ON Semiconductor Corp (ON) — Q3 2020 Earnings Call Transcript

Thank you. Good morning and thank you for joining ON Semiconductor Corporation's third quarter 2020 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 of this webcast, along with our 2020 third quarter earnings release, will be available on our website approximately one hour after this conference call, and the recorded webcast will be accessible for about 30 days afterward. The script for today's call and additional information related to our end-markets, business segments, geographies, channels, share count, and 2020 and 2021 fiscal calendars can be found on our website. Our earnings release and this presentation include certain non-GAAP financial measures. Reconciliations of these non-GAAP financial measures to the most directly comparable measures under GAAP are included in our earnings release, which is available separately on our website in the Investor Relations section. During this conference call, we will make projections or other forward-looking statements about future events or the company's future financial performance. The words 'believe,' 'estimate,' 'project,' 'anticipate,' 'intend,' 'may,' 'expect,' 'will,' 'plan,' 'should,' or similar phrases are used to identify forward-looking statements. We want to caution that these statements are subject to risks and uncertainties that could lead to actual events or results differing significantly from projections. Important factors that could affect our business, including those that may cause actual results to deviate from our forward-looking statements, are detailed in our Form 10-K, Form 10-Qs, and other filings with the Securities and Exchange Commission. Additional factors are outlined in our earnings release for the third quarter of 2020. Our estimates or other forward-looking statements may change, and the company has no obligation to update them to reflect actual results, changed assumptions, or other events that may occur, except as required by law. During the fourth quarter, we plan to attend two virtual conferences: NASDAQ's 43rd Virtual Investor Conference on December 1 and Wells Fargo TMT Summit 2020 on December 2. Now, I'll turn it over to Bernard Gutmann to provide an overview of our third quarter 2020 results.

Thank you, Parag, and thank you everyone for joining us today. During the third quarter, we saw strong recovery in business conditions due to sharp acceleration in global economic activity, especially in the automotive market. Order activity has picked up meaningfully across end-markets and geographies. Manufacturers are striving to meet the upsurge in demand, which was previously disrupted by the COVID-19 pandemic. Along with the strong macro-driven recovery of our business, momentum in our key strategic growth areas in industrial, automotive, and cloud-power end-markets is accelerating. Our design wins are accelerating and the design funnel is expanding at a rapid pace. As we stated earlier, gross margin improvement is the primary strategic priority for the company. We are on track with our manufacturing consolidation plans, and discussions are ongoing with various parties regarding the previously announced intended sale of our fabs in Belgium and Niigata, Japan. In the near term, revenue tailwinds from the ongoing recovery in business conditions and favorable end-market mix shift should help drive margin expansion. Now, let me provide you details on our third quarter 2020 results. Total revenue for the third quarter of 2020 was $1.317 billion, a decrease of 5% as compared to revenue of $1.382 billion in the third quarter of 2019. The year-over-year decline in revenue was driven primarily by a slowdown in global macroeconomic activity due to the COVID-19 pandemic. GAAP net income for the third quarter was $0.38 per diluted share, as compared to a net loss of $0.15 per diluted share in the third quarter of 2019. Non-GAAP net income for the third quarter of 2020 was $0.27 per diluted share as compared to $0.33 per diluted share in the third quarter of 2019. GAAP gross margin for the third quarter of 2020 was 33.5% as compared to 34.4% in the third quarter of 2019. Non-GAAP gross margin for the third quarter of 2020 was 33.5% as compared to 35.8% in the third quarter of 2019. The year-over-year decline in gross margin was driven primarily by lower revenue as discussed earlier, and COVID-19 related costs. Our GAAP operating margin for the third quarter of 2020 was 9%, as compared to negative 3.2% in the third quarter of 2019. Third quarter 2019 GAAP operating margin included an impact of $169.5 million related to the intellectual property settlement with Power Integrations. Our non-GAAP operating margin for the third quarter of 2020 was 12%, as compared to 13% percent in third quarter of 2019. The year-over-year decline in operating margin was driven largely by lower revenue and impact on gross margin due to the COVID-19 pandemic. GAAP operating expenses for the third quarter were $322.2 million, as compared to $519.1 million in the third quarter of 2019. Third quarter 2019 GAAP operating expenses included $169.5 million related to the intellectual property settlement with Power Integrations. Non-GAAP operating expenses for the third quarter were $283.6 million, as compared to $314.3 million in the third quarter of 2019. The year-over-year decrease in non-GAAP operating expenses was driven primarily by strong execution on the cost front and by restructuring and cost-saving measures undertaken by the company. The third quarter free cash flow was $101.8 million and operating cash flow was $163.4 million. Capital expenditures during the third quarter were $61.6 million, which equates to a capital intensity of 4.7%. As we indicated previously, we are directing most of our capital expenditures towards enabling our 300mm capabilities in the East Fishkill fab. We expect total capital expenditures for 2020 to be in the range of $370 million to $390 million. We exited the third quarter of 2020 with cash and cash equivalents of $1.654 billion, as compared to $2.06 billion at the end of second quarter of 2020. The decline in cash balance was primarily due to a pay down of amounts drawn under our revolving debt facility as a precautionary measure in response to the COVID-19 pandemic. At this time, with a cash balance of approximately $1.6 billion, we are very comfortable with our liquidity position. In the fourth quarter, we expect to use approximately $690 million to pay off our 2020 convertible note principal at maturity. At the end of the third quarter, days of inventory on hand were 133 days, down 7 days as compared to 140 days in the second quarter of 2020. In the fourth quarter, we intend to continue to reduce our balance sheet inventories. Therefore, we plan to run our factories at current levels of utilization, despite expected higher revenue levels in the fourth quarter. In the third quarter, distribution inventory decreased by approximately two weeks as sales through the distribution channel increased significantly quarter-over-quarter. Instead of shipping products in the distributor channel for revenue, we brought down channel inventory, even though it was within our comfort zone. 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 for the third quarter was $647.4 million. Revenue for Advanced Solutions Group or ASG, for the third quarter was $494.6 million, and revenue for our Intelligent Sensing Group or ISG, was $175.3 million. Now, I would like to turn the call over to Keith Jackson for additional comments on the business environment.

Thanks, Bernard. Let me first update you on our manufacturing optimization plans, and then I will provide an update on the current business environment. We are in discussions with various parties regarding the planned sale of our Belgium and Niigata fabs. We are working diligently to get a quick resolution on these fabs, but we do not have an announcement to make at this time. The process for ceasing operations of our fab in Rochester, New York, is progressing as per plan, and we expect to begin seeing annual savings of $15 million starting in the first quarter of 2021. We achieved a major milestone in the third quarter as we recognized our first revenue from our 300mm products. We continue to make solid progress in our manufacturing transition to 300mm fab in East Fishkill, New York. As I have indicated earlier, yields for our 300mm manufacturing processes have been spectacular, and we expect to see a meaningful positive impact on our gross margin as our 300mm manufacturing ramps in the coming years. Additionally, our 300mm manufacturing capability in East Fishkill fab has afforded us significant flexibility, which has enabled us to optimize our network. We continue to make substantial progress in our key initiatives to expand gross margins. We are driving a shift towards higher margin products by aggressively winning designs in automotive, industrial, and cloud-power end-markets. At the same time, we continue to optimize our portfolio to drive margin expansion. The fundamentals of our cost structure remain unchanged. With ongoing recovery, as our revenue and factory utilization increase, we expect to see a meaningful increase in our gross margin. The benefits from manufacturing optimization, mix shift, and portfolio optimization should be additive to the fall-through we see from incremental revenue. Now, let me comment on the current business environment. We have seen a meaningful acceleration in order momentum in the third quarter, and we expect that business activity will continue to grow at above seasonal levels in the near term. Along with an improving global macroeconomic environment, our accelerating design-wins in automotive, industrial, and cloud-power end-markets are key contributors to our momentum. From a geographic perspective, we are seeing acceleration in demand from all regions. Economic data such as PMI and GDP point towards a strong recovery in industrial activity and in the overall business environment across the globe. Although the COVID-19 pandemic temporarily affected our business, the underlying fundamentals of our business and secular trends driving our business remain unchanged. We continue to see strong momentum in key strategic initiatives for electric vehicles, robotics, factory, and warehouse automation, cloud-power, and ADAS. We are well positioned to benefit from the ongoing recovery with our highly differentiated power, analog, and sensor products, which enable key secular trends in automotive, industrial, and cloud-power end-markets. Now, I’ll provide details of the progress in our various end-markets for the third quarter of 2020. Revenue for the automotive market in the third quarter was $419.2 million and represented 32% of our revenue in the third quarter. Third quarter automotive revenue declined by 6% year-over-year, primarily due to the COVID-19 driven decline in automotive production. We are seeing strong momentum for our Silicon Carbide offerings with additional design wins at leading OEMs and tier-1 customers. In addition to winning new designs, we are expanding our engagement with new customers for Silicon Carbide, and we are currently sampling products to many of these customers. On the ADAS front, we continue to win designs with major global automotive players. We are also seeing a higher level of attach rates for both ADAS and viewing applications. We are very well positioned to benefit from the technology transition in automotive LiDAR to newer SiPM and SPAD technologies from APD technology, and we are seeing strong traction for our LiDAR products with leading customers. Other areas of automotive were strong as well in the third quarter. We saw strong growth in our lighting, ultrasonic, and actuator solutions. From a geographical perspective, we saw strength across all regions. Despite a steep increase in automotive production, it appears that dealer inventories are low. We expect the current recovery in global automotive production to continue in the near term. Based on our outlook and third-party reports, we believe that our 2020 annual automotive revenue growth rate should exceed the 2020 global light vehicle annual production growth rate by a wide margin. Revenue in the fourth quarter of 2020 for the automotive end-market is expected to be up quarter-over-quarter as we expect to see continuing recovery in global automotive production. The Industrial end-market, which includes military, aerospace, and medical, contributed revenue of $327.6 million in the third quarter. The Industrial end-market represented 25% of our revenue in the third quarter. Year-over-year, our third quarter industrial revenue declined by 7%. This decline was driven by reduction in global industrial activity due to the COVID-19 pandemic and geopolitical issues related to a specific customer. In the Industrial end-market, we are seeing strong adoption of our Silicon Carbide modules for solar power-related applications, and we are rapidly expanding our customer base in the alternative energy market. On the Industrial power front, we are seeing increasing design activity for motor control and building automation. Energy efficiency regulations that are slated to be enacted in 2021 and beyond are driving power management and motor control-related activity. Our medical business grew strongly quarter-over-quarter in the third quarter as the pace of elective procedures picked up. We continue to work with leading market players to design our image sensors for automation and machine vision applications. We have secured additional design wins for large format image sensors for professional movie camera applications. Revenue in the fourth quarter of 2020 for the industrial end-market is expected to be up quarter-over-quarter. The Communications end-market, which includes both networking and wireless, contributed revenue of $255.4 million in the third quarter and represented 19% of our revenue during the third quarter. Third quarter communications revenue declined by 7% year-over-year. We saw strong year-over-year growth in our 5G infrastructure business in the third quarter. Our Smartphone business declined year-over-year, in part due to geopolitical factors related to a customer. Revenue in the fourth quarter of 2020 for the communications end-market is expected to be flat to down quarter-over-quarter, due to expected revenue decline from customer-specific geopolitical factors. The Computing end-market contributed revenue of $172.2 million in the third quarter. The computing end-market represented 13% of our revenue in the third quarter. Third quarter computing revenue increased by 12% year-over-year due to strength in both server and client businesses. We are seeing strength in our server power business with increasing content in new server platforms and share gains. Most leading processor makers are projecting higher current requirements in their next generation products. We expect this trajectory to continue in the near to mid-term due to increased demand for computational capabilities, driven primarily by artificial intelligence. Revenue in the fourth quarter of 2020 for the computing end-market is expected to be up quarter-over-quarter. The Consumer end-market contributed revenue of $142.9 million in the third quarter. The consumer end-market represented 11% of our revenue in the third quarter. Third quarter consumer revenue declined by 9% year-over-year. The year-over-year decline was due to broad-based weakness in the consumer electronics market due to the COVID-19 pandemic and our selective participation in this market. Revenue in the fourth quarter of 2020 for the Consumer end-market is expected to be up quarter-over-quarter. In summary, we are accelerating our efforts to drive margin expansion. We are rationalizing our fixed cost footprint. At the same time, we are also aggressively winning designs to drive a mix shift towards automotive, industrial, and cloud-power end-markets, which have higher margins. The ramp-up of our 300mm manufacturing processes at East Fishkill fab should further help in gross margin expansion. In the near term, strong revenue growth driven by ongoing recovery in our business should contribute to margin expansion. Business conditions have improved meaningfully and we expect the improvement to continue in the near term. We are seeing broad-based recovery across most end-markets and geographies. Key secular megatrends and long-term drivers of our business remain intact, and we are excited about our medium to long-term prospects. We are seeing accelerating momentum in our key strategic initiatives for electric vehicles, robotics, factory and warehouse automation, cloud-power and ADAS. Now, I would 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 level, we anticipate that total ON Semiconductor revenue will be in the range of $1.3 billion to $1.4 billion in the fourth quarter of 2020. For the fourth quarter of 2020, we expect GAAP and non-GAAP gross margin between 32.9% to 34.9%. We expect total GAAP operating expenses of $315 million to $333 million. Our GAAP operating expenses include the amortization of intangibles, restructuring, asset impairments, and other charges, which are expected to be in the $32 million to $36 million. We expect total non-GAAP operating expenses of $283 million to $297 million in the fourth quarter. The expected increase in our fourth quarter operating expenses as compared to those in the third quarter is driven by the planned reinstatement of salaries and benefits that were reduced due to a decline in our business resulting from the COVID-19 pandemic. In our 2020 operating expenses, the variable component of compensation was not significant. However, as we enter into 2021, we plan to accrue meaningful variable compensation with the expectation that 2021 will be a strong year. Consequently, we expect an increase of about $25 million to $30 million quarter-over-quarter in our operating expenses in the first quarter of 2021. We anticipate fourth quarter of 2020 GAAP net other income and expense, including interest expense, will be an expense of $41 million to $44 million, which includes the non-cash interest expense of $9 million to $10 million. We anticipate that net other income and expense, including interest expense, will be an expense of $32 million to $34 million. Net cash paid for income taxes in the fourth quarter of 2020 is expected to be $22 million to $28 million. For 2020, we expect cash paid for taxes in the range of $52 million to $58 million. We expect total capital expenditures of $100 million to $120 million in the fourth quarter of 2020. We are currently targeting an overwhelming proportion of our CapEx for enabling our 300mm capability at an accelerated pace. We expect share-based compensation of $16 million to $18 million in the fourth quarter of 2020, of which approximately $3 million is expected to be in 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 GAAP diluted share count for the fourth quarter of 2020 is expected to be in the 425 million to 426 million shares, based on our current stock price. Our non-GAAP diluted share count for the fourth quarter of 2020 is expected to be 413 million shares, based on our 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, respectively. With that, I would like to start the Q&A session. Thank you.

Hi guys, congrats on the results, and thanks for letting me ask you a question. I want to focus both my questions on margin. So, the first one is on the gross margin side of things, I see that you're guiding to about a 50% incremental gross margin in the fourth quarter. Given that you're not changing utilization, I understand that, but I guess first, why aren't you changing utilization given the strength in the business? And then if we go beyond the first quarter, can you just talk about how the fab closures, the utilization increases, and the 300 millimeter ramp all layer into the gross margin? Because I would assume that would need to be above that 50% incremental that you've guided to historically and even in the fourth quarter.

Hi. Thank you, Ross, for your questions. This is Bernard. We are also intending to continue working on our inventory in the inventory. We don't plan on increasing our utilization substantially to keep working on that. And you're correct as we start getting the benefits of the factory closures. We have talked about $75 million of annual savings coming from those closures or sales. The Rochester closing is on its way to being completed. As a result, we expect to get about $15 million of that annual savings starting in the first quarter of 2021. The other two are a function of when we end up and what we end up negotiating with the intended buyers of these fabs, and that's ongoing and in progress right now. So, yes, the answer is yes, we should expect to see better than 50% fall-through as we go throughout 2020.

Great, thanks for those details. And then as my follow-up question, again, sticking on the margin front and moving to the expense side of things. I think everybody understands why you had variable compensation down this year, and why it would step up sequentially in the first quarter. But if I look at a year-over-year, it's basically flat is what's your guiding, there might have been some COVID-related impacts in the first quarter of 2020. But given the structural changes and cost cuts you guys announced earlier this year, I'm still struggling to figure out why the guide for OpEx in the first quarter of 2021 would be flat year-over-year.

As mentioned in our prepared remarks, we did not have any variable compensation in our orders for 2020 and 2019. We took significant cost reduction measures, some of which were temporary and others permanent. The variable compensation will be contingent on the results from next year. If we experience a strong year, as we are currently assuming, there will be a notable increase in variable compensation. However, if the year does not trend positively, then it will not increase.

Hey, guys, just a quick clarification on the gross margin. So, why was it 50 basis points better than the guide? Was that all revenue upside, or was there some mixer pricing or something else that was driving it higher?

Mostly revenue upside.

Got it. And then any update on the CEO search?

It's ongoing and there's nothing to announce at this time.

Yes. Thank you. Good morning. Just a question on inventory and what you're planning on doing with production. Could you give us a sense of where you would like both the channel inventory and your internal inventory to get to before you would increase utilization? And generally, what's the reason for the more cautious approach to inventory right now?

So, the inventory we have on the channel, we said in the prepared remarks, we took it down two weeks where we are within our comfort range, so we feel good going into next year that we’ve been at an appropriate level for that. In general inventories, we peaked in the second quarter to 140 days, decreased to 133 days in the third quarter and we think there's still room to continue gradually decreasing it into the fourth quarter.

All right. Following up on the automotive market, it seems like you're currently experiencing a decline in the mid-to-high single digits year-on-year. Last quarter, you mentioned that you expected customers to reach full production in the second half of the year. Can you provide an update on that? How are your customers performing in terms of their production? Additionally, what is the difference between their progress towards normalcy and your own year-on-year decline? Once you reach a flat year-on-year performance, how do you anticipate growth taking place?

Yes. We believe that auto customers will be operating at levels similar to pre-COVID in the fourth quarter. The main difference, if there is one, would be changes in inventory within the supply chain. There was definitely some caution in the supply chain during the COVID-19 pandemic, and I expect that in 2021 it will begin to replenish even beyond our own rates.

Yes. Thank you and congrats as well on solid results. Regarding the momentum in the automotive business, you talked about outgrowing auto production by a wide margin. Obviously, we're going to see a rebound in auto production post-COVID, but on top of that, what's driving the wide margin commentary specifically in sensors and EV? Any color there would be helpful in terms of how much semiconductor content you're going to layer on top of that rebound production?

Yes. So I think you know the two topics. From an ADAS perspective, we're seeing a significant amount of the production move to level two, which has quite a bit more dollar content. It kind of goes from $10 at level one to $150 at level two, so we're seeing that transition would drive very significant growth above the SARS rate. And then, on the electric vehicles, now, there will be more electric vehicles still dominated by internal combustion, but nonetheless, more vehicles. And again, the content there goes from, you know, $40, $50 bucks up to $500. So those – if you look at both of those things, there were an order of magnitude change. And so, as a result of that, we would expect a very significant outgoing.

And just for my follow-up, I know you can't provide more guidance, but if we're looking at gross margin trajectory, if you look at the margins in 2019, you know, they were kind of at 36% for the year. And obviously, it took a big dip in the first half of this year because of COVID. But you're kind of moving back. So, how do we think about, you know, the margins in 2021 getting back to kind of normal, maybe more normalized levels, what we saw in 2019, and then, kind of moving beyond that? Is there really going to be a function of revenue? I know you talked about the closure of that fab, but should we be expecting to get back to kind of 2019 levels and beyond as we progress into 2021?

It depends on a lot of factors, but the same premises that we have put forth in the past holds true. We do expect the 50% fall-through on just a few of revenue changes and expect that 2021 will be a good year in terms of revenue. We will layer on top of that mixed savings with the premise that our revenue growth in automotive and industrial and cloud power, which all have better than corporate average gross margin, will contribute to be taped to some gross margin and as mentioned earlier, in response to another call – question, we do expect to get the savings from the fab sales or closures that we have announced previously. And last but not least, we do still have some lingering COVID costs in our numbers. We expect that most of those will take a while to get those logistics and freight costs, as the pressures on that ease out, we should also get a little bit of tailwind in addition to what I just mentioned.

Yes. Hi, good morning, guys. Just a couple of questions here. On the distribution side, I know you talked about September quarter distribution inventory coming down two weeks. Typically, Q4 inventories go down and I was just wondering what you're seeing in terms of distributor inventories exiting Q4 versus where normal levels are? Thanks.

I'm not sure I got all of that question. Audio issues on our side, but we brought the distribution inventory down in the third quarter to kind of the low-end of our normal operating ranges. So, we're not looking to take it down substantially from there, but kind of hold it toward that lower end. We think this does give us more flexibility, particularly if the market is more robust than we're seeing right now. So that's the plan. Did that get your question, Vijay?

Yes, it does. Thanks a lot. And one other question here. On the gross margin side, obviously, you know, there's some near-term costs, logistics, COVID-logistics costs and operational costs. Just wondering what the headwinds from those are? And do you see those subside as you go into the first half next year? Thanks.

Yes, definitely much less than what we had in the first and second quarters. The lingering costs are more logistics. It will normalize when we see airlines flying again, so that's mostly commercial. So that's a big question mark. So, probably, it's going to be more protracted. But it's much less than what we had seen in the first half of the year. So, it's just some lingering headwinds, not significant.

Hey, guys. Thanks for the question. I guess first following up on the automotive side of things and silicon carbide, can you talk about the pipeline there after your win on silicon carbide? And then, also, how we should think about IGBTs and your position there?

So, we continue to see wins for both IGBTs and silicon carbide. You know, it's maybe oversimplified, but in the lower lifetime or smaller cars, the IGBT is still the dominant solution. In the more powerful cars designed with much longer range silicon carbide is becoming the predominant solution. So, we have wins at many different Tier 1s and OEMs at this stage for both IGBT and silicon carbide.

Great. And I was wondering if you could give us an update on your footprint consolidation. I guess, any update on Belgium and any other updates in terms of targets or potential opportunities?

In Belgium, we are having, what I would call, the final round of negotiations right now, and expect that we – during the quarter, we'll be able to find solutions there. In Niigata, there's still process ongoing, you know, probably ease into the New Year.

Yes. Thanks so much for taking the questions. And I'll just ask a couple of follow-ups. First on gross margins, so it's clear that it's hard to handicap the exact timing of a fab sale, but, gentlemen, I'm wondering if you can just help us scope the amount of the $75 million in COGS efficiency gains that you'd expect to get in calendar 2021, not by quarter, but just overall? How much of that could be realized in 2021? And then, how much would come through in calendar 2022?

It's a tough question, Craig. Definitely, we can talk about the Rochester one, which is the first $50 million that will start immediately in Q1. The other is still a function of what we end up negotiating with the buying parties in terms of MSA that will drive what those savings are. Typically the closure of a fab takes somewhere in the 18 months to 24 months, but obviously, we have been already working on it.

Got it. And then, if I could just bundle two follow-ups together, Bernard. The first is to Ross' question, beyond the first quarter, which not only would include discretionary comp, but also things like FICA, what should we expect from 2Q through 4Q? Do you actually get some OpEx decreases in the back half of the year as FICA goes away? And then, with the debt pay down in the fourth quarter, the convert, what should we expect for interest expense in the first calendar quarter?

Let me start from the last question first. Interest expense, we tend to continue paying down debt as we generate the good amount of free cash flow next year, so it's just a function of how much that debt paid down. Definitely, the pay down of the $690 million will be a little bit of interest away. So, I expect the trend of interest expense to go down over time. The OpEx trend, we expect this step function improvement or increase in OpEx in the first quarter. And indeed, you're correct. In addition to that, there is within that assumption a timing or seasonality of FICA in other U.S.-based payroll expenses. So, I don't expect that the expenses will go up more materially for the rest of the year. They may trend mostly flat.

Hi, this is Josh Buchalter on behalf of Matt Ramsay. Congrats on the results. And Keith, congratulations on your retirement. I guess I wanted to start on the – on the last call, you mentioned you weren't expecting to see any under-utilization charges in the second half. Can you confirm it, you know, this is still the case given you're keeping utilizations flat and inventory sounds like they are going to trend downwards?

Yes, obviously with the disclaimer that we don't control what governments do. So, at this stage, we don't expect there is no mandated shelter in place – mandates from governments. So if that continues, which we expect it to we will not see any additional COVID-related expenses.

No. We continue to be excited about that addition to our network. And so, from that perspective, we continue to get qualifications of products, processes, and customers in there, and continue to enjoy the ramp that we envision. The only change I would get is maybe a little more acceleration on closure of some of the other factories that have been brought about by the overall lower environment that COVID brought.

Hi, good morning. Thanks for taking the question. I had two as well. First of all, you guys talked about geopolitical factors having impact on your business in Q3 and I do believe in your Q4 guidance as well. If you could confirm how meaningful the headwinds were associated with geopolitical factors in Q3, and what's embedded in your Q4 guidance, that would be helpful? Thank you.

In Q3, there certainly was an impact, but, you know, primarily in Q4 until licenses are granted, the answer is there's no business at all and they were one of the top customers.

Got it. And then, as a quick follow-up, I wanted to double click on gross margins as well. In the past, you guys have talked to a 40% plus long-term target for gross margins. I guess is that still the case? Is that still very much intact? And to the extent it is, I was hoping you could rank order the drivers that get you there? I think throughout this call, you've talked about, obviously, Rochester, which is done. You've got Niigata, Belgium. You're rationalizing or optimizing your portfolio. You've got the 300-millimeter transition. And obviously, you've got the COVID costs, which hopefully go away over time, so if you can rank order some of the drivers as you think about gross margin expansion over the next couple of years that would be helpful. Thank you.

Pretty much summarize that very well for us. Thank you. Definitely, when we did our model, which actually was 43%, and we predicated on a $7.1 billion revenue, we believe that that still holds true. So, we do have a good amount of catch-up from different levels of 5.15 to that level with the fact that we have a good fall-through on that that still holds true. The footprint consolidation as well as the benefits of the 300-millimeter fab will also be a significant factor and mix, as a third one is the one that will help us get there.

Yes. Hey, guys. Congratulations first of all, two questions. First of all, would you be able to give us some color on particularly the automotive and industrial markets? I know you said they should be up, but maybe help us think about how we should think about modeling them? And then, another part of that same question, you talked about distribution and mentoring auto, how many weeks excess do you think, if at all, there is in the system, particularly in auto?

Okay. I'll start with automotive. I believe that distribution and the overall supply chain there do not have excess inventory going into the fourth quarter; that's mostly been addressed. If anything, we may have underestimated the demand, which sets us up for replenishment next year. The automotive market's supply chain is currently efficient, and I don't see any significant issues. As I mentioned earlier, we expect auto production rates in the fourth quarter to be similar to those in 2019, which indicates improvement compared to the third quarter. From an industrial perspective, we are seeing a recovery as well. We think that the excess supply has largely been removed from the channel, but we do not observe any signs of rebuilding, indicating a moderate recovery in the industrial sector. Most of the production in those two specific factories is going to our other internal fabs. We are selectively transferring high-volume products from the other internal fabs to East Fishkill, which involves a two-step process. Currently, we have full ownership and operation at one site, while we're still ramping up production at the second site, which we just began to ramp up in the third quarter.

Hi, thanks for taking my question. I had a question about the process of shutting down or selling a factory. When you're transferring parts from your old facilities to your new facilities, can you describe what the qualification process is like? How long does that take? Or is it a matter of practice for you that you primarily make it in one factory? You also are always qualifying them at other factories just for redundancy sake and that's not a big deal to re-qualify parts. That's the first question, I have a follow-up too.

Okay. So for the first one, most of our high volume processes have more than one factory to run in, just from a supply chain risk perspective. For those products, in essence, take the specific products that you're running, that may not be in the alternate factory, you have to run some reliability tests and you have to run those by your customers. And for those processes, it's anywhere from 182 days to a year. For other processes that don't have as much volume, you do have to first bring up the process in the new factory. That can take anywhere from nine months to a year, then you have to run the same qualification, so that gets you kind of out in the two-year range for that. We had started moving things for the factories that we're talking about here before we announced those transactions. And so, we're well into that second phase now of getting the customers qualified. By the selling of the factories, in our customer agreements, there will be some amount of time required. We will still take product from those factories, but you're now down into that kind of 18 months or so range.

Got you. That's very helpful. And longer-term, Keith, to you – as you work your way to your gross margin bogey, did you think that translates to a higher internal mix of or a higher outsource boundary mix on the front end?

So, the front end, yes, the front end part will become more external, but that's less to do with consolidation and more to do with some of our fastest growing products that use boundaries for.

Morning, and thanks for taking my question. Has the East Fishkill fab in auto grade qualified? And if not, when do you expect to achieve qualification? And then, in terms of revenues today from Fishkill, what products and end-markets are you shipping into?

So today, we're shipping primarily into industrial with some automotive content out of EFK. So, we are qualified for both.

Great. And then, Keith, with 13-weeek to 15-week lead times on average, you know, you guys are booking into the March quarter. You also have a good view on customer forecasts as well. I believe normal seasonality for the team is flat to down a couple of percentage points in March. You talked about above seasonal demand trends near term, wondering if you're seeing this in the orders for the March quarter.

Yes. Orders are good and the comments we've made on above market, the seasonality will extend past this year.

Yes, thanks. So let me ask the question. Keith, maybe just a follow on there to Harlan’s second question, when you think about the calendar first quarter, is there enough leverage above seasonal revenue growth and gross margin leverage that you can have op margins be flattish, despite the increase in OpEx? And if that's not the case, why isn't variable comp more tied to profitability? Why not wait until later on in 2021 to re-establish some of the variable comp?

So, we really don't want to give guidance for Q1. We do it one quarter at a time. What I will tell you is certainly, we would expect revenues to continue to increase nicely throughout next year. And the way accounting works, you have to accrue for the entire year at the expected rate for the year even though you may have a quarter somewhere in there that doesn't fully meet the objectives. The answer is yes, we have wide margins. As I mentioned, the drivers are an increase in level 2 cars with ADAS and a higher percentage of electric vehicles. From a SARS perspective, we aim to be conservative and expect to return to 2019 levels next year on a SARS basis. However, we believe we have been outperforming overall SARS in 2020. The supply chain has become leaner, which impacted some of that margin. But as I mentioned earlier, in 2021, we anticipate some re-stocking will be necessary to achieve the appropriate four levels.

Thank you for taking my question. Keith, I have a conceptual question about gross margins. When I examine gross margins in the power discrete industry, they typically range around high 30%, even for the largest companies in this field, like Infineon, which have been operating 300-millimeter fabs for a considerable time. Historically, gross margins have never really surpassed 38% or 39%, and even then, quarterly revenues were significantly higher than what we see now. So, how much of the gross margin dynamics are simply a consequence of selling specific types of products? This suggests there might be a cap on how much we can increase gross margin, regardless of revenue levels, fab closures, or 300-millimeter capabilities. I wanted to present this hypothesis to you.

So, simple answer there is when we gave our expectations for being able to reach 43%, it fully comprehended the product mix and market mix that we see here. And while there was some number of bips, which we disclosed on mix per se, but from a product perspective, we still think we can get over 40. It does take a leaning out of our manufacturing, which we are in the process and getting the utilization rates up. But we don't think inherently that the power business is stuck in the 30s. We definitely think we can get that into 40s. The other piece of that equation is a lot of the new EV stuff is in modules and there we think the opportunity for the modules is for a better margin than the discrete devices.

Got it, very helpful. And, Keith, as my follow-up, in terms of the competitive landscape, just given U.S. and China trade tensions, do you see any headwinds to gaining share in China i.e., that share perhaps going more to your European or Japanese competitors? Like have you – other than Huawei, have you seen any effect of trade tension so far? Or do you anticipate any effects going into next year? Thank you.

I think there will be more reluctance for customers to accept sole source positions from U.S.-based companies as a result of the trade tensions. I still think they're very wise economic buyers and they're going to do the best thing for their company, but they certainly don't want to be completely reliant on the U.S. supplier. We certainly saw at the account you mentioned elsewhere. We have not seen it.

Hi, good morning, and thank you for taking my question. Keith, are you noticing anything regarding raw material suppliers or foundry supply, especially as it relates to what you've heard from distributors? There's been some news about potential pre-buying of materials or capacity for next year due to trade tensions. Are you expecting any effects going into next year? Thank you.

We have noticed some constraints, particularly with substrates in the communications market, which seems to be a common issue. The growth in that area appears to be lagging behind the overall market. Additionally, there are specific tight spots in the foundry market. However, in general, the supply chain remains in good condition.

Yes, I had a question on silicon carbide. Naturally, a lot of the discussion is around EVs, but Keith, from an industrial perspective, can you talk about any interesting applications or opportunities you see in the industrial market?

Yes. We're seeing big pickup in solar energy. The pickups that you get there from an efficiency perspective are pretty significant. We have an opportunity for about $650 worth of silicon carbide there. And then, in EV charging, so not the traction inverters, but actual charging stations, we're also seeing opportunities for up to $500 there.

Got it. And then, just a follow-up on just the geopolitical issues with the customers, is that something that you expect? Ultimately, revenue will go to another OEM and that could be opportunity at some point next year?

The way the rules are written, it's unclear. Anyone can ship without a license. And so, that's at least our interpretation. And so, I think right now, the license process is most critical to answering who might be providing this, and we should benefit the widening in our approach.

Thank you for taking my question. Keith, I have a conceptual question about gross margins. When I examine gross margins in the power discrete industry, they seem to be at their best around the high 30% range, even for the largest companies in the field, like Infineon, which have been operating 300-millimeter fabs for a considerable time. Historically, gross margins haven’t really surpassed 38% or 39%, and even during those times, quarterly revenues were significantly higher than current levels. So, to what extent are the gross margin dynamics influenced by the types of products being sold? It suggests that there might be a limit to how much gross margin can be increased, regardless of revenue levels or fab closures or 300-millimeter capability. I wanted to share this hypothesis with you.

So, simple answer there is when we gave our expectations for being able to reach 43%, it fully comprehended the product mix and market mix that we see here.

Yes, thanks. So let me ask the question. Keith, maybe just a follow on there to Harlan’s second question, when you think about the calendar first quarter, is there enough leverage above seasonal revenue growth and gross margin leverage that you can have op margins be flattish, despite the increase in OpEx?

So, we really don't want to give guidance for Q1. We do it one quarter at a time. What I will tell you is certainly, we would expect revenues to continue to increase nicely throughout next year. And the way accounting works, you have to accrue for the entire year at the expected rate for the year even though you may have a quarter somewhere in there that doesn't fully meet the objectives.

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