ON Semiconductor Corp (ON) — Q3 2022 Earnings Call Transcript

Thank you, Liz. Good morning, and thank you for joining onsemi's third 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 2022 third quarter earnings release, will be available on our website approximately 1 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 inspection of our website. Our earnings release and this presentation include certain non-GAAP financial measures. During the course of this conference call, we'll make projections or other forward-looking statements regarding future events or future financial performance of the company. 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 most recent filings. Our estimates or other forward-looking statements may change, and the company assumes no obligation to update forward-looking statements to reflect actual results, changed assumptions or other events 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 the call. We have closed our sixth consecutive quarter of record financial results with revenue of $2.2 billion and a non-GAAP EPS of $1.45 in the third quarter. Onsemi is now a very different company. Our strategy has proven successful, and our employees are the ones to thank for their commitment and dedication to excellence through these changes. Congratulations to our worldwide teams. I am proud of your steadfast and consistent execution, and I'm confident we will continue to deliver on our long-term growth plans. Now let me address the current demand environment. In the third quarter, we saw continued strong demand in the automotive and industrial end markets, with revenue increasing sequentially 11% and 5%, respectively. As we noted last quarter, we saw softening in our non-strategic end markets of consumer and computing, with both markets declining mid-single digits sequentially. We expect the weakness in these markets to persist and extend to some legacy areas of industrial, while demand and design activity remain robust for EV, ADAS and energy infrastructure. Today, more than 30% of our revenue is generated from the sales of new products at accretive margins, and the third quarter new product revenue was a record for the company. Over the last 18 months, we have taken a concerted approach to improve the predictability and reduce the volatility of our business. We have transformed the company into one with a sustainable long-term growth outlook and attractive financial profile and a resilient operating model. We made proactive structural changes to prepare us for eventual headwinds. We rationalized our product portfolio and exited $277 million of business to eliminate our exposure to price-sensitive, non-differentiated products at dilutive gross margins. We addressed price-to-value discrepancies and instilled a discipline in the company to capture the right value of our products. We executed our fab-lighter strategy with planned exits of four fabs to reduce our fixed costs. We secured long-term supply agreements that provide committed and transparent supply assurance against long-term customer demand. We decreased wafer starts by 20% from the peak in Q1 to limit the inventory build, with distribution now at an all-time low under seven weeks. We drove efficiencies and streamlined operations to control OpEx below our 17% target. These changes set onsemi apart from the legacy semiconductor industry, and we are now well equipped to navigate through the coming quarters. And while we are planning for short-term uncertainty, long-term demand for our highly differentiated intelligent power and sensing solutions continue to grow, with Q3 design wins increasing 19% quarter-over-quarter. Our intelligent power revenues grew by 35% year-over-year and 6% quarter-over-quarter, driven by the accelerating momentum in electric vehicles and alternative energy. In these markets, customers are increasingly relying on us to enable their long-term product road maps with the market-leading efficiency of our solutions and our end-to-end supply chain capabilities. Our progress toward our silicon carbide leadership is accelerating. As compared to our exit rate in Q4 of '21, we tripled our silicon carbide revenue in the third quarter, and we continue to install capacity across the entire supply chain. We just passed the one-year mark since acquiring GTAT, and we remain on track to expand our Boule growth capacity by 5x year-over-year exiting 2022. We have also increased silicon carbide wafer fab starts by 3x this year to keep up with our Boule output, a number which we plan to double again next year. We remain on track to triple our SiC revenue in 2022 and deliver $1 billion of revenue in '23 based on committed revenue from LTSAs. To limit our long-term CapEx investments, most of the silicon carbide equipment we are installing around the world is 200-millimeter capable, and we are on track for 200-millimeter wafer qualification in 2024 and related revenue ramp in '25. Our energy infrastructure revenue is accelerating with a year-over-year increase of 70% in the third quarter. For '22, we expect our energy infrastructure revenue to grow by 60%, exceeding our target of 50% year-over-year growth. The volatility in global energy markets is driving an accelerated transition to alternative energy. With a broad portfolio of silicon carbide and silicon power modules, we have emerged as a leader in this market. The top 10 solar inverter providers in the world collectively have a market share of 80%, and we have now signed LTSAs with 8 of them. As countries around the world strive for energy security and lower greenhouse gas emissions associated with fossil fuels, we can expect strong long-term growth in our alternative energy business. Traction for our silicon carbide solutions is complemented by continued growth in our silicon power business. A key differentiating advantage for onsemi is our ability to offer silicon and silicon carbide solutions across a wide range of power and voltage requirements. Many EV customers use our silicon carbide solution for rear axle and a silicon solution for the front axle. Similarly, solar inverter customers choose our silicon carbide or silicon solutions based on power and efficiency requirements. Customers who use a combination of power solutions value our ability to offer a complete range of products, which enables us to gain market share across both technologies. In the third quarter alone, our IGBT and MOSFET businesses grew 37% year-over-year, driven by high-growth mega trends in automotive and industrial. Our intelligent sensing revenue increased 43% year-over-year and 11% quarter-over-quarter. The growth was driven by additional semiconductor content required in automotive and industrial applications as well as an increase in units shipped. The number of sensors per car will continue to grow, and the sophistication delivered by the latest generation systems is also driving ASPs higher. Safety rating requirements for new vehicles continue to increase, such as a broader field of view and higher-resolution sensors, accelerating the shift from 1-megapixel image sensors to 8-megapixel sensors for ADAS applications. Onsemi was the first to market with 8-megapixel automotive-grade sensors that provide both high detection range and a wide field of view, delivering consistent performance across all temperature and lighting conditions. Based on this industry-leading dynamic range, dark noise performance, and LED flicker mitigation feature of our sensor, we are winning new designs. In the third quarter, we displaced the large incumbent at local Japanese automotive OEMs. We expanded the internal back-end capacity to ensure we support the growth of our business and enhance our margins. Demand has been outpacing our ability to supply, but our early investments in capacity expansions allowed us to deliver 38% more automotive sensors in Q3 than in the quarter a year ago. We are a much stronger company today because of our commitment to our transformation and the structural changes we have implemented over the last 18 months. We have executed our strategy in one of the most challenging environments we have ever seen, not only for our industry but for the world, and we've set ourselves up for a leadership position in our target markets. Driven by exposure to secular mega trends of vehicle electrification, ADAS, energy infrastructure, and factory automation, we are well positioned to continue to outgrow the semiconductor market. Now I will turn the call over to Thad to provide additional details on our financials and guidance.

Thanks, Hassane. Our third quarter results clearly showcase the effectiveness of our transformation strategy with record revenue, operating income, and free cash flow. The measures we have implemented to enhance our operational model will not only help us navigate short-term market fluctuations but also support our long-term scaling efforts. By defining our key focus areas, we have intensified our commitment to intelligent power and sensing technologies, establishing our leadership in differentiating factors within the automotive and industrial sectors. Our customers now see onsemi as a strategic partner for success in emerging and disruptive fields like electric vehicles, ADAS, energy infrastructure, and factory automation. We are witnessing new agreements being forged and existing long-term supply agreements being expanded to secure more extended supplies. Revenue committed through our long-term agreements rose by $5.3 billion in the third quarter, totaling $14.1 billion and often covering hundreds of parts over multiple years. As Hassane pointed out, we've also implemented further structural changes to enhance our margin sustainability by streamlining our product portfolio and reducing exposure to price-sensitive, non-differentiated goods. So far, we have walked away from $277 million in revenue at an average gross margin of 25%, with $39 million from this revenue in the third quarter at a gross margin of 35%. We are continuing our fab-lighter strategy by reassessing our manufacturing footprint. After selling the Belgium and South Portland fabs in the first half of the year, we closed the sale of our 8-inch fab in Pocatello, Idaho in October and entered into a definitive agreement to sell our 6-inch fab in Niigata, Japan, expecting that transaction to close in the fourth quarter. Exiting these four fabs will lower our annual fixed costs by $160 million, surpassing our target of $125 million to $150 million. The complete benefits of these sales will unfold over the next several years as we transition production to other fabs in our network, further bolstering our long-term gross margin expansion plans. As for our third-quarter results, we achieved total revenue of $2.2 billion, marking a 26% increase from the third quarter of 2021 and a 5% rise quarter-over-quarter. We reached record revenue levels in our strategic automotive and industrial markets, which accounted for 68% of total revenue compared to 61% last year. Despite persistent weakness in our non-strategic computing and consumer markets, we observed sequential growth in automotive and industrial sectors of 11% and 5%, respectively. Revenue from both intelligent power and intelligent sensing also reached record heights, with intelligent power growing 35% year-over-year and intelligent sensing increasing by 43% year-over-year. Furthermore, all three of our business units reported record revenue in the third quarter. The Power Solutions Group generated revenue of $1.12 billion, a 25% increase year-over-year. The Advanced Solutions Group reported $734 million, a 20% year-over-year increase, while the Intelligent Sensing Group saw revenue of $342 million, reflecting a 45% year-over-year growth. Our GAAP gross margin for the third quarter was 48.3%, with a non-GAAP gross margin of 49.3%. The non-GAAP gross margin declined as anticipated by 40 basis points quarter-over-quarter, mainly due to an accelerating ramp in silicon carbide and a lower factory utilization at 75%, as we proactively reduced wafer starts by 20% since the beginning of the year. We previously indicated that silicon carbide start-up costs could reduce gross margins by 100 to 200 basis points during the initial revenue ramp. The GAAP operating margin for the quarter was 19.4%, while the non-GAAP operating margin reached a record 35.4%, an increase of 90 basis points quarter-over-quarter and about 1,100 basis points year-over-year. GAAP earnings per diluted share for the third quarter stood at $0.70, unchanged from the same quarter last year. Non-GAAP earnings per diluted share hit a record high of $1.45 compared to $0.87 in the third quarter of 2021. For your models, GAAP operating expenses for the third quarter were $634 million compared to $322 million in the third quarter of last year. Non-GAAP operating expenses were $304 million, up slightly from $296 million in the same quarter last year, which was below our guidance due to postponing certain programs to the fourth quarter, hiring delays, and proactive management of discretionary spending across the company. Our non-GAAP tax rate for the third quarter was 15.8%, and we expect it to stay within the 15.5% to 16.5% range. Our GAAP diluted share count was 449 million shares, while the non-GAAP diluted share count was 441 million shares. We repurchased 1.2 million shares for $80.1 million in the third quarter. There is an updated reference table on the Investor Relations section of our website to help with calculating our diluted share count and various share prices. On the balance sheet, cash and cash equivalents amounted to $2.45 billion, with $1.5 billion undrawn on our revolver. Cash from operations reached $1 billion, and free cash flow was $731 million, marking a record level of 21% of revenue on a last twelve months basis. Capital expenditures for the third quarter were $271 million, translating to a capital intensity of 12.4%. As previously mentioned, we are allocating a significant portion of our capital expenditures towards silicon carbide and enhancing our 300-millimeter capability at the East Fishkill fab. Accounts receivable totaled $857 million, down by $281 million, and DSO of 36 days declined by 14 days quarter-over-quarter. Days of inventory decreased by 7 days to 129 from 136 in the second quarter, which includes approximately 23 days rich inventory to support the upcoming silicon carbide ramp. Distribution weeks of inventory fell to 6.9 weeks, down from 7.0 in the second quarter as we actively manage inventory at historically low levels for our distribution partners. Total debt was $3.2 billion. As for our fourth-quarter guidance, detailed GAAP and non-GAAP guidance is available in the press release regarding our third-quarter results. In terms of non-GAAP guidance for the fourth quarter, we continue to observe strong demand from our automotive markets, propelled by electrification and ADAS. However, we are starting to see some weakening in specific industrial applications and expect further decline in our non-strategic markets that we plan to exit during our portfolio rationalization. Given the current macroeconomic uncertainty, we are approaching our fourth-quarter guidance cautiously, forecasting revenue in the range of $2.01 billion to $2.14 billion. We expect non-GAAP gross margin between 47% and 49% due to lower factory utilization and the dilutive effects of ramping silicon carbide, which also incorporates $3 million for share-based compensation. Because of the delayed hiring and project expenditures in the third quarter, we predict non-GAAP operating expenses will rise to between $305 million and $320 million, including $21 million for share-based compensation. We anticipate our non-GAAP OIE to be between $22 million and $26 million. Our expected non-GAAP tax rate is likely to remain in the range of 15.5% to 16.5%, and our non-GAAP diluted share count for the fourth quarter is projected to be around 441 million shares, leading to non-GAAP earnings per share in the range of $1.18 to $1.34. We foresee capital expenditures of $300 million to $330 million in the fourth quarter as we continue to ramp up silicon carbide production and invest in 300-millimeter capability for long-term growth. We expect our capital intensity to be in the mid- to high-teen percentage range. In conclusion, our transformation strategy has made onsemi a more resilient and sustainable company. We were recently recognized by Investor Business Daily as one of the 100 Best ESG Companies for 2022 as we strive for net zero by 2040. We are well-positioned to invest in our future and deliver long-term financial results for our shareholders while reinforcing our competitive advantage. Now, I'll turn the call over to Liz for the Q&A session.

I guess the first one, Hassane, is on the revenue side and the demand side of the equation. You mentioned uncertainties and then you talked about auto staying strong, but weakness in other places. Can you just talk a little bit about the linearity of demand and maybe dive a little bit deeper into what you're seeing in the industrial market? I think people understand your other segments have been weekend markets and aren't strategically a focus for you, but the industrial side is. So a little bit of color on those metrics would be helpful.

Sure, Ross. At a high level, we are seeing strong orders in automotive, which are supported by the long-term supply agreements we've discussed, including renewed and extended agreements that align with our demand outlook. That's the reason we're increasing our capacity. We've observed robust performance in our business this quarter as we advance electrification and advanced driver-assistance systems. These trends are propelling automotive demand, and we expect that to continue. On the industrial side, we are witnessing strengths in factory automation and renewable energy, along with our medical sector. However, we are experiencing some softness in segments closer to the consumer, like white goods. This softness appears to be driven by macroeconomic factors, and we are monitoring it closely, but that's where we see the challenges in the industrial market.

Anything in the linearity side of the equation, just the back half of that question?

It's up and to the right.

And I guess as my follow-up, one for Thad, on the gross margin side of things. It's good that you guys are still sticking with the 1 to 2 percentage point headwind from the silicon carbide ramp, but we've heard a number of your competitors talk about the difficulty in that ramp. So can you give us a little bit more color on what gives you the confidence in maintaining that hit as you're ramping so significantly? And if the revenue side of the equation and the demand side is as high as it is, doesn't the CapEx have to rise accordingly? If you're going to do over $1 billion in revenues, how is your capital intensity staying roughly the same?

Yes. Look, I'll cover the first part of that as far as the difficulty, and let Thad talk about the CapEx. Look, yes, this is hard stuff. So I sympathize with our competitors because it's not easy. We've been facing standard ramping challenges, but we're able to leverage our scale worldwide and the worldwide manufacturing scale that we have and the experience to address these issues as they come up. We have an excellent and very experienced operations team, and that's what they do every day. We have mature processes. We have a very strong scale of manufacturing playbook. So any excursion, if they do happen, we're able to tackle it quickly, we're able to resolve it quickly, and that impact is always minimal. That's why you've seen us always focusing on the ramp and more importantly, our confidence in our ramp against the difficulties of what that silicon carbide ramp will bring in. So our targets that we've been giving and our targets that we've been talking specifically on the revenue ramp are all within our capabilities, and we strongly believe the risks are very manageable for us.

Yes. Ross, on the capital intensity, as I said in my prepared remarks, we expect our capital intensity to go up to the mid- to high single digits over the next several quarters. Clearly, we're having to place orders for equipment further out to support this revenue ramp, but we do expect our capital intensity to go up.

So as part of this weakness, have your pricing expectations changed for 2023? And then do you expect the weakness to bleed over into the automotive end market as well?

This is Hassane. No, we don't see any movement on pricing. Obviously, we've been talking about the LTSAs we have in our strategic products are based on the value of the products. That does not change based on the outlook and the demand, and the LTSAs provide that certainty of both volume and pricing, as we've said in the past. So I don't expect that to be any place in the equation, not even in automotive and industrial. Obviously, where pricing would be potentially volatile is in the businesses that are not core that we plan to exit, and that has always been part of our exit strategy. That would actually be favorable to margin. So we're not worried about the pricing environment at this point.

And Chris, the one thing I would add is as we see input costs going up, we are passing that on to our customers, and we'll continue to do that as well. So the pricing environment is very stable.

Great. For my follow-up, have you noticed any changes in your lead times? Additionally, are there any existing shortages for the products, or have those all been resolved?

Lead times are stable and consistent. We do have certain technologies that are still in short supply relative to our demand, and we anticipate that these technologies will remain constrained throughout 2023. We have long-term supply agreements in place with our strategic customers to ensure that we can cover the entire bill of materials for our customers, supporting our new product ramp-ups next year.

Hassane, I just wanted to follow up on the question Chris also asked, which is on just the supply-demand balance on the automotive side. There is a concern that automotive could be kind of this next show to drop in this rolling correction in semis. What are you hearing from your auto customers about? Are they building inventory right now? What is the supply-demand balance when you look at OEMs and Tier 1s, especially towards the first half of next year?

Look, the visibility we have shows there is no inventory. Are there small pockets because of the golden screw problem? Yes. We work with our customers to make sure when we batch build something, we will give them a few weeks or two to three weeks ahead, and they drain it over the next few weeks. So those, I'm not worried about because we work with our customers directly. If you look at the demand environment and where our growth and our demand is coming from, it's coming from EVs. No matter what report you look at or what customer you talk to, an OEM, pure-play EV OEM or a broad OEM, there's one thing consistent. No matter what the SAAR does, they will build more EVs next year than they do this year. That's where our growth is coming from, both power and then more and more safety in cars. That's where our sensing comes in. Between those two megatrends, our content is going to grow and remain growing even through '23, no matter what the SAAR does in this case, based on a lot of the predictions. So that gives us the confidence. Again, we have secured that outlook with LTSAs. So I'm not worried about that part of it. Is ICE engine going to have some softness because of rates going up or demand going down? Potentially. But again, the EV plants are the ones that we focus on, the ones that our OEMs want to make sure they secure their EV penetration or they're going to lose share. So that's what we work on. But it is not because of any inventory. If anything, it's potentially just demand. But at this point, we don't see it for our business given our exposure to EV.

Got it. And for my follow-up, on gross margins. Thad, I think on the last call, you said you felt comfortable staying in this 48% to 50% range. So when I look at the Q4 outlook, you are at 48% already. How should we think about the puts and takes from a calendar '23 perspective? Because you'll be taking on the East Fishkill fab, right, which you have outlined some headwinds from, and then, of course, silicon carbide ramps. So there are some headwinds, and your utilization right now is 75%. So can you stay in this 48% plus kind of range for next year? Just what are kind of the puts and takes of gross margins for next year?

Yes. For 2023, there are a couple of headwinds to consider, including a dilution of 100 to 200 basis points from silicon carbide and 40 to 70 basis points from the East Fishkill foundry business. Ultimately, our margins will largely be influenced by market dynamics. We're confident in our pricing for next year, but it really hinges on utilization. Given the current environment, we are being very cautious and modeling conservatively. However, based on what we see now, we believe there is a floor for our gross margins in the mid-40% range, driven primarily by market conditions.

This is Josh Buchalter on behalf of Matt. Congratulations on the results. I wanted to ask about capital expenditures. It seems that for at least next year or the next few quarters, spending will be significantly higher than the initial 12% outlook. Can you explain what is driving this increased spending and particularly, why the rise is happening now?

Yes, the uptick is to support the LTSA revenue that we continue to lock in. I referred to the increase that we had in Q3. Clearly, we're locking up more and more open carbide wins, and the ramp will go out for the years, and that requires additional capital. That's the reason that we're continuing to make investments.

Then obviously, Thad mentioned the equipment lead time. We want to make sure we stay ahead of it. So that's forcing us to place orders materially earlier than we typically would need to. We don't want to run the risk of not being able to support our ramp. So we're being very proactive given the environment and the lead time of equipment vendors.

I appreciate the color there. And then you sort of mentioned the issue at one of your competitors with the yields that we found out about last week. Since then, we've been getting a lot of questions on whether there is any read-through into your own internal substrate ambitions. Can you walk us through your thinking there? Is it sort of just a normal part of coming up the yield curve? Or was it from your view, some specific to design decisions that they made?

I can't comment on their decisions or assumptions. I can only discuss our business and what we are doing. We have consistently provided the same outlook regarding our ramp, margin targets at scale, and the headwinds from start-up costs, all of which are reflected in our reported results. These factors have remained unchanged, and we have been very consistent over the past few quarters. This consistency should give you an idea and confidence that the numbers and models we provide are well within our capabilities, including any challenges we may face. We have factored all of those into our plans. Our strong process and playbook, developed over two decades of manufacturing power products like IGBTs, support our ability to scale and navigate yield and production ramp challenges. We are still meeting both our top line and margin expectations, and those margins will be accretive at scale. There has been no change from our side.

Thad, you mentioned that you guys exited from $39 million in revenue in Q3. Three months ago, you talked about, I think, $150 million in the second half of this year and an incremental $450 million in 2023. Is that still the plan? Or given the weakness in the consumer end markets, could some initiatives be accelerated?

Yes. We've always said that the exit would be market-driven. The faster we could exit, the better off we'd be; we exited $35 million as you referred to. As we move forward to Q4, we think we're going to exit somewhere between $65 million to $75 million in Q4. For 2023, we still think we're on track, and again, this would be market dependent, but we think it will be in the neighborhood of $400 to $450 million in exits for next year as well. We think the softness in this market kind of supports this exit, allowing us to reallocate that capacity somewhere else that’s more valuable to us. Those are the numbers that we have line of sight to right now.

Great. And then as my follow-up, another one on gross margins. I'm curious what your plan from a wafer start or utilization rate perspective into Q4? You said 75% utilization rate in Q3. I'm guessing it continues to move south, but curious what the assumption is there? And in response to another question, you said you expect the mid-40s to be a floor for gross margins. In making that statement, what kind of volume and pricing assumptions are you making for '23?

Okay. Let me start by addressing the mid-40s as a floor in a downturn next year. We expect pricing to remain very stable for next year. While I won't provide specific guidance on that, it will be more influenced by market conditions. What was the first part of your question?

Utilization rates in Q4, what the plans are?

Yes. Thanks for the reminder. So Q2, we were at 77%. We dropped to 75% here in Q3. As we look forward into Q4, again, we'd assume incremental softness here. So we think it's flat to down slightly in Q4 as our assumption.

Question on the guidance on the top line. Can you give us any kind of direction by the nonstrategic or strategic?

Yes, Raji, let me break it out by end market. Auto, we think, is going to be up kind of low single digits. We think industrial is down kind of mid-single digits. Our other category, non-strategic, is down kind of mid- to high single digits. That's the way that we think about the guidance there.

Got it. The industrial sector is experiencing a mid-single-digit decline, and we have noticed a slowdown in the year-over-year growth rate, which has decreased quarter-over-quarter. Some competitors have pointed out softness in the industrial market. I'm interested to know if you believe this weakness in white goods is limited to just that segment. Even if it is confined to this small portion of the market, it still represents a significant share of your industrial division, especially if you're observing a mid-single-digit decline quarter-over-quarter. Are there any additional insights regarding your customers? Aside from alternative energy, are you observing slower industrial production in sectors like medical or others?

The industrial sectors, particularly factory automation and alternative energy, are expected to perform well. The white goods category serves as an example of what we consider legacy industrial, which is closely linked to consumer spending and real estate. The industrial market is extensive, and we're beginning to notice some softness in several of these legacy industrial areas. Our main emphasis is on factory automation and alternative energy, where we have been focusing our investments to drive new products, and this area continues to show strength and growth. However, it's important to note that the automotive and industrial markets are quite broad.

I appreciate that, Hassane. Regarding the operating expenses, they seem to vary significantly from quarter to quarter due to program pushouts. For Q4, the estimate is 12.5. As we move into 2023, I'm interested in how you're approaching the ramp in operating expenses. Will there be ongoing investment in research and development? I'm curious about how you're managing the operating expense framework, especially if demand slows down, and similarly how you're handling inventory. How are you planning to control operating expenses in calendar 2023?

Yes. Look, we've already been managing discretionary spending very carefully. Some of the lumpiness, as I mentioned in my prepared remarks with the timing of some R&D projects. What you'll see us continue to do is reallocate some of the spending into R&D as we grow. As we think into next year, we've set our model at 17%. We've been running well below that; I think kind of too low at this point. As I look into next year, I don't think we're going to get to 17%. I think we're probably going to be somewhere around 15.5%, maybe max out at 16% on the top end. That would be my thinking for next year.

Yes. This is Jeremy Kwan calling for Tore. I guess just two quick questions here. The first, regarding your long-term supply agreement, are there any upfront cash commitments or peak pace associated with this? I just want to get a sense of any kind of financial commitments that your customers have given.

Can you repeat the first part of your question? You broke up a little bit.

Sorry about it, Thad. Yes, the long-term supply agreement, just wondering if there's any prepayments associated with these?

Yes, absolutely. I mean, our customers have been co-investing with us, and we've been saying that for a while. That has to be prepayments that can be payments for capital. It could be co-investing in R&D. That's very typical.

Any chance you could quantify that for us?

No, they vary by agreement and duration. So I wouldn't want to try and put a number on it.

Got it. Okay. And then just returning to the pricing question. Is there anything you would like to highlight regarding the timing of the price increases you are implementing compared to the price increases you are experiencing in the supply chain? Also, is there a way to quantify this?

No, we're not giving quantitative because we're just passing whatever we get. From the outlook and from our margin, you can think about it as being neutral. So as we get it, we pass it on.

Your intelligent sensing group, mainly focusing on image sensor solutions, has a significant portion of the portfolio that was previously limited in capacity last year. This sector has shown strong performance this year, reportedly increasing by around 41% in the first nine months. I'm assuming you're receiving better capacity allocation from your foundry partners. Is the demand for image sensors still exceeding supply, and can you provide an update on the insourcing initiatives?

Yes. The demand environment remains strong, exceeding supply due to significant penetration in ADAS for automotive, regardless of whether it involves electric vehicles or internal combustion engines. We maintain a robust position in this market. Additionally, we've introduced several new products tailored for both automotive and industrial sectors, which are contributing to our new product ramp-ups. On the supply side, we are gradually receiving more supply each quarter as we update our road map with foundry partners. Internally, we are also expanding our back-end capacity to align more closely with the demand as we receive more wafers from our foundry partners. These efforts have allowed us to boost our units and revenue, primarily due to higher average selling prices resulting from technological advancements. We don't anticipate any slowdown in this growth. We will continue to increase capacity and secure more wafers from our foundry partners, which will sustain our business growth into next year.

Great. Hassane, you also talked about this a little bit in your prepared remarks. Being a leader in power, you guys have a pretty broad portfolio of solutions, right? So in addition to the silicon carbide traction inverter for EV and onboard charging, how successful has the team been in also pulling in, for example, the gate driver module, which uses your MOSFET portfolio, the front-wheel drive, IGBT traction inverters? This, I assume, is not included in the $4 billion pipeline, but it does sit alongside your silicon carbide solutions and represent further content gain opportunity. So how successful has the team been in sort of attaching these other components to your silicon carbide pipeline?

That's a good question. The team has been very successful. What I refer to as cross-selling is something our sales team actively engages in with the business unit I oversee. Specifically, the $4 billion committed revenue we mentioned for silicon carbide pertains solely to that product. Thad discussed our long-term sales agreements (LTSAs) which are now over $14 billion, having increased by more than $5 billion last quarter and encompassing hundreds of parts. You can view this as the cross-selling with a customer, ensuring that all the necessary components on their bill of materials (BOM) are included in the LTSA. The worst-case scenario is having 99 parts available but missing one critical component. We ensure complete coverage for each BOM. For new designs, we leverage a lot of our other offerings to support system-level sales. I've mentioned before that we do this with image sensors as well, where new advanced sensors come with a power management IC (PMIC). It's not just about power; we also incorporate power in our intelligent sensing business as part of our cross-selling strategy. This is a regular part of our operations. Our sales team and business units are dedicated to this effort.

I wondered if you could quantify in Q4, the gross margin headwinds from the underutilization, and then maybe help us think about does that get better in Q1 or worse?

Well, look, the way we're thinking about the market right now is we think it remains soft. I think utilization kind of stays in this level, maybe even goes backwards slightly as we go into Q1. So I don't expect that to improve just based on what we're all seeing in the news. In terms of quantification, we said silicon carbide is 100 basis points to 200 basis points dilutive there. The utilization is a factor in addition to that.

Okay. Can you help quantify the LTSAs? It seems like most of the increases are related to other content within the silicon carbide business because of its significance. Can you discuss how much of the $2.2 billion is currently being included in the LTSAs? There's often skepticism surrounding LTSAs. Could you also address any changes in customer behavior within an LTSA compared to revenue that falls outside of it?

Yes. As I mentioned, customers are extending their long-term supply agreements and are also increasing them. The goal has been consistent: customers want to secure long-term supply. To clarify, our committed revenue from these agreements over several years now exceeds $14 billion, with an increase of over $5 billion in the third quarter. This indicates that customers are securing supply not only for silicon carbide but across our entire portfolio. We are not entering into long-term agreements for the business segments we plan to exit, as we want to avoid any commitments in those areas.

Just a follow-up on this. So in industry-wide in analog outside of LTSAs, we know that other companies had implemented earlier this year, non-cancelable orders too. So are those holding into next year or at least into the first half of next year in terms of how you're dealing with or outside of your LTSAs?

Yes. It's not only about NCNR; it also involves our end customers. LTSAs provide a broader perspective and span multiple years. Regarding NCNR, it varies. We have seen NCNRs with backlogs extending up to 12 months. We maintain a cautious outlook even when we have NCNR orders. There is inventory at the distributor; will we still ship it? We have been very disciplined with our inventory to ensure it doesn't inflate uncontrollably. We have kept it around seven weeks and are comfortable with this visibility. We have enough NCNR orders to meet our existing demand, but we remain very cautious and disciplined about our shipping quantities and timing, as it's essential to ensure that our point of sale aligns with our expectations for inventory weeks with our partners during the quarter.

Yes. Tristan, I would add that of our $14.1 billion of LTSA, it does not include the NCNR orders. So when you combine the two, we have very good visibility into our backlog and what we're truly.

Okay. That's great. And then for my follow-up, it looks like based on the specs provided on your website, your silicon carbide products are already at 650 volts. I know there's some silicon carbide products from other suppliers out there going all the way to 1,200 volts. So could you talk about this in terms of specs? And what's your expectation? Because I'm assuming that increasing the voltage also increases your TAM within EVs.

Yes, I don't know where you're referring to, but we have 1,200 volts already in production and supplying to customers. So I'm very comfortable with our roadmap and the breadth of our portfolio, both in silicon and silicon carbide, but our 1,200 volts is already in production, and it has been.

Just a quick question. On the silicon carbide side, obviously, you're seeing pretty solid traction. Just wondering if you could give us an idea of what the dollar content you're getting per car in terms of the range, if you can as you go from a dual motor to quad motor, etc.?

Yes. Look, Vijay, I'll give you a couple of comments because it depends on how much power for the drivetrain or the inverter and so on. So it's a broad range. But just to give you an idea for an equivalent reference. For us on EVs, you can think about incremental content; it's about $700 for an EV versus ICE. Obviously, the majority of it is from the traction inverter, then you add onboard chargers and so on. As far as the ASP, you can think about it as the silicon carbide ASP is about 3x that of an IGBT. So that gives you kind of an apples-to-apples as far as if you normalize it on a specific power output.

Got it. And then the second question is, as you look at your design win pipeline growing very nicely. You talked about how you're displacing some legacy suppliers as well incumbents. Just wondering if you could kind of go through what are the top 3 things that are helping you drive the design wins. I think that would be very helpful? And if we had an updated backlog you can cover backlog number there as well?

So from an overall perspective, obviously, there are two things driving a lot of our design wins and the new product revenue and all of the forward-looking revenue confidence. One is always starts with technology. Our technology and a lot of our focus areas and our strategic areas are compelling and very competitive against what's in the market today. Obviously, we've talked about silicon carbide and why we win, both on the technology and the packaging as far as module, getting more power in a smaller and smaller module, reducing costs and improving efficiency. So that's on silicon carbide. Image sensing, I'll give you a few examples. LED flicker mitigation is a great example of where our superior technology meets a market need where a lot of the signs are LED and standard camera or a competitive camera cannot detect an LED sign. We have technologies that address that. Global shutter is what is needed for detection and/or factory automation. Every single strategic market we are going after, we have products that are tailored made with specific technology to address real problems that the customers have. That's what creates value and puts us in the lead for new designs, and also puts us in the lead when there's a refresh and design for us to capture share. But it always starts with technology and capability.

Thank you all for joining us today. Our teams have yet again delivered outstanding results in the third quarter. I'm excited about our future as we have not yet reached our full potential, and we have everything we need to lead in the fastest-growing markets: superior technology, committed customers, and a talented workforce that will continue to expand to support our long-term growth. And as always, we remain consistent and committed to executing with the highest degree of excellence. We look forward to seeing you at various investor events during the quarter. Thank you.