revenue recognition policy. Do you guys continue that as part of ON Semiconductor and what are the implications of that?

Yes. Thanks, Chris. So Fairchild's stub period, which is the one we had on our control, was $53 million. We don't have full visibility of what occurred before. It wasn't under our ownership and there was no public forum for that. In general terms, I believe it was pretty much in line with what their management was expecting and was not a surprise in general terms, but we don't have a precise number. Indeed, Fairchild, you see, recognizes revenue on a sell-in basis. We will continue recognizing revenue on a sell-in basis for the Fairchild piece and we are exploring the possibility of early adopting the sell-in conversion, which, as you know, all companies will have to migrate to sell-in as of 01/01/2018 as the latest. So we're exploring whether we do an early adoption of that at the beginning of 2017. It's still not completely defined, but that's the current thought process. So pretty much after 01/01/2017, we should all be changing to a sell-in methodology.

Okay. Thank you. And as a follow-up, perhaps you could talk about the handset business a bit. Obviously, a lot of moving parts there with some new product ramps going. How is that going versus your expectations and what can we assume as we go into Q1?

Yeah. That's a little bit of why seasonality is a little better than normal. We've actually seen some pickups in our design platforms, both with the global providers and in China. And so we think there should be some good opportunities for strength in Q1, and I think that certainly is going to remain so at least through the early Chinese New Year this year.

Hi, guys. Thanks. Just briefly on the gross margin side, I know long-term, you guys have maintained that 40% outlook. Is that a 2018 target? And what top line do you need to get to that 40% longer-term gross margin? Thanks.

So we will be giving details on that at the next Analyst Day, but the fundamental tends to get to that 40% remain intact and we actually believe that the Fairchild acquisition enhances our ability to get there. And in general terms, as we have said before, it consists mainly of fall-through in incremental revenue, of self-help on manufacturing and consolidation, and mix improvements and potentially divestitures. Those are the four legs that will really allow us to get to that 40%. We have, in the past, talked about a 5% growth in revenue. That has fallen short in 2015 and 2016, but we do expect that there will be some low to middle single-digit growth in the markets that will allow us to get there.

Got it. And on auto side, you mentioned ADAS being a nice tailwind here. Can you talk about what percent of your autos is now ADAS and how that is growing and how you see your mix of auto revenues in 2017? Thanks.

Yeah. I don't have precise numbers of ADAS because it's defined slightly differently by each of the makers and whether it's class I through class V. And so, I don't really have access to precise data to give you there. What I can tell you is we're going to be up double digits in automotive in 2016 and the opportunity is there in 2017 as well, really on the backs of more adoption of more safety features.

Yeah. Thanks for taking my question. So just a housekeeping. So on the Q4 guidance, the Fairchild business implies something like $335 million revenue to get to the midpoint. And if I look at the organic business being down about 2%, it implies that it's up about 5% year-over-year. So I just want to make sure that those numbers are accurate.

In general terms, they are indeed in the ballpark. As we said in the prepared remarks, we expect ON legacy to be down about 2%, which is seasonal, and Fairchild to be down about 7%, which is also seasonal or maybe slightly better.

Okay. Thank you. And in terms of the gross margin drivers next year – and you talked a little bit about that in your prepared remarks, but I was wondering if you could maybe elaborate on the Fairchild business, how that will contribute to a higher gross margin either through fab consolidation or back-end test assembly consolidation. I was wondering if you could describe where you see some of the gross margin levers as you fold Fairchild in.

Yeah. There won't be any consolidation savings in 2017. It takes us more than a year to actually realize those. What we're looking at next year is additional insourcing into the combined factory network, so basically less outside manufacturing. This will get us better factory utilization and frankly some much lower costs in some of ON's factories by moving them from the low 80s up further from there. So, a lot of factory loading, mostly insourcing would be a primary driver. And then, secondarily, continued mix shift, which has been enhanced with the acquisition.

Thanks for taking the question. Team, I wanted to follow up on the ahead-of-schedule synergies progress and just explore the longer-term implications. The prior calendar 2017 to 2019 targets were $160 million, $200 million, and $225 million. If you're tracking ahead both on OpEx and COGS now, should we expect there to be upside to those targets? And if so, can you provide either quantitative or qualitative color on that?

I'll chime in. Bernard can give more details. But the answer is yes, we do expect upsides. We're not ready to give specific numbers at this point, but there's no question we will both accelerate, meaning bring them in in time and actually have identified more total numbers that we'll be able to deliver.

Thank you, everyone, for joining the call today. We look forward to seeing you at various conferences during the quarter. Thank you.