ON Semiconductor Corp (ON) — Q2 2022 Earnings Call Transcript

Thank you, Lisa. Good morning, and thank you for joining onsemi's second quarter 2022 quarterly results conference call. I'm 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. A replay of this webcast, along with our second quarter earnings release, will be available on our website approximately one hour following this conference call, and the recorded webcast will be available for approximately 30 days following this conference call. Additional information is posted on the Investor Relations of our website. Our earnings release and this presentation include certain non-GAAP financial measures. Reconciliation of these non-GAAP financial measures to the most directly comparable GAAP measures is 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 the future events or the future financial performance of the company. We wish to caution that such statements are subject to risks and uncertainties that could cause actual results or events to differ materially from projections. Important factors that can affect our business are described in our most recent Form 10-K and Form 10-Qs and other filings with the Securities and Exchange Commission and in our earnings release for the second quarter of 2022. Our estimates may change, and the company assumes no obligation to update forward-looking statements to reflect actual results, change assumptions or other events that may occur except as required by law. Now let me turn it over to Hassane. Hassane?

Thank you, Parag, and thank you, everyone, for joining the call. Nearly a year ago to the date, we unveiled our strategy to deliver intelligent power and sensing technologies for the sustainable ecosystem, fueled by high-growth megatrends: automotive, industrial, and cloud power. This meant that we would not only provide differentiated solutions for our customers but that we would execute on our commitments to our shareholders. Today, we announced another quarter of record revenue, gross margin, and EPS, and I could not be prouder of the progress we have made. We achieved our first-ever $2 billion revenue quarter with record revenue in the automotive and industrial end markets. As compared to last year's second quarter, our total revenue increased 25%. Our non-GAAP gross margin expanded by 1,130 basis points, and our earnings per share more than doubled to $1.34 per share. In the face of challenging business conditions, our employees have been steadfast in their dedication to our customers, and I want to thank them all for their continued hard work and tenacity. Despite ongoing geopolitical and macroeconomic uncertainty, demand for products in our focus areas remains strong. Our automotive and industrial revenue now accounts for 66% of our overall business and combined grew 9% quarter-over-quarter and 38% year-over-year. This performance was driven by increasing adoption of our market-leading intelligent power and sensing solutions in the fastest-growing applications. We have seen a slowing demand in our non-core end markets, but demand from automotive and industrial continues to outpace supply. The volatility in energy markets and supply chain disruptions across the globe are driving an accelerated adoption of electric vehicles, alternative energy, and industrial automation. Our market-leading portfolio, coupled with the differentiated performance of our products and end-to-end capabilities, has distinguished onsemi for intelligent power and sensing solutions, and our customers are increasingly relying on us to enable their roadmap in a rapidly evolving market. While we are optimistic about our outlook, we remain sensitive to dynamic market conditions. The structural changes we implemented over the past 18 months to rationalize our product portfolio and optimize our cost structure have reduced the volatility in our financials and positioned the company to be more resilient in all business environments. The nature of our customer engagements has evolved into strategic partnerships to support our customers' long-term technology roadmaps, advanced capacity planning, and supply assurance. Customers continue to expand the scope of their Long-Term Supply Agreements (LTSAs) to include ON Semi's entire portfolio of intelligent power and sensing solutions, which accounted for 66% of our total revenue in the second quarter, up from 62% a year ago. We have signed LTSAs covering up to 200 parts across our entire portfolio, and for existing LTSA customers, they are still requesting additional near-term volumes and extending the duration of our agreements in some cases through 2029. For their longer-term demand, they are co-investing with ON Semi capacity expansion to secure their supply, which in turn improves our demand planning. We continue to make progress in our transformation journey to structurally improve the gross margin of the company. We have redeployed capital to high-margin, high-growth areas such as silicon carbide, and over the last 12 months, we have exited approximately $210 million in revenue and an average gross margin of 24%, of which $36 million occurred in the second quarter at an average gross margin of 34%. Despite the deliberate loss of non-core revenue, we have been able to grow at an impressive pace and offset these losses with new product revenue, which increased 35% year-over-year at favorable gross margins. Our Intelligent Power revenue grew by 31% year-over-year and 10% quarter-over-quarter, driven by the market-leading efficiency of our solutions. The superior performance of our silicon carbide products and IGBTs has enabled us to engage directly and sign LTSAs with leading automotive OEMs and EV disruptors across the globe. They rely on ON Semi's silicon carbide expertise and end-to-end capabilities to help them achieve their electrification goals. Although internal combustion engine vehicle sales were nearly flat in 2021, EVs grew by 94% and are expected to grow at a CAGR of 22% to 45% of total light vehicle units in the next five years. Electric vehicles require up to $700 of incremental ON Semi content for drivetrain and onboard charging compared to an internal combustion engine car. As the transition continues to accelerate from ICE vehicles to electric, we expect to see steep growth in our Intelligent Power revenue for automotive. Our progress toward silicon carbide leadership is one that I'm especially proud of. We are seeing a steep acceleration in our silicon carbide ramp and have doubled our silicon carbide revenue quarter-over-quarter in the second quarter. We had forecasted to double last year's silicon carbide revenue in 2022 and thanks to our global team's impressive acceleration of our capacity expansion plans and our latest customer engagement, we are confidently raising our annual projection to triple last year's silicon carbide revenue in 2022 and exceed $1 billion in revenue in 2023. Towards that end, we have also secured more than $4 billion of committed silicon carbide revenue through long-term supply agreements for the next three years as compared to the $2.6 billion we had previously disclosed. To support the steep acceleration in our silicon carbide revenue, we are rapidly expanding capacity across our sites. By the end of this year, we plan to quadruple our substrate output on a year-over-year basis, and we are adding capacity for wafering, IP, and modules at our various sites around the globe. Furthermore, we are adding 200-millimeter silicon carbide capacity at our existing fabs, and we are on track to double our front-end wafer capacity by the end of 2023 compared to that at the end of 2022, and further double that capacity by the end of 2024. Our energy infrastructure business is also growing at a rapid pace. With a year-over-year revenue increase of 61% in Q2, we are on track to exceed our 2022 target of 50% growth year-over-year. As I indicated earlier, volatility in the global energy supply is driving rapid adoption of alternative energy and with our broad portfolio of high-efficiency silicon carbide and IGBT modules, we are the key enabler in this market. We expect the alternative energy market to be a long-term driver for our business, as utility-scale power plant installations grow rapidly worldwide, reducing both fossil fuel dependence and associated climate impact. The top 10 solar inverter suppliers have more than 80% of the global market share, and ON Semi has signed long-term supply agreements with seven of them totaling more than $1 billion in revenue. Beyond the LTSAs, we continue to expand our footprint in the alternative energy market, and in the second quarter, we secured a design win for our silicon carbide module for solar inverters with a leading global industrial OEM. While silicon carbide is the fastest-growing part of our power business, our silicon power products remain integral to our intelligent power portfolio with year-over-year growth of approximately 30% in our IGBT and MOSFET revenue. This growth was primarily driven by automotive and industrial, where higher efficiency of our products is a key differentiator. Our Intelligent Sensing revenue grew by 39% year-over-year and by 10% quarter-over-quarter. The growth in our intelligent sensing was driven by both automotive and industrial end markets which grew by approximately 60% and 30%, respectively, year-over-year. The steep growth in our automotive image sensors is driven by an increasing number of cameras per car, a mix shift towards higher resolution and higher ASP sensors, and accelerating penetration of ADAS. One of the primary drivers of the increasing number of cameras per car has been the efforts by traditional OEMs to match the ADAS and related safety features offered by competitors and the new EV models. We are seeing increasing use of our image sensors to enable safety through the replacement of traditional mirrors with camera-enabled digital mirrors. We secured a design win for a digital mirror that incorporates four cameras for the rear and outside views. This mirror overcomes obstructions caused by passengers, headrests, and other objects and provides integrated rearview and side view for blind spot monitoring. We signed another LTSA to supply image sensors for a vision system to replace mirrors with cameras in commercial trucks. This system provides the driver with a more complete view of operating conditions compared to traditional mirrors and delivers improved driver vision and blind spot elimination. We entered into an LTSA with a leading manufacturer of agricultural equipment to supply our new super exposure flicker-free high dynamic range image sensor for targeted spray systems in weed elimination. A vision system comprising more than 30 onsemi image sensors identifies weeds and signals the nozzle control system to precisely spray herbicide in just the right quantity. This application sustainably eliminates the indiscriminate use of agricultural chemicals, enabling savings of more than 75% of herbicide and helps protect the environment. In the industrial end market, our growth is driven by industrial and warehouse automation applications. Our scanning business grew by 70% year-over-year, driven by strong traction of our image sensors in industrial and warehouse applications. This growth is driven by expansion and increased automation of warehouses by global e-commerce leaders. Our proprietary global shutter technology, which enables high-speed capture of images and low-light performance, coupled with strong technical support, are key drivers of our leadership in this market. Our transformation journey is well underway, and we are aggressively hiring worldwide to keep up with our growth. ON Semi is driving disruptive innovation and route energy in the semiconductor space. The work we do matters for our customers, our employees, and for the environment. We play a greater role in the most exciting megatrends that will define our future, such as electric vehicles, autonomous driving, robotics, automation, and alternative energy. There is no better time to be part of a growth story like ours, and I invite anyone interested in joining our talented team to apply online. Now I will turn the call over to Thad to provide additional details on our financials and guidance.

Thanks, Hassane. Another quarter of record results clearly demonstrates our accelerating momentum in the fastest-growing semiconductor market and the progress we have made in our transformation. We are a stronger company today after having focused our strategy, redirected our investments, and doubled down on intelligent power and sensing solutions for the automotive, industrial, and cloud power markets. We rationalized our product portfolio by exiting price-sensitive products in favor of highly differentiated, intelligent power and sensing solutions. Our worldwide teams are focused on operational efficiencies to reduce costs while we continue to make progress towards our fab lighter manufacturing strategy with the announced divestitures of two subscale fabs. The structural changes we have implemented over the last 18 months have significantly improved the predictability of our financial results and positioned the company to consistently execute in dynamic market conditions. Our disciplined execution resulted in record financial performance for the last five consecutive quarters, and we are thrilled that the results of our transformation are being recognized by the financial and business communities. In a noteworthy milestone, ON Semi has been included in the S&P 500 Index and recognized as a Fortune 500 Company. We could not have achieved these results without the dedication of our worldwide team, and I continue to be impressed with their operational excellence quarter after quarter. To our employees around the world, thank you for your unwavering commitment to ensuring the success of our customers. We are seeing unprecedented demand for our products driven by accelerating megatrends of vehicle electrification, ADAS, factory automation, and energy infrastructure. In silicon carbide alone, we have LTSAs of more than $4 billion for the next three years. Our customers value the market-leading performance of our solutions, the breadth of our intelligent power and sensing portfolio, and our end-to-end manufacturing capabilities, and they choose ON Semi as a strategic partner to enable their long-term technology roadmaps. Our focused markets of automotive and industrial grew by 41% and 34%, respectively, year-over-year, to account for 66% of revenue compared to 59% a year ago. We expect continued strength in the automotive and industrial end markets amidst slowing demand for our non-core businesses, parts of which we are exiting to further achieve our transformation goals. We're also making progress on our sustainability initiatives. Last quarter, we published our sustainability report in which we reiterated our commitment to achieving net zero by 2040. We recognize the importance of doing our part for the environment as we deliver cutting-edge technologies that enable our customers to create a sustainable future. In 2021, approximately 75% of our revenue was sustainable product revenue. We significantly reduced our water consumption compared to the previous year, and we are already making progress in reducing our greenhouse gas emissions. Our Intelligent Power solutions for electric vehicles, EV charging, and energy infrastructure are helping to slow the pace of climate change, and our Intelligent Sensing solutions enable automation and efficiencies, which in turn reduce energy consumption. Turning to results for the second quarter, as I mentioned, Q2 was another quarter of record results. Total revenue was $2.085 billion, an increase of 25% over the second quarter of 2021 and 7% quarter-over-quarter. This increase was driven by strength in our automotive and industrial businesses, which grew 38% year-over-year and 9% quarter-over-quarter. Our Q2 revenue was above the high end of our guidance range as we navigated the China lockdown and recovered the impacted revenue late in the second quarter. Revenue from both Intelligent Power and Intelligent Sensing was at record levels. Intelligent Power grew by 31% year-over-year to 48% of revenue, and Intelligent Sensing grew by 39% year-over-year to 18% of revenue. All three business units reported record revenue in the second quarter. Revenue for the Power Solutions Group was $1.06 billion, an increase of 25% year-over-year, achieving its first $1 billion quarter. Revenue for the Advanced Solutions Group was $716.7 million, an increase of 18% year-over-year. Revenue for the Intelligent Sensing Group for the quarter was $311.3 million, an increase of 44% year-over-year. GAAP and non-GAAP gross margin for the second quarter was 49.7%. Our non-GAAP gross margin improved 30 basis points quarter-over-quarter, primarily driven by a favorable mix of automotive and industrial markets and despite a proactive slowdown in our wafer starts, which reduced our utilization from 81% in Q1 to 77% in Q2. Six quarters into our transformation, a better control of our operational levers helps us optimize efficiencies, maximize output, and deliver for our customers and shareholders. GAAP operating margin for the quarter was 28%, and non-GAAP operating margin was a record of 34.5%. GAAP earnings per diluted share for the second quarter was $1.02, compared to $0.42 in the same quarter a year ago. Non-GAAP earnings per diluted share was $1.34, compared to $0.63 in the second quarter of 2021. We relaunched our share buyback program and for the first time in over two years, repurchased 1.5 million shares or $89.7 million at an average price of $59.76 per share. This represents 44% of our free cash flow for the second quarter, and there is $1.2 billion remaining on our authorized repurchase program. Now, let me give you some additional numbers for your models. GAAP operating expenses for the second quarter were $453.1 million compared to $357.9 million in the second quarter of 2021. Non-GAAP operating expenses were $317.7 million compared to $314.2 million in the quarter a year ago. Non-GAAP operating expenses increased by $14.9 million sequentially and was driven by hiring to support our growth. As I indicated in previous calls, OpEx will continue to trend higher as we bring in additional talent to support our growth. As we guided in the past, our non-GAAP tax rate will increase in 2022 as we have substantially utilized our NOL attributes. For the second quarter, our non-GAAP tax rate increased to 16.3% from 4.6% in the fourth quarter of 2021. This change accounted for $0.18 of EPS dilution in the second quarter and $0.34 year-to-date. Our GAAP diluted share count was 447 million shares, and our non-GAAP diluted share count was 441.6 million shares. Please note that we have an updated reference table on the Investor Relations section of our website to assist you with calculating our diluted share count at various share prices. Turning to the Q2 balance sheet, cash and cash equivalents was $1.79 billion, and we had $1.5 billion undrawn revolver. Cash from operations was $420.8 million and free cash flow was $202.7 million, which on a last twelve months basis was 17% of revenue. Capital expenditures during the second quarter were $218 million, which equates to a capital intensity of 10.5%. As we indicated previously, we are directing a significant portion of our capital expenditures towards the capacity expansion of silicon carbide and enabling our 300-millimeter capabilities at the East Fishkill fab. We expect to see a higher level of capital intensity in the second half of the year as we continue to invest in equipment and capacity expansion to support our growth. Accounts receivable was $1.1 billion, resulting in DSO of 50 days. The sequential increase in accounts receivable was due to non-linear shipments as we recovered revenue late in the quarter from the China lockdown. Inventory increased $67 million sequentially to $1.56 billion, and days of inventory decreased by 3 days to 136 days. We continue to build inventory to support our fab transitions and ramping silicon carbide. Distribution inventory decreased approximately $12 million quarter-over-quarter and remains consistent with Q1 at 7.1 weeks. We continue to maintain distribution inventory at historically low levels to hold more inventory on our balance sheet for our customers' needs rather than building inventory in the supply chain. Total debt was $3.2 billion, and our net leverage remains well under 1%. Turning to guidance for the third quarter, demand continues to outpace supply in our targeted automotive and industrial end markets, while there are pockets of softness in our non-core markets. Given the uncertainty in the macro environment, we are taking a conservative stance in judging down demand in our guidance for the third quarter. A table detailing our GAAP and non-GAAP guidance is provided in the press release related to our second-quarter results. Let me now provide you key elements of our non-GAAP guidance for the third quarter. We anticipate revenue will be in the range of $2.07 billion to $2.17 billion. We expect non-GAAP gross margin to remain between 48% to 50%. This includes share-based compensation of $3 million. Although we continue to focus on long-term gross margin expansion and sustainability, our rapidly accelerating silicon carbide ramp will be dilutive to gross margins by 100 to 200 basis points over the next several quarters due to the incremental start-up costs as we scale the operation. We expect non-GAAP operating expenses of $319 million to $334 million, to include share-based compensation of $21 million. We anticipate our non-GAAP OIE will be $24 million to $28 million. For the remainder of 2022, we expect our non-GAAP tax rate to be in the range of 15.5% to 16.5%, and non-GAAP diluted share count for the third quarter is expected to be approximately 440 million shares. This results in non-GAAP earnings per share to be in the range of $1.25 to $1.37. We expect capital expenditures of $265 million to $295 million in the second quarter, as we ramp up our silicon carbide production and invest in 300-millimeter capability. In summary, the transformation of the company has enabled us to deliver outstanding financial results and at the same time, reduce the volatility in our financials. With leadership in intelligent power and sensing solutions for the fastest-growing applications in automotive and industrial, we are well positioned to deliver sustained long-term financial performance for our shareholders. With that, I'd like to turn it back over to Parag to open up for Q&A.

Hi, guys. Thanks for letting me ask a question. I guess, my first question is on the general macro trends and how you're reacting to them. You talked about a little bit of weakness in your non-core businesses, Hassane. And then Thad, just talked about the utilization actually coming down sequentially. So how do I, in general, reconcile demand being greater than supply in your core businesses, weakness in your non-core, and kind of what does it mean to the ability to backfill on that given your utilization is dropping?

Yes, this is Hassane. Not all capacity is interchangeable. We have been very careful with our inventory management. You may have noticed that our inventory levels have decreased. We are concentrating our inventory efforts on strategic areas within our core business, as well as silicon carbide and the transition in our fabrication processes. This will ensure that part of our utilization remains strong. However, with the current economic softening and our cautious outlook reflected in our guidance, we are implementing measures to maintain the resilience of our model, which we have discussed previously during both good and challenging times. These are the key areas we are focusing on to navigate this situation and emerge even stronger.

Okay, thanks for that color, Hassane. I guess, Thad, one for you on a little more specifically on the gross margin side of things. You talked about a bunch of different moving parts in your third quarter guide and then even over the next few quarters with silicon carbide being a point or two headwind to gross margin. Can you just walk us through the puts and takes? And I believe at one point, you thought you could keep the gross margin relatively flat at this kind of 49-ish level for the next few quarters, even into the first half of next year. Is that still true?

Yes. Look, we're in our targeted range of 48% to 50% in our guidance. I noted that they got a headwind of 100 to 200 basis points resulting from silicon carbide. As Hassane mentioned, the silicon carbide is ramping faster than we anticipated even 90 days ago, and that's causing a dilutive impact. Silicon carbide products at scale are at or above the corporate average. So we're comfortable that we'll continue to achieve our goals there; it's primarily just the lumpiness of bringing capacity on and supporting that growth that gives us a headwind here. But we are still very happy that we can maintain margins at this level within our target range as we ramp silicon carbide. And by the way, bringing utilization down slightly to offset some of the inventories that Hassane talked about as well. So I think, again, that shows the resilience in the model.

Thank you.

Hey, thanks, guys. Just a follow on Ross' question. So theoretically, when would gross margins bottom for both the silicon carbide and for the overall company?

We believe we are within our target range. There will be some fluctuations in the coming quarters, but we expect to maintain that range, give or take. I would suggest this is the rate to use when modeling.

Okay. And then as a follow-up, you talked about some macro issues in the non-auto and industrial business. Can you just expand on that? And are you guys predicting that they will get any worse, or have we seen the worst there? And does this have any impact on the overall pricing for the company?

Yes. This is Hassane. Look, I don't know about getting better or worse. They're non-core. We've always said a lot of that business are the areas we want to exit. So we're taking utilization down as part of our strategy. It's not going to have an impact on margin from a dilutive side because I've always said, and I've been firm even on these calls prior, we're not going to chase that pricing down. We are planning on exiting that business. And therefore, you shouldn't expect any dilution on the margin because of it.

Great. Thanks, guys.

Thanks for taking my question. I wanted to dig into your very strong disclosure on the silicon carbide side. If I got it right, I think, Hassane, you mentioned $1 billion for next year. I think in the past, you said $1 billion exiting '23 and then probably more than $2 billion in '24 and then $4 billion in terms of run rate or pipeline. I forget the exact word you used, and I think that number used to be $2.6 billion? So, I'm curious, what has driven the upside to your silicon carbide numbers to this extent? How much of this is autos? How much is expanding relationships with existing customers versus new customers versus new customers? And then I had a follow-up.

Sure. Look, I've always said the strength of our silicon carbide starts with technology. And when I talk about technology, devices and packages, we have differentiated solutions that matter at the end system, meaning it translates into longer battery life, longer range, whatever tuning the OEM would like for that specific platform. So that's consistent, that's now proven in the results that we've seen already, beyond what we projected, but also in the outlook that we've said. And you're right, the first disclosure that I put is, I've always said we're going to double our silicon carbide in '20. I changed that to triple in ’22 based on the trends that we're seeing already, even in the second quarter. So, we're going to exit 2022 at a higher run rate than we expected. And then we're going to continue that growth in '23, which leads to the updated number that I've given on the $1 billion in '23. Now on the $4 billion, that's a mix of existing customer that started ramping, came back and for its traditional platform on LTSA and some of them extended the LTSA, but also within the quarter. We have extended the LTSAs with new customers and new platforms. So, it is broad, it's geographically and customer diverse. And some of it includes OEMs directly, and that's the level of strategic partnerships we have had. About 90% of it is automotive, and then you saw me talk about the solar side or the renewable energy side, where we've also had LTSAs with the top 7 that's a slower ramp, obviously, than automotive. But nevertheless, that keeps pushing. So, 90% of automotive strength and stickiness because of our technology across the board. And of course, we can’t underestimate the end-to-end capability we have for the supply assurance.

Got it. And for my follow-up, how should we think about the percentage of in-sourcing versus outsourcing of substrates that it will take to achieve your $4 billion target over time? Maybe if you could give us a sense for how much of the substrate requirements are being met internally? And then how do you see that ratio go through time? And what that implies for your capital intensity over time? Thank you.

Yes. So look, our capital intensity already has a lot of the expansion that we talked about. I've always said we're going to exit this year with a quadrupling of our substrate capacity after the GTAT acquisition. We're on track of doing that. That's going to fuel the growth in the subsequent years. And, of course, as we put that capacity online, the percent of internal will keep increasing towards what we want, which is the majority internal. We're always going to have an external component of it because we don't build capacity for a max peak of a ramp. We build capacity for a steady state. So we're going to use external substrate if we need to flex during a ramp. But other than that, I would expect the majority will be from our internal, and that's already accounted in our CapEx numbers.

Hi, good morning. Thank you so much for taking the question. I've got two as well. First on gross margins. I guess a multi-part question. Thad, you mentioned that the gross margin headwind from the silicon carbide ramp over the next several quarters to be one to two percentage points. Curious how the progression of that will look like, meaning should we expect 25 to 50 basis points of headwind every quarter, or is it more back-half loaded? Any sort of shape of that headwind would be helpful. And then how should we think about EFK from an accounting perspective, how much depreciation would hit your P&L? And what are the implications for gross margins in the first half of 2023?

Yeah. So this is Thad. Let me take those in reverse order. So EFK comes online in 2023. So you're not going to see an impact in Q3 and Q4, obviously. As we bring on the fab, we'll be providing foundry services to GLOBALFOUNDRIES for the next three years, which will wind down. As we've said, there is revenue associated with that foundry agreement, which is low margin. You can think about it as being foundry margins in the mid to high single digits range. You can think about for 2023 as that being a headwind of somewhere around 40 to 70 basis points on a quarterly basis. And that's the impact of that. The rest of it, we feel like we can offset. And obviously, we get the efficiency of a better cost structure as we move more products into that fab over time as well. On the silicon carbide, as I said, 100 to 200 basis points of headwind. It is a little lumpy depending on the revenue and the timing of the equipment. We do believe we can keep the margins in this range of 48% to 50% for the next several quarters. Even with that headwind, you may see it move around a little bit, plus or minus 50 basis points here and there, but we think we can be in that tight range even offsetting those margins. But it doesn’t necessarily linear from this point to 200 basis points; it's a little more fluctuation. And like I said, you'll see a little bit of fluctuation on the gross margin line, but we don't think it's material, and we think we can offset it with other efficiencies.

A quick follow-up, Thad. The 40 to 70 basis point headwind from the EFK, should we expect you to hold the current range on gross margins even with that headwind, or could that drive another leg down in 2022?

No, no. Yeah. No, we believe we can offset it with other gross margin expansion initiatives in our fab lighter strategy. So even though it's a headwind, we feel like we can still maintain our margins in this range.

Great. Thanks for taking my questions, Thad. I think you said that your CapEx plan includes funding from customers. Can you perhaps detail how much of your CapEx plan includes such advances and how that influences your thinking about spending?

Our capital expenditure remains stable at around 12% for the next few years. We anticipate maintaining funding from customers to offset this, although it won’t be reflected in our capital expenditure figures. Our capital intensity will not change as we continue to report it that way. We are working with customers who are co-investing with us, including some non-recurring engineering expenses, to develop silicon carbide and other capacities we are bringing online. This collaboration enhances our relationships with those customers on a strategic level, making them more committed to us.

And my follow-up, if I can, relates to the business that you intend to exit. Can you remind us how much of that is left after the current quarter? What's left to exit, and maybe the pacing and margin of that, please?

Yes, good question. So, we've got roughly around approximately $600 million left to exit. We've always said that would be market-driven. We're pricing that in a position that as capacity comes back on, and it's the price-sensitive part of our portfolio that we would likely exit it. We haven’t been exiting as fast as we anticipated. Originally, we thought we'd exit about another $300 million in the latter half of this year. We think we're probably going to exit about half of that. So, roughly about $150 million between Q3 and Q4. And then that obviously leaves a big slug for us next year as well in 2023. If the market gets softer faster, we could exit that faster. We've always said faster is better for us. We'll right-size our manufacturing and reallocate that capacity into automotive and industrial. But you can expect roughly kind of even, I think, $75 million a quarter between Q3 and Q4.

And the margin on that, can you remind us?

Yes. That margin is, when we exited last quarter, I think it was about 34% margin. You can think about most of that today being in the low 40% range.

Thank you for taking my question and congratulations on achieving good results in this uncertain environment. Thad, I'd like to follow up on the gross margins. If I consider the EFK challenges resulting in negative 40 to negative 70 basis points per quarter, along with the silicon carbide startup costs causing negative 100 to 200, we're looking at a total potential impact of negative 140 to negative 210 basis points on gross margins over the upcoming quarters. If we exclude those factors, your gross margins could exceed 50% in a more normalized situation. My first question is, that still represents a significant challenge when combining the two impacts, yet you're discussing a range of 48% to 50%. What specific factors are helping you counteract that headwind, particularly given that utilization rates may decline for some of the non-core business? I'm interested in understanding how you plan to manage these various challenges in the coming quarters.

Yes, this is Hassane. In the short term, we are managing headwinds through our internal efficiencies. I've mentioned the ramping of new products, especially those outside of silicon carbide, which positively impact gross margin. We are actively working on numerous items to mitigate these challenges. In the longer term, as silicon carbide production increases, the dilution effect will decrease. Additionally, our foundry business with GLOBALFOUNDRIES will show a year-over-year reduction, further alleviating these headwinds. For now, we are focusing on operational efficiencies, and as we progress, we will adjust structurally. Throughout this process, we are carefully navigating the market by balancing utilization and inventory.

Thank you for that, Hassane. For my follow-up, the auto business generated $784 million in Q2 compared to $556 million in June of last year. Excluding 2021 and 2020, which were impacted by COVID, it's still nearly 80% above pre-COVID levels. In June 2019, it was $440 million, and now it's $784 million when viewed in that context. Clearly, unit sales have been declining since 2019. While the content remains strong, I'm curious about how you're achieving such significant growth compared to pre-COVID levels. What are the dynamics regarding pricing, and how sustainable is this pricing scenario as we approach next year?

Yes, that's a very good question because that's something I look at internally. So, from the unit's perspective, you can't really linearize the units because a lot of the things we have been exiting also when we talk about not just the non-core market, but also nondifferentiated products, a lot of it is that very, very high volume very, very low ASP business that we have been exiting, which some of it is going into automotive. So, from a unit decline, I review that. The only thing I look at that is how to balance the manufacturing into our fab lighter strategy. So that's one thing here. But a lot of the new products that we are shipping are higher ASP but not as much volume. Think about IGBT modules, think about silicon carbide modules, much higher ASP and much lower volume. The second part of the growth is, if you compare the EVs built back into, if I go back to '18, if you want to do that as the baseline, EV units are much, much higher percent of total units built than they were three years ago, even compared to last year. So, a lot of that is the content. Then of course, you have the pricing stuff, which I've always said, is some of it we're pricing ourselves out of the market and that's the stuff we're not going to chase down and that's sustainable as far as margin, not sustainable from a price perspective, and that's expected. But the price-to-value discrepancies that we have been doing are sustainable. And the way I monitor that is, one, the LTSAs that customers are signing, which include volume and price over the length of the LTSA. And even in my prepared remarks, I talked about customers coming in and wanting to extend those LTSAs beyond the original timeline that they had. And LTSA is not about image sensors or silicon carbide; it is some of them have 200 parts from ON Semi. So, customers are valuing the whole portfolio, they're valuing where we are economically, even with the price-to-value discrepancies because we started way below market, and that is sustainable, one from the LTSA side; and two, I know kind of a feel of where we are versus the market, and we're not an outlier.

Thank you.

I believe that would be me, Gary Mobley, Wells Fargo Securities. I apologize, if otherwise. But I had a multi-part question on silicon carbide. And so, I'm wondering what your view is on silicon carbide contribution to gross margin over the long term? Will it be at corporate gross margin when that business is $1 billion plus next year? And with respect to silicon carbide materials capacity or supply, I believe there's a constrained situation in that market today. And so, I'm wondering if that's contemplated as well into your fiscal year '23 outlook?

Yes. The silicon carbide, as we've said, is at or above the corporate average gross margin at scale. We believe for the next several quarters, we're going to have the headwinds of 100 to 200 basis points. But I think if you think about late next year, we will – that headwind should be behind us, and we will be achieving those gross margin targets at that time.

From a supply and demand perspective, it's challenging to produce silicon carbide, and scaling it at our desired rate is even more difficult. Given the rapid increase in electric vehicle adoption, it's evident, and industry analysts support our view, that silicon carbide supply will be limited in the near future. This is why we are heavily investing in expanding our production capacity and supporting our long-term supply agreement customers. The increase in these customers signing up for committed revenue reflects their desire for us to invest in capacity so we can meet their needs without delays. They want to avoid announcing electric vehicle plans without ensuring the necessary technology is available. We are collaborating closely with our customers to assist in their electric vehicle initiatives through long-term supply agreements and significant investments to accelerate our production pace.

Appreciate. Thanks, guys. As my follow-up, I wanted to ask about what's embedded in your third quarter guidance with respect to some of the end markets that may be showing some softness? In particular, I'm curious to know what your exposure is currently between consumer PCs and smartphones. Can you remind us of that?

Yeah. Look, when we think about the guidance going forward, we believe that auto and industrial continue to be supply constrained. So we believe that auto is up more than our guidance. We think that industrial is flat to up, and we think the other markets are potentially down, and that's the conservative our guide there. We don't break out between those various markets. They're not strategic to us. And part of where we're seeing the softness is the non-core business that we're hoping to exit. So if that does get softer faster, that could allow us to exit even quicker.

Great. Thank you. Staying with the silicon carbide topic, as I add up the numbers you're talking about and I look at the numbers that your top four or five competitors are talking about, we're getting to numbers that are much larger than the third-party estimates for silicon carbide. So I assume that the market is growing faster than the third-party success, but I would have thought we were constrained by battery capacity and just the general EV and battery power capability of your customer. So, do you think the market is expanding that much more rapidly versus onsemi’s success within the market? And do you think some people might be overly optimistic about how big this could be?

Yeah. Look, one thing you sure have taught me is external reports are accurate backwards-looking, not so much forward-looking. The numbers I'm putting together, and I'm sure some of my peers do that. Our bottom line for us, I can speak specifically, are numbers that are under long-term supply agreements. And remember, we always talked about those are committed revenue. I don't talk about funnel. I don't talk about projections of what conversion is going to be. These are long-term supply agreements; contractual documents between us and the customer, stating by year and some of them by quarter about what the ramp profile. We have identified vehicle platforms that we're working on with the customer where that silicon carbide is going to go into. So from the onsemi side, I can speak very comfortably about the ramp that we are seeing because that's what we're working on. Now from what derisks the ramp and the market in general is the geographical and customer/platform diversity that we have engaged in, where if there is one model that doesn't ramp the way they expect, there will be another model that will ramp faster than they expect. Because for us, the LTSA, especially the ones with an OEM, are at an OEM level, not necessarily at a model level. So that's how we balance the risk. A lot of the strategics that we are working with, we always look at overall capacity from a battery perspective because that will be kind of the secondary bottleneck. A lot of these OEMs have committed battery capacity and they've made their own disclosures, so I won't comment on that. So from a ramp perspective, it is ahead of where we even thought; there is an acceleration of silicon carbide that we have seen in our current revenue and have seen outlined in our projections with the long-term supply agreements, but we are ready for it and our customers have everything else they need to ramp up that volume.

Thank you very much. I have a quick follow-up regarding a housekeeping matter. Is the treatment of the start-up expense in silicon carbide similar between GAAP and non-GAAP, or are there significant differences we should know about?

All of our startup costs are in our non-GAAP results. So we don't exclude anything. That's the headwinds.

Hey, guys. I had a quick one. When I talk to investors that are negative or bearish on the stocks, they often bring up the fact that you guys might have been involved in raising prices a lot more aggressively than some of your other competitors. I was curious, Hassane, if you could walk me through how things work in real life in the business. Is that even possible that you are super aggressive in raising prices and maintaining business with our customers, or do you risk losing business? I was just curious if you can give me the puts and takes on that angle. And then I've got a quick follow-up.

Yes, I've been clear about this. There are two parts to consider. First, in the non-core business we aim to exit, we have priced ourselves out of the market. This is an intentional strategy, and we have acknowledged how much business we've lost and plan to lose. On the other hand, regarding our value products, I believe there is no risk of losing that business. We remain committed to our customers and have long-term supply agreements with them, indicating that our pricing is reasonable. If it weren’t, customers wouldn’t sign or renew these agreements. While we may have raised prices more significantly than some competitors, it’s critical to understand where we began. In many areas, our prices were below market, so adjusting them back to market levels may look like a larger percentage increase, but it does not place us above market. The data and our customers’ commitments support this perspective.

Hey, thank you very much, Hassane. That was very helpful. And then, as a follow-up real quickly, there's a lot of chatter, a lot of talk, not from you guys, but from everywhere else about a Tesla contract possibly. Are you willing to talk about that at all? And is that a part of the $1 billion 2023 goal? That's another question we get from investors a lot.

Look, I will maintain my policy of not commenting on specific customer engagements or customer ramps. So I'll leave it at that.

Fair enough. Thank you, Hassane. Congrats, guys. Thanks.

Thank you.

Thank you.

Thank you all for joining us today. We delivered outstanding results in the second quarter, and I again want to thank our worldwide team for their commitment to excellence as we execute our strategy. While we have exceeded our expectations, we are nowhere near the full potential of ON Semi. With accelerating growth in our silicon carbide and megatrends, we are on a path to deliver sustained above-market revenue and earnings growth. We look forward to seeing you at various investor events during the quarter. Thank you.