ON Semiconductor Corp (ON) — Q3 2021 Earnings Call Transcript

Thank you, Brent. Good morning and thank you for joining ON Semiconductor's Third Quarter 2021 quarterly conference call. I am joined today by Hassane El-Khoury, our President and CEO, and Thad Trent, our CFO. This call is being webcast on the Investor Relations section of our website at www.onsemi.com. Immediately after this webcast, our 2021 third quarter results will be readily available on our website approximately one hour following this conference call. The recordings will be available for approximately following this conference call. Additional information related to our end markets in these segments, geographies, channels, share count, and 2021 and 2022 fiscal calendar is also posted on the Investor Relations section of our website. Our earnings release and this presentation include certain non-GAAP financial measures. The reconciliation of these non-GAAP financial measures to the most directly comparable measures and GAAP are included 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 financial performance of the Company. The words believe, estimate, project, anticipate, intend, may, expect, will launch soon, 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 that can affect our business, including factors that could cause actual results to differ from our forward-looking statements are described in our most recent Form 10-K, 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 2021. Our estimates or other forward-looking statements may change, and the Company has no obligation to update forward-looking statements to reflect actual results or other elements that may occur except as required by law. Now, let me turn it over to Hassane.

Thank you, Parag, and thank you everyone for joining us today. We delivered yet another quarter of record results driven by exceptional execution by our worldwide teams and strong demand for our Intelligent Power and Sensing products. We posted record quarterly revenue and non-GAAP operating margin and EPS. With our results and outlook, we have made a solid start towards achieving our financial target model. Even though our Q3 results and Q4 outlook significantly exceed expectations, we believe that we are just in the early innings of transforming the business. As we make further progress in our transformation initiatives and as our Intelligent Power and Sensing design win with automotive and industrial customers, we expect to see sustained revenue growth and margin expansion. Today we announced the close of our acquisition of GT Advanced Technologies, or GTAT. As we outlined at our Analyst Day, our goal is to provide our customers in the industrial and automotive end markets with highly differentiated intelligent power and sensing solutions, and we are investing to achieve that goal. With GTAT's market-leading silicon carbide substrate technology, ON Semiconductor is now the only silicon carbide player in the industry with end-to-end capabilities encompassing modules, devices, and substrates. Our acquisition of GTAT has been a catalyst for key automotive customers to engage in long-term strategic partnerships with us, and we can expect GTAT to be a critical enabler of our impending ramp in our silicon carbide business. In fact, in Q4 2021, we will be shipping silicon carbide product-based revenue utilizing the GTAT substrate. I am also excited to announce that GTAT has delivered 200 millimeter wafers, which we have processed at our ON Semiconductor manufacturing facility, and we'll be sampling our first devices in January 2022. We welcome the GTAT team to the ON Semiconductor family and look forward to expanding its capacity to support our silicon carbide growth plans. On a year-to-date basis, our power design win funnel grew by 75% year-over-year. At the end of the Third Quarter, we have signed a long-term supply agreement with a committed revenue of $2.5 billion over three years for our Power Solutions. Over $2 billion of this committed revenue is for our silicon carbide solutions for automotive and industrial applications, and two-thirds of this committed revenue is for traction inverters for electric vehicles. We expect to exit 2023 with a silicon carbide revenue run rate of about $1 billion. The demand for our Intelligent Power and Sensing Solutions in our strategic end markets continues to outpace our current supply capability. The strength in demand is driven by secular mega trends such as vehicle electrification, ADAS, industrial automation, and the transition to alternative energy from fossil fuel-based power generation. For the third quarter, automotive and industrial end markets together grew 42% year-over-year. On a year-to-date basis, our design win funnel for these end markets grew 55% year-over-year, giving us excellent visibility into future revenue. In addition to secular factors, demand for our products is being driven by the industry-leading performance of our products in both Intelligent Power and Sensing. Consistent with our strategy outlined at our Analyst Day, we are driving a shift towards automotive and industrial end markets to drive margin expansion. For the third quarter, automotive and industrial together contributed 60% of our revenue compared to 56% in the quarter a year ago. And we will continue phasing out low-margin non-core revenue into next year. Looking forward, we expect demand to remain robust and outpace supply through most of 2022. We are selectively investing in our operations to relieve capacity bottlenecks for our strategic product lines while working with our foundry partners to obtain a higher allocation of capacity. At the same time, we are shifting our production to a strategic high-value mix of products. Longer-term, we are qualifying products and the 300-millimeter Fishkill facility to increase the efficiency of our fab network while executing our fab lighters strategy. Along with expanding supply, we are working collaboratively with our customers to ensure an uninterrupted supply of our products, and we have entered into long-term supply agreements with many of them. These long-term supply agreements commit a multiyear revenue stream with stable and sustainable margin. Coupled with our expanding design win pipeline in the automotive and industrial end markets, we have outstanding visibility into our revenue and margin in support of our target model. Along with entering into long-term supply agreements, many of our largest automotive and industrial customers are co-investing with us. These investments solidify the strategic nature of our long-term supply agreements and enable us to support our customers by ensuring supply and providing development support. Let me now discuss a few highlights of our key strategic markets, starting with automotive. We set a record for our automotive revenue in Q3 of $575.6 million. Automotive represented 33% of our revenue in Q3 and grew 37% year-over-year and 4% quarter-over-quarter. The strength in automotive was driven by both our Power and Sensing product categories. We are seeing strong momentum in our electric vehicle business for both silicon carbide and IGBT-based solutions. We have signed long-term supply agreements for committed revenue for electric vehicles of a little less than $2 billion over the next few years, starting to ramp in Q4 2021 and approximately doubling year-over-year for the next few years. Over 80% of this committed revenue is for silicon carbide solutions for EV traction inverters. As we have indicated earlier, in addition to the industry-leading performance of our products, a key source of our differentiation is our expertise in packaging, which is critical for improving heat dissipation, increasing power output at a smaller footprint than our closest competitor, and reducing weight and cost of a power module. The efficiency of our modules allows our customers to make lower trade-offs between the cost of battery and the range of the vehicle; they get both. Our automotive imaging revenue grew more than 10% quarter-over-quarter and 45% year-over-year. We continued to see momentum in automotive safety with new design wins and increasing content for our CMOS image sensors and power management. Year-to-date, our automotive imaging design win funnel grew by 75% year-over-year. As systems shift to higher pixel density and the need for automotive safety requirements around power management increases, our content will increase as these solutions have higher ASP. The increase is further compounded by a higher number of sensors and power ICs per car and the increasing number of cars with active safety features. The industrial end market, which includes military, aerospace, and medical, contributed revenue of $478.5 million in Q3, representing approximately 27% of our revenue. Our third-quarter industrial revenue increased by 48% year-over-year and 11% quarter-over-quarter, driven by strong demand for our Intelligent Power and Sensing Solutions. We are seeing more than 2x growth in our design win funnel from alternative energy customers for our Power Solutions and expect the alternative energy market to be a long-term driver for our business as utility-scale power plant installations are expected to grow worldwide to reduce the climate impact of fossil fuel-based power plants. Industrial power tools are another area of growth, as power tools transition from brushed motors to brushless motors and from AC to battery-powered, both trends driving significantly higher content for us. The demand for our imaging products in industrial automation applications remained strong with a 20% quarter-over-quarter growth. Industrial customers are investing in automation at an increased pace to improve efficiency and to reduce volatility and operations due to social distancing mandates and labor shortages. We have leveraged our experience in automotive to offer our industrial customers rugged, high-resolution, and high image quality sensors for the most demanding industrial applications.

Thanks, Hassane. I'm pleased to announce yet another quarter of record results. As Hassane mentioned, we posted record quarterly revenue and record non-GAAP operating margin and earnings per share while generating free cash flow margin of 20% for the quarter. All three of our business units reported record quarterly revenue, and our targeted automotive and industrial end markets grew sequentially, achieving record revenue levels. With a rapidly expanding design win funnel of Intelligent Power and Sensing Solutions and ongoing structural changes for our business, we are well positioned to make sustained progress towards our targeted financial model. While the ON Semiconductor team has accomplished a lot in a short period of time, we have significant opportunities ahead of us to drive sustained revenue growth and predictable financial performance. From a revenue perspective, we are in the early innings of the ramp in our vehicle electrification business and expect to see significant drivers of our long-term growth complemented by increasing demand for ADAS, industrial automation, and alternative energy. We're pleased with our performance thus far and remain focused on margin expansion as we execute our transformation initiatives, including portfolio optimization and our fab-lighter strategy. Turning to the results for the third quarter. Total revenue for the third quarter was $1.74 billion, an increase of 32% over the third quarter of 2020, and a 4% increase quarter-over-quarter. The sequential revenue growth was driven by our ability to increase our supply both internally and externally, shipping 3% more units than in Q2, along with favorable mix and pricing across all end markets. Revenue for our Intelligent Power and Sensing products were also at record revenue levels, increasing sequentially by 3% and 8% respectively while accounting for 62% of total revenue in Q3. Our automotive revenue grew 37% year-over-year and 4% sequentially. Industrial revenue grew 48% year-over-year and 11% sequentially. Automotive and industrial contributed a total of 60% of revenue in Q3, compared to 56% in the year-ago quarter. Turning to the business units, revenue for the Power Solutions Group (PSG) was $892.2 million. PSG revenue increased by 38% year-over-year due to strength in automotive and industrial end markets. Revenue for the Advanced Solutions Group (ASG) was $613.5 million, an increase of 24% year-over-year. In addition to strength in automotive, ASP benefited from strength in computing, especially in high-end graphics cards. Revenue for the Intelligent Sensing Group (ISG) for the third quarter was $236.5 million, an increase of 35% year-over-year. Growth in ISG was driven by both automotive and industrial end markets. GAAP gross margins for the Third Quarter were 41.4% and non-GAAP gross margin was 41.5%, representing an 800 basis point improvement year-over-year and a 310 basis point improvement quarter-over-quarter. Our gross margin expansion is ahead of our original plans with improved efficiencies of our manufacturing sites, favorable mix, and improved pricing as we continue to examine our portfolio for price-to-value discrepancies. Over the last two quarters, we have exited approximately $100 million of non-core revenue at an average gross margin of 15% and allocated this capacity to strategic products with accretive gross margins. Over 60% of this exit occurred in Q3, and we expect to continue phasing out our low-margin non-core revenue over the next two years, as we outlined at our August Analyst Day. Today, we have been successful in navigating rising input and manufacturing costs by adjusting pricing to our customers. While we will likely see more cost increases in early 2022, we don't expect these increases to have a negative impact on our gross margins. Our factory utilization was at 80%, down slightly from Q2’s level of 83%, primarily due to COVID-related slowdowns affecting our back-end facilities in Southeast Asia. As our operations stabilize, we expect utilization to remain in the low 80% range consistent with previous quarters. GAAP earnings per share for the third quarter was $0.70 per share. Non-GAAP earnings per share for the third quarter was $0.87 per diluted share, compared to $0.27 per share in the third quarter of 2020 and $0.63 in Q2. As noted earlier, this is the highest-ever quarterly non-GAAP EPS reported by the Company. Now I'll provide some additional financial numbers. GAAP operating expenses for the third quarter of 2021 were $321.6 million, compared to $322.2 million in the third quarter of 2020. Non-GAAP operating expenses were $296.2 million, a decline of $18 million quarter-over-quarter, as we continue to restructure our operations to align with our new strategy and reduce investments in our non-strategic areas. While we saw the benefits of lower APEX in Q3, we expect to redeploy capital into our strategic areas in Q4. Therefore, there will be an increase in spending back to normal run rate levels while achieving our 17% operating expense target. Our GAAP operating margin for the third quarter was 22.9%, compared to 9% in the third quarter of 2020. Our non-GAAP operating margin was at a record level of 24.5%, compared to 12% in the third quarter of 2020 and 19.6% in Q2. Our GAAP diluted share count was 440.7 million shares, and our non-GAAP diluted share count was 435.7 million. Please note we have an updated reference table on the Investor Relations section of our website to assist you in calculating our diluted share count in periods of share prices. Turning to the Q3 balance sheet, cash and cash equivalents were at $1.39 billion, and we had $1.97 billion undrawn on our revolver. Cash from operations was $448.9 million, and free cash flow was $355.7 million, or 20% of revenue. Capital expenditures during the third quarter were $93.2 million, which equates to a capital intensity of 5.4%. As indicated previously, we're directing a significant portion of our capital expenditures towards enabling our 300-millimeter capabilities at the East Fishkill Fab and expanding our silicon carbide capacity. Accounts receivable were at $720 million, resulting in accounts receivable days outstanding of 37 days. Inventory increased by $18 million sequentially to $1.3 billion, and days of inventory increased by three days to 119 days. The increase in inventory was driven primarily by an initial build bridge inventory for product transition and work in progress inventory of finished wafers not yet processed through the back-end capacity constraints. Distribution inventory decreased by $39 million to 6.8 weeks from 7.3 weeks in Q2. Once again, we are proactively reducing our distribution inventory to hold more inventory on our balance sheet to support our customer needs rather than building inventory in the supply chain. Total debt was $3.1 billion, and our net leverage ratio is now approximately one times. Turning to guidance for the quarter, we are detailing our GAAP and non-GAAP guidance provided in the press release related to our third-quarter results. Our guidance includes our expected results for roughly nine weeks of the GTAT acquisition after closing last Thursday. Let me now provide you with key elements of our non-GAAP guidance for the fourth quarter. Based on booking trends, we believe demand will remain strong through much of next year. We continue to increase supply through operational efficiencies and work with our external partners to obtain additional capacity. We're also accelerating product qualification at our 300-millimeter fab at East Fishkill. Despite these efforts, we will be limited by supply constraints, and we're working with our strategic customers to ensure long-term, uninterrupted supply. Based on current bookings, trends, and backlog levels, we anticipate that revenue for the fourth quarter will be in the range of $1.74 billion to $1.84 billion. This includes expected GTAT revenue of approximately $3 million to $4 million for the quarter. We expect non-GAAP gross margins between 42% and 44%, including share-based compensation of $3.6 million. We expect total non-GAAP operating expenses of $298 million to $313 million, including roughly $4 million in OpEx for GTAT and share-based compensation of $18.6 million. We anticipate our non-GAAP OIE, including interest expense, to be $24 million to $27 million. This results in non-GAAP earnings per share to be in the range of $0.89 to $1.10. This includes the impact of GTAT business, which is roughly $0.01 dilutive for the quarter. We expect total capital expenditures of $130 to $140 million in the quarter. Our non-GAAP diluted share count for the fourth quarter of 2021 is expected to be approximately 437 million shares. In summary, I am extremely pleased with our progress on the execution of our transformation initiatives. I add my thanks to our worldwide teams for their hard work and unwavering commitment to our customers. With that, I'd like to start Q&A, but I'll turn it back over to Brent to open the line for questions.

Hi guys. Congratulations on the strong results. Hassane, my first question is for you regarding the transformation of the revenue line. At your Analyst Meeting, you talked about exiting 10% to 15% of your revenues over the next couple of years. I wanted to see if we could get an update on that, and how much of that is a headwind today, or is that still yet to come?

Hey, Ross. It's Thad. I'll take that. In my prepared remarks, I talked about we've exited approximately $100 million over the last two quarters, 60% of it being in the third quarter. The average margin without business was roughly 15%. We plan on continuing to exit our business over the next two years. As we've discussed, it will be fairly linear for the next two years as we continue to execute and shift that capacity into higher-value products and higher-value capacity.

And then just to add to that, you talked about the headwind. We're able, of course, with the demand environment, to shift that capacity to meet demand in our strategic market with our strategic customers. That's the mix shift that we are going through, and we'll keep going through that for the next couple of years.

Great, thanks for those details. The follow-on to that would be on the gross margins side. Great job upsizing even your expectations there. Can you talk about how much of that you view to be structural versus cyclical? And I know you're going to say it's structural because of the way you just answered my first question, but how much of a cyclical tailwind are you getting with price increases, etc., that you think are truly sustainable going forward?

Look, this is Thad again. We think the majority of it is structural. We've been making changes to our manufacturing operations, driving efficiencies there. There's definitely a pricing component of it; it's a favorable pricing market. As I stated, we've been passing on the cost increases that we've seen coming our way. We believe that we'll continue to get the gross margin expansion. Our target remains at 45% over time, and like I said, most of it is structural in nature.

Yes, at the end of the day, customers pay for value. We have been reducing the price-value discrepancy like we talked about. The long-term supply agreements provide longer-term visibility on both revenue and margin. When we talk about long-term, we're discussing an average of three years, which aligns with the structural nature of it and provides sustainability.

Thanks, guys.

Thanks for taking my question, and congratulations on the strong results and the very impressive execution. Hassane, how do you see the interplay between automotive production which has been flat this year versus content and pricing? There's a lot of concern that auto chip suppliers are maybe shifting a lot to inventory rather than benefiting from content or pricing or mix. I would just love your views on that from an industry perspective and obviously from an ON-specific perspective. What’s giving you the confidence that, you're saying that units are exceeding are really being driven by content or mix or pricing as opposed to sitting in inventory somewhere?

Yeah, look, I can speak for Hassane. First, we track content based on design wins that we have had over the last few years that are starting to ramp and have ramped beyond what we expected in the '21 timeframe. That’s why we can’t support the demand. From that point of view, I know exactly how much content has been going up for our customers using our products, so that ties in and gives me the confidence that it is a content growth story. Now as far as people talking about inventory being built out, look, I gauge that. We have a lot of data to assess it, but to me, the main gauge is the escalations that we're getting. We’re still getting an intense level of escalations from our customers to ensure that parts go into cars and cars go out of the lot. That is a pretty good gauge for where the economy is and where our content is going. I can tell you it's not being built up; it's going to cars, because if we don't ship, the cars don't ship. That's a one-to-one correlation that I can personally validate given all my conversations with my peers at our customers. So both of these tell me that we are still in a supply-constrained situation. There is not inventory. Are there pockets, maybe one or two weeks of inventory here and there? Yes. Because we sometimes will pre-ship, and the customers we know are not able to kit it. But that lasts for about one or two weeks until they get our next shipment. So all of these things are manageable. We have full visibility on it and we track it internally and with our customers, providing confidence.

Alright. Very helpful. For my follow-up, great job on the gross margin side but when I look at the incremental margins in Q3 and then the midpoint of Q4, it's over 100%. I imagine part of it is the exit from the non-core areas. But could you help us bridge what your original assumption was for gross margin? Why is this coming at these levels? But then also importantly, you're at these low 40s gross margins already before completing a lot of the actions that were supposed to take you to the 45% journey. So is 45% still the end goal of this journey, or do you think that's a very strong start given your confidence that there are maybe leverage or gross margins beyond what you have contemplated?

Yeah, hi, Vivek. What we've always said, 45% is a milestone, and that we would talk once we got there. We're not changing that target. The improvement that we've seen has been through operational efficiencies, favorable mix, and then clearly pricing. If you go back to the chart that I showed at Analyst Day, we provided the bridge. The next big piece of the improvement is really the manufacturing, the fab-lite or footprint. That’s the part we’ve always said would take the longest and be the hardest to achieve. It’s about exiting the fabs and consolidating into more efficient fabs, ramping the 300mm fab. That’s the next leg that we've got to execute on. So I think what we've been able to pull forward on is favorable mix, operational efficiencies, and clearly a good pricing environment has helped. But what I think is going to get us to that next level of 45 is the manufacturing piece. Once we get there, we'll talk about what the end goal should be. But we've never stated 45 would be the end goal as much as it was a milestone that we'd be looking to achieve.

Thank you.

Good morning. Thanks so much for taking the question and congrats on the strong results. Hassane, in your prepared remarks, you talked a little bit about Southeast Asia and your operations there being a little bit disrupted in the quarter. Can you speak to any impact on revenue and gross margins in the quarter and where your operations are today? Then I've got a quick follow-up.

Yeah, hi, this is Thad. We talked about our utilization came down slightly to 80%. We think that will return back to normal levels of low 80%. We think it had minimal impact on this quarter, primarily because we were able to allocate those resources and capacity into other sites and recover from it. The sites are stabilizing now, they're not back up to full speed yet, but we think they will be there very quickly, and that's why we think utilization will come back up into normal run rate levels pretty quickly.

Got it. That's helpful. As my follow-up, I wanted to ask about Q1 of next year. I think historically pre-COVID seasonality would drive business down a little bit. I think pricing, some of the adjustments that you would make historically would hit Q1 disproportionately. Curious how we should be thinking about Q1 into next year, just given how strong the environment is. You talked about all the design wins and the visibility you have into the quarter. So should Q1 of 2022 be above seasonality? And again, how should we think about pricing and gross margins into the March quarter as well? Thank you.

Well, we're not going to give you guidance for Q1. We only guide one quarter at a time. But normal seasonality for Q1 is down 2% to 3%. Based on what we see today, we are going to perform better than that. We can see in terms of backlog and supply coming online, and we're probably looking at flat to what our Q4 number is going to be. But we're not going to provide more guidance than that.

First of all, congratulations on the impressive execution. I have a broader question regarding the EV segment. I know you're focusing heavily on electric vehicles and making significant investments in that area. Can you share how much revenue you expect to generate from EVs today? Additionally, once you reach your target of $1 billion in 2023, what percentage of your overall business do you anticipate will come from EVs by then, considering all the other aspects of your operations?

We're not breaking down the EV revenue today. I gave the outlook just to highlight the growth that we're seeing, but more importantly, to highlight the penetration of silicon carbide, getting to the run rate of $1 billion. We've always said over the next few years, we're going to see a coexistence of IGBT and silicon carbide. However, silicon carbide is starting to accelerate as customers see its efficiency, coupled with our technology on packaging. So that is going to accelerate our ramp in silicon carbide to get to that run rate above $1 billion by 2023, which is very meaningful from where we are today and our revenue trajectory getting building is basically doubling for us every year. I'll be providing more of that color as we start ramping. But at this point, that’s the level we're going to be talking about. I'm very comfortable with the EV ramp. Many people have been discussing EV ramps and content for a few years now. Now we have it starting, and customers have these long-term supply agreements to guarantee their supply, and we'll be supporting their growth along with ours.

Thank you, Hassane. For my second question, I believe Vivek mentioned a long-term target of 45% while guiding to 43%. I want to confirm that there are no short-term factors influencing this and that it's all based on structural elements. Could you provide some insight into how much the strong average selling prices contributed compared to the reduction in the legacy business, which I believe we can also calculate? Additionally, considering that you were supposed to sell fabs and we haven't seen significant progress in that area, I'm wondering why you would even need to sell fabs as you continue to grow, especially since you're already operating at low 80s utilization.

A significant portion of our progress is due to self-improvement initiatives. We discussed the increase in units sold, which is linked to a favorable margin mix, indicating a shift in that mix is already occurring. We also mentioned our decision to move away from a $100 million business with a 15% gross margin. Even in the current pricing landscape, low margins are not acceptable, and we will proactively disengage from that segment to focus on the automotive and industrial sectors, which generate higher margins. These actions are self-improvement, and importantly, sustainable. Furthermore, our utilization rates have worked in our favor over the past year. This trend will continue as we scale back some of our fabs, restructure, and optimize manufacturing processes. Utilization should remain high despite a 10% to 15% reduction in the non-core business. All these actions are self-driven. Regarding the current pricing environment, two aspects are noteworthy. First, we are passing price increases to our customers, which maintains our gross margin since we are merely transferring our incurred cost increases. Thus, this is essentially margin-neutral for us. Second, we have a price-value mismatch where some of our high-value products have historically been sold below market rates. These adjustments are sustainable because they reflect the true value that many other customers recognize. We need to stay ahead of manufacturing utilization as we reduce the remaining low-margin business by 10% to 15%. We are confident we'll achieve this, as mentioned during our Analyst Day. All of these steps will contribute to a structurally sustainable financial model, and when we reach that point, we will discuss our next steps.

Yeah. I would add on the manufacturing side, we're still exiting the manufacturing sites. We’ve got the 300-millimeter fab coming online later next year in 2023, that we’re taking ownership of. But we've got to fill that out—that gives us a better cost advantage as well. You saw that we were building inventory on the balance sheet to support those fab transitions. So we’ve always said it’s about exiting the fabs as well. It’s not as simple as ending the fabs; somebody is about the exit and the qualification process and timing. Even though we haven't announced divestitures of those fabs, we're making progress in qualifying those products in other locations that are more efficient. We’re building the inventory for that transition. The progress is underway.

Understood. Thanks, guys. Great stuff.

Yes, thank you, and I want to echo my congrats on the excellent results. Hassane, I want to delve a little bit deeper into the long-term agreements that you're seeing in your business. You talked about $2.5 billion of committed business, particularly $2 billion in silicon carbide and for EVs, and two-thirds was related to traction inverters. Could you maybe describe what you're seeing in that market? It seems like you have the right products to align for future growth. Can you talk a little bit about the qualification process, the engagements with your customers on that massive committed capital business, and just more broadly, are you seeing in the industry a shift, a transition to more long-term commitments, better visibility from your customers in response to the component shortages that we've seen this year? Are you seeing a change in behavior from your customers to enter into long-term supply agreements to get access to that supply? Thank you.

Absolutely right. Let me talk about the first point. We are seeing a very different engagement model for design and capability. When you’re talking about a product that is fit for purpose for a customer’s traction inverter, every car is different, whether in terms of performance or range or heavy-duty applications, and so on. All these variables are considerations for our team and the customer's team as we get a design win. I highlight that to give you visibility that it's not a dual-source concept. It is a design and concept that leads to the design win, and that’s why customers, once they solve their problem on their side, the long-term supply agreement is the next natural step. Because if and when we give them a traction inverter that provides much better efficiency than any of our competitors, they will either co-invest or provide us with the long-term supply agreement over the longest period of time, at least through the run rate of that product. That stickiness of the revenue that I talked about indicates stickiness from a design win perspective. It's not something that is easily replaceable. But also, there’s stickiness from the commitment that the customers are providing to us, which leads to the second level of your question, and the answer is yes. The engagement model is now different. It’s not equal for everything. For products where they're not strategic potentially for our customers, however, they’re important; we’re not going to lock up capacity with a long-term agreement. But when we talk about strategic components like silicon carbide, IGBT, and the 48-volt rail—and the strategic themes that I've discussed that go along with our ADAS for cameras or image sensors—those are key products that enable differentiated technologies for our customers. Those customers do want the stability and do want supply resiliency that we’re able to provide them through the long-term agreements. That’s the model that we’re moving toward with a lot of customers. Again, it’s not 100%, but it is strategic and selective as I’ve always said when it comes to long-term supply agreements.

And for my follow-up, I guess my follow-up relates to the pricing question, but it's more about the longer-term structural aspect. You're obviously seeing some price increases, but would you say that the days of heavily deflationary pricing for semiconductors are starting to come to an end, or at the very least that price declines will start to abate ongoing forward because of the strategic importance of these components for ADAS, EVs, and industrial automation? Do you think this is more structural in nature where the pricing environment may not be as high as it is now, but could continue to be favorable over the coming years, or do you still view this as more temporary?

I think it is also sustainable. I don't think the pricing benefit that we historically give our customers year-over-year is going to disappear. However, it will be very muted for these new ramps. Given the capital intensity required to ramp those products and bring them online, they’re not going to be subject to your traditional pricing negotiations like we’ve had in the past, where it’s a flat request for a percentage decrease. Those days are over for the strategic ones. That gives me comfort in investing in the Capex to match that demand. We work with our customers on efficiencies that we can achieve together. If our products allow our customers to save on costs in other areas through efficiencies, that's still savings on an end-unit price, which is also advantageous for our overall offering. That’s what makes our solution attractive because efficiency drives significant cost reductions beyond just semiconductor economics. That’s very appealing to our customers.

Okay, thank you.

Yes. Thank you. Good morning. Just a follow-up question on the long-term supply agreements. If you could clarify, what are the obligations from both you and the customers over those agreements? What are they promising you? What are you promising them? And within those agreements, one of the investor concerns right now is, one day, demand will probably flow from these levels. What are the provisions that protect you and protect them in the event that the demand winds up being different from what’s envisaged in those agreements?

When we talk about long-term supply agreements, we focus on strategic intent. Let me talk about silicon carbide or EVs, as an example. To me, that demand and that ramp is happening. EVs are being driven by companies and customers themselves. If that ramp is shifting one quarter or two quarters, we work with customers to meet their needs. What they get is the supply assurance that as they ramp, we will be able to support their growth. Now, what gives me confidence in the ramps that we are signing with our customers is that when a customer co-invests with us to support that ramp, that's a high-confidence move, indicating that they expect to win in that market because they're putting their resources into our capacity expansion. We are also investing through capex to support their ramps. This gives us the long-term visibility and sustainability of revenue and margins, with customers being able to depend on us when they need the ramp. And the customers will ramp according to the timeline outlined in the long-term supply agreement. This structure provides me with a high degree of confidence. Again, I'm not after long-term supply agreements for all of our products. I’m very selective and strategic about which agreements we pursue to avoid the issues that you talked about.

Great. That's very helpful. Thank you. As a follow-up, I guess you can give us some sense of how much of the business now is within that strategic framework that you speak of? And I suppose some of it’s within the long-term supply agreements, some of it’s not. But I guess the question is, over time we've seen pricing for ON Semiconductor typically down 5% a year, and that's made up with cost reductions. It sounds like, for a large part of your business, you're working with a different framework. What about for the rest of the business? Are there structural changes happening in both ON Semi and the industry that will prevent that price decline and make things a little stickier even in the event of an industry downturn?

Look, we're not the ON Semiconductor that you’re used to. We're the new ON Semi, and our focus is on strategic products and a sustainable financial model. Part of that business that we are walking away from generates the average you're describing. For the low-margin business, we have made it clear that we do not prioritize that revenue. I only care about proprietary business that adds value to the customer. When you have proprietary business, even silicon carbide as an example, those are sustainable from both a pricing and margin perspective. We are no longer chasing fab fillers in a downturn, which is historically what the Company has done. We’re moving the mix that goes into our fabs to proprietary and high-value products, and those are not going to fluctuate based on what the end market does. That’s the new ON Semiconductor we have become, and we’re delivering results against this model today. This gives me confidence in the sustainability of our model moving forward, regardless of what the market situation may be.

Well done. Thank you.

Hey, good morning, guys. Thanks for letting me ask the question. Hassane, just quickly going back to the auto sector: if you read some third-party reports, the industry might miss out on as much as $220 billion of revenue this year because they don't have chip inventory. I'm just curious, as you talk to the auto supply chain, do you think they are going to structurally change the way they think about their inventory and their partners going forward? And the long-term supply agreements are great, but I'm curious if you've explored the idea of actually taking some customer capital, especially as you work to build out your silicon carbide capacity?

Yes. Let me touch on the last point first. We have taken customer capital through the forms of investments or co-investments in our capacity expansion. So that model is new, and we’ve opened it up to customers, and some customers have taken us up on it. The model is changing; let me put it this way. You talked about the $200 billion in revenue; nobody wants to miss out on that. There are customers that, unfortunately, are still in denial, and that’s okay—though not okay for them—that’s okay for me. We’re doubling down with customers who get it and understand the importance of semiconductors, and the importance of power and sensing in the future of mobility. Those customers have jumped on the opportunity to secure supply. There is a shift for customers to go with credible suppliers. Suppliers that are reputable and scalable will be very important. Supply resilience is a hot-button issue for all customers, all the way down to the OEM. My personal engagements with OEMs are about supply resilience, not just supply assurance. Our ability to run products in two geographically independent locations provides the resilience customers need in terms of supply. There have always been disruptions. We've had disruptions for the last four to five years. Showing our supply resilience and proving it to the customer, ensures their business continuity because they do not have to build inventory and hoard their chips. They can depend on us to have what they need. That matters in the selection process these days: not only do you have to have proprietary and high-efficiency products, but you also have to be selected as a strategic supplier with co-investments.

Then, Hassane, as my follow-up, I want to get back to the notion of cyclical versus structural. I get your auto and industrial businesses have laid out a clear structural thesis, which is fairly easy to underwrite. I want to think about the other bucket a little bit. If I add back the $60 billion of divestitures, I’m assuming most of that is coming in your other category, that’s up over 30% year-over-year, and it’s up almost, I believe about high single-digits sequentially, so even outgrowing your auto business. When you think about that other bucket, was there value discrepancy that the old company wasn't pricing right, or is that somewhere where we might need to be a little bit worried about the cyclical pricing leverage today that might go away tomorrow?

Yeah. Now, look, you don't have to worry about that. When we talk about other products, that doesn’t equate it to non-core or declining or commodities either. What you’re seeing a lot of is the benefit of high margins in the other bucket that are not getting diluted by that $100 million of lower-margin business. So the growth you see is largely driven by proprietary products in that category, even if you don’t associate them with the power and sensing categories. That’s part of our strategy moving forward. I don’t want to equate other products as being less important for the company; that’s why you’re seeing that growth being across the board while still managing the $100 million drag from the low-margin business.

Thank you.

Good morning. Congratulations on the solid results and execution. On the Intelligent Sensing business, if I look at it, the first nine months of this year it has undergrown both your auto and industrial segments, right? However, on a year-over-year and quarter-over-quarter basis, the trends have been improving every single quarter this year. I know there has been heavy supply constraints because most of this business is outsourced. It looks like your foundry partners are increasing their supply, but do you expect the segment to also be constrained into most of 2022? Also, can you give us an update on your efforts to bring in some of the image sensor manufacturing in-house?

Yes. So you’re correct. That business is primarily outsourced, and it has been constrained throughout 2021. We're starting to see a bit more capacity being directed to us because of the growth we're experiencing. Really, this is due to the impact that it has on the automotive side. We’re getting more secured supply and you'll see that increase through next year. Having said that, we do have an effort for new products to bring in-house. You’re not going to see us do a big shift of existing products just moving them in. But we have a healthy pipeline of new product development. We already have imaging products taped out in our East Fishkill facility. Our new imaging products are in development and have progressed to production yields. So again, we are out of the research phase; we're now in development and production across many of our products, and we’ll keep doing that into 2022.

Good continued execution. Thank you.

Thanks, Harlan.

Yes, and congratulations on the record results. Hassane, the first question is on this transition from ICE to EV. It seems like the pandemic has really accelerated that transition. I don't know if there’s anything that you could share with us from your end? Any numbers, any data points, because clearly that transition is accelerating materially.

Look, I don’t think it’s the pandemic that accelerated it. I think there are several factors contributing to this: a heightened focus on environmental responsibility driven by corporations, boards, investors, and employees. Additionally, government mandates play a role, whether in the U.S., Europe, or Asia, which force a shift to EVs. All these factors are driving accelerated adoption and investment in new car models. You hear a lot about the targets set for EV adoption by 2025 and 2030, and those are hard milestones defined by companies themselves or government regulations. Coming out of the pandemic, demand for EVs has increased as more customers prefer electric vehicles that they expect to keep for the next 5 to 10 years. That’s had a very positive impact on our EV push, sustaining our growth. Many of the numbers I provided earlier as far as the long-term supply agreements for silicon carbide and IGBT are to highlight that this market is experiencing pure growth, offsetting the 10% to 15% of revenue we’ll be walking away from. This expected growth will continue over the next 10 years, which is what makes it exciting for us. We’re in the right place.

That’s very helpful. And for my follow-up regarding Capex of $130 to $140 million next quarter: is that kind of the run rate we should use for next year or will there be some further step-up potentially the following quarter?

No, we've said that starting next year, capital intensity will go up to roughly 12% for the next couple of years. After that, it will moderate down to about 9%. But we will be investing significantly, with a lot to do to support silicon carbide expansion. We also have investments to make related to the GTAT acquisition as well. Thus, we anticipate around 12% capital intensity for the next couple of years.

That’s very helpful. Thank you, and congrats again.

Hi, thanks for taking my question. I guess I had a couple: There's a lot of conversation on pricing in your product portfolio. But can you give us some color around one, how much of your pricing is actually on a like-for-like basis? How much of it is actually like-for-like versus how much of it benefits from a mixed shift to your products, which I would assume is a little bit more structural and longer-lived? And then I’ll have a follow-up.

Look, I mentioned earlier on the call that most of our actions are structural because they're driven by a mix shift. We talked about walking away from $100 million at an average of a 15% gross margin. Those product lines are being slowly phased out and replaced with much higher gross margin products. So we replaced that $100 million with a much more structurally favorable mix margin-wise moving forward. For costs, I mentioned earlier that price increases are neutral for our margins because we are passing them on to customers directly; therefore, that's sustainable as well. We're walking away from business that doesn't serve our long-term strategic goals; its impact is limited to about 1% to 2%. The remaining upside on margin expansion comes from the mix moving forward. I’m not worried about the sustainability of it. The benefit is sustainable and driven by the value of the products we’re shipping today. We’re moving 3% more units in Q3 than we did before. The additional units sold are favorable margins constituting true demand, and that is sustainable.

Got it. Thanks. On the GTAT, I guess, when I look at GTAT in the context of your overall EV revenue, is there a contribution you can speak to regarding GTAT potentially supplying other customers versus how much of your EV revenue is actually coming from your products versus GTAT?

Today, only a small portion is coming from GTAT since we just closed the acquisition. I mentioned that we will be shipping more revenue based on GTAT substrates in Q4. Moving forward, we will start seeing more of the mix transition from outside substrates we have historically used toward GTAT-based substrates, which will be internal. As that mix shifts towards our internally grown or sourced substrates, our margins will also benefit because having an in-sourced, vertically-integrated substrate is more favorable than using external sources. We haven’t yet realized the benefits of that margin, which will come as we transition more into GTAT-based substrates. And that's on a ramp that I talked about during my prepared remarks.

Yes. And I would just add in the Q4 guidance, there is $3 million to $4 million of GTAT revenue, and that's with third parties and other customers outside of ON Semiconductor. So you can think about that as being the run rate going forward. So it's not a material amount to the Company.

Got it. Thank you.

Great. Thanks for taking my questions. First, I was hoping you might linger on the co-investing theme for a moment. Is this customers investing in their own capacity that aligns with ON Semiconductor, or is it more like non-recurring engineering, or are they actually investing to sort of own or perhaps guarantee capacity in your fab? And then I do have a follow-up.

Yes. So the investment obviously comes from their side. But the investments I’m referring to are their investments on our side primarily for supply assurance and for late-stage development for products that will go for their applications. That I talked about gives me confidence in the sustainability and stickiness of that revenue, as it shows the late-stage R&D that customers are investing in order to secure that product and supply assurance needed for their ramp. Both of these concepts come into play. Of course, they are working to build their own capacity while we are focused on investment needs aligned with our business.

Great. That’s helpful. And then, the follow-up is about the tone of buyers or buyer behavior, if you will. When we think about their behavior a quarter ago relative to where it is today. When we think about their propensity to chase shortages and try to reel in as much upside as they can and that sort of thing versus maybe cooling off or narrowing the scope or expanding the scope of expedites. Can you comment on that trend, please?

Look, I think everybody is in blocking and tackling mode. They’re working to ensure they have just enough supply to keep production lines moving. I can't tell you how many lines are at what capacity, but many of them are now running at 100%. However, keeping the line running is more important than maintaining a 100% uptime rate. That’s what the focus has been from our side and our customer’s side. There's not enough product to go around to give everybody a 100%. We’ve been working constructively with our customers to make sure they get the minimum quantities of all our products to maintain ongoing production and meet their unit sales targets. That is the engagement we have directly with the OEMs. It’s no longer just about us providing to Tier-1s, then they deal with the OEMs. It’s a two-party dialogue between us and the OEM, where we understand their needs, or it’s a three-way meeting that involves Tier-1 and OEM to ensure everyone is coordinating effectively while being transparent. Every team shares one common goal, which is to keep the lines running because that’s when real demand is apparent and not just sitting somewhere in the supply chain. That level of engagement provides me with confidence in our collaborations and forecasts.

Thank you, and congrats.

Thank you all for joining us today. I once again thank our worldwide team for their hard work in driving our transformation towards solid and sustainable results. We have established a strong foundation of revenue, long-term supply agreements, and funnel growth over the last few quarters to deliver a leadership position in the vehicle electrification ramps driven by our silicon carbide products. Along with our leadership in automotive safety with our sensing products, we have become the supplier of choice for all marquee names worldwide. We're very excited about the opportunity in front of us, and we remain focused on execution to make sustained progress towards our target financial model. Thank you.