ON Semiconductor Corp (ON) — Q2 2023 Earnings Call Transcript

Thank you, Liz. Good morning, and thank you for joining onsemi's second quarter 2023 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 at www.onsemi.com. A replay of this webcast along with our 2023 second quarter’s 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 section of our website. Our earnings release and this presentation includes certain non-GAAP financial measures. Reconciliation of these non-GAAP financial measures to the most directly comparable GAAP measures and the GAAP financial measures are included in our earnings release, which is posted separately on our website in the Investor Relations section. During the course of this conference call, we will make projections or other forward-looking statements regarding future events or the 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 our most recent Form 10-K, Form 10-Qs and other filings with the Securities and Exchange Commission and in our earnings release for the second quarter of 2023. 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. Hassane?

Thank you, Parag. Good morning, and thanks to everyone on the call for joining us. The executive staff and I are thrilled with the results following another successful quarter for onsemi with Q2 revenue of $2.09 billion and non-GAAP gross margins of 47.4%, both above the midpoint of our guidance. Our worldwide teams are firing on all cylinders. Our approach of disciplined, consistent and reliable execution continues to be the winning formula for onsemi quarter-after-quarter. We have again exceeded our targets, despite the current market environment, all while delivering best-in-class performance for our customers. The most recent example is our silicon carbide performance. We ramped a new and highly complex technology, while continuing to surpass internal manufacturing and financial metrics and we are all very proud of everyone that contributes to its success daily. Given our progress in Q2 silicon carbide revenue growing nearly fourfold over Q2 '22, we remain on track to achieve our first $1 billion revenue year and remain on track to have more than 50% of our substrates coming from our internal production by the end of Q4. EV is the fastest growing part of this business, followed by energy infrastructure. Customers are excited to work with us. Our successful capacity expansion is creating an opportunity for onsemi to gain share in silicon carbide by supporting new demand amid ongoing supply uncertainty in this space. In Q2 alone, we signed more than $3 billion of new Silicon Carbide long-term supply agreements, bringing our total lifetime Silicon Carbide revenue committed through long-term supply agreements to over $11 billion. One of our largest wins last quarter was with Vitesco, a leader in modern drive technologies and electrification solutions, who signed a $1.9 billion agreement to support their growing need for silicon carbide in electric vehicles. They are co-investing $250 million as part of this 10-year long-term supply agreement to ensure capacity for the ramp. We also extended our silicon carbide engagement with BorgWarner to integrate our EliteSiC 1200 and 750-volt power devices into its power modules to deliver increased power density and higher efficiency, which will increase the range and overall performance of EVs. We have had a longstanding relationship with BorgWarner and this extended long-term supply agreement now amounts to $1 billion of committed silicon carbide revenue. Finally, with Magna, one of the world's largest automotive suppliers, we have signed a silicon carbide long-term supply agreement to expand our strategic collaboration, which has long included technologies across our intelligent power and sensing portfolio. Together, we will integrate our 1200-volt intelligent power devices into Magna's traction inverter solutions to improve the performance of electric vehicles over the next 10 years. By integrating onsemi's industry-leading EliteSiC technology, Magna e-drive systems will deliver greater cooling performance and faster acceleration and charging rates that will help improve efficiency and increase the range of EVs. In addition, they will co-invest $40 million in new silicon carbide equipment in our Hudson and Czech Republic locations to ensure access to future supply. Long-term supply agreements have become an integral part of the way we do business with our strategic customers. Long-term supply agreements continue to provide us with extended visibility, stability in pricing and volume commitments, while allowing us to plan for long-term capacity. In terms of market dynamics, both automotive and industrial remained healthy in Q2 with quarter-over-quarter growth of 8% and 10% respectively, and now account for 80% of our total revenue. It was the first time that our automotive revenue surpassed the $1 billion mark in a single quarter driven by strength in intelligent power for electric vehicles and intelligent sensing for advanced safety applications. New regional regulations will require that vehicles be equipped with both a wider field of view to detect vulnerable road users, such as pedestrians and cyclists, as well as high-speed electronic braking for highways. These new standards can only be met with higher resolution image sensors, like the eight-megapixel device, which we first introduced two years ago and is now widely adopted by top car makers for production in their 2024 models. With this accelerated adoption, we expect our 2023 revenue for our eight-megapixel image sensors to more than double year-over-year. We have further expanded our intelligent sensing portfolio with the newly introduced Hyperlux Family of image sensors for automotive and industrial markets, designed to eliminate flicker, all while delivering the highest dynamic range available in the market. For industrial applications such as surveillance and machine vision, our new products also offer very low power with intelligent Wake-on-Motion to further extend energy savings. Another significant milestone this quarter is the sampling of our automotive-grade image sensor out of our East Fishkill fab to leading global ADAS customers and partners, making onsemi the only image sensing supplier with a U.S.-based 300-millimeter fab in both internal and external sources across every step of the imaging supply chain. Customers value the investments onsemi has made to improve supply resiliency. With evolving vehicle requirements and consumer behavior, automotive design cycles are getting shorter. Therefore, we must remain at the forefront of the latest trends and regulations, and ahead of our customers' needs. We are innovating with the best in the world and being recognized for the value we provide. Most recently, we received a prestigious Volkswagen Group Award for Innovation for our strategic partnership on future electric vehicles with our broad portfolio of intelligent power and intelligent sensing technologies, along with our focus on establishing vertically integrated silicon carbide production capabilities. We are grateful for partners like VW, as well as our other strategic customers who trust onsemi's packaging expertise, scalable manufacturing capabilities and problem-solving approach to deliver joint innovation in the rapidly evolving automotive market. In Industrial, our revenue grew 5% year-over-year and 10% sequentially, with continued strength in medical applications, as well as energy infrastructure, which increased nearly 70% year-over-year in Q2. Our growth in the Industrial segment is driven by the accelerated adoption of high-growth energy infrastructure applications like solar inverters, energy storage inverters and EV fast chargers. Solar is forecasted to surpass coal and gas in installed capacity by 2027. And onsemi has the number one market share position with a full suite of silicon, silicon carbide and packaging technologies to deliver the most highly efficient and system-optimized solutions to customers. We have now secured $1.95 billion in long-term supply agreements for power modules with leading global manufacturers of solar inverters, among which are eight of the top 10 solar inverter suppliers. These customers are securing supply assurance to support their growth. Highlights in medical include market expansion for continuous glucose monitors driven by the reimbursement of monitoring therapies. We are number one in continuous glucose monitors, which we support with our sensor interface portfolio. And we expect this market to continue to grow at a 20% CAGR over the next five years. In hearing aids, we have partnered with innovative customers who will push accelerated adoption in the market with over-the-counter solutions, improving accessibility and lowering the cost of ownership. Lexie Hearing is one of the world's game changers in hearing aids and uses onsemi's intelligent sensing technology at the heart of their solution, earning them recognition as one of Time 100's Most Influential Companies in 2023. Once again, I want to thank all our employees who work on our incredible silicon carbide effort around the world, as well as those who remained focused on all of our other strategic growth areas of intelligent power and sensing. We have a unique opportunity as a company to accelerate our investments in areas where we believe we can outpace the market with the capital generated by our mature and growing businesses. The size and scale of our operation have allowed us to leverage our infrastructure and expertise inside the company to tackle complex problems and drive increased output to support the growing needs of our customers. And now, let me turn the call over to Thad to give you more details on our results. Thad?

Thanks, Hassane. We're pleased to report another stellar quarter for onsemi. Our Q2 results and our Q3 outlook clearly demonstrate our consistent execution, outpacing the industry while navigating the soft macro environment. We are uniquely positioned as our business has been powered by multiple secular growth drivers in the fastest growing end-markets of Automotive and Industrial. All our Q2 financial metrics exceeded the midpoint of our guidance. We grew revenue 7% sequentially, expanded gross margin by 60 basis points to 47.4%, and delivered a 12% quarter-over-quarter increase in earnings per share to $1.33, which exceeded our guidance range. Our global teams have transformed the business to deliver predictable and sustainable performance with above industry growth at attractive margins. Revenue for the second quarter was $2.09 billion, roughly flat compared to the second quarter of 2022 and increased 7% over Q1. The sequential increase was driven by growth in the Automotive and Industrial end markets, with accelerating demand for electrification and renewable energy. Even without silicon carbide, our revenue increased at an impressive pace sequentially. Turning to silicon carbide. Hassane mentioned our continued execution and increasing number of long-term supply agreements with automotive and energy infrastructure customers. We are ramping our silicon carbide production to support the increasing demand and remain ahead of our internal plans. Over the past two years, we have made strategic brownfield investments to expand capacity and ramp production much faster by leveraging our existing manufacturing footprint and expertise. These industry-leading return on investment capital investments are now contributing to our financial results. In the second quarter, our silicon carbide business nearly doubled gross margins sequentially. And I'm proud to report our silicon carbide business achieved its first profitable quarter, delivering high-teen operating margin on a fully loaded basis, which includes all start-up costs. I'd like to take this opportunity to thank the 33,000 onsemi employees across the globe for their commitment to success and delivering outstanding results quarter-after-quarter. Turning to end-markets. Our Automotive revenue hit a new record of over $1 billion in Q2, growing 8% quarter-over-quarter and 35% year-over-year, driven by the accelerating adoption of electrification and the continued need for sensing in vehicles. In Q2, Industrial revenue grew 5% year-over-year and 10% sequentially, with continued strength in EV charging, medical applications, as well as energy infrastructure, which increased nearly 70% year-over-year and is now a meaningful part of our overall revenue. We continue to exit volatile non-core businesses, which included another $57 million in Q2 revenue, bringing our total year-to-date of exited revenue to more than $100 million and nearly $400 million since the start of our transformation. We will continue to be opportunistic in non-core markets, where margins are favorable and engagements are strategic with our customers. We now expect to exit $350 million to $400 million in 2023. Looking at the split between operating units, revenue for the Power Solutions Group was $1.12 billion, an increase of 6% year-over-year, with more than 60% year-over-year increase in auto and nearly 70% year-over-year increase in energy infrastructure. Revenue for the Advanced Solutions Group was $650 million, a 9% decline over Q2 '22, driven by deliberate exits and continued softness in non-core markets, offset by strength in Automotive and Industrial. Revenue for the Intelligent Sensing Group was $325 million, a 4% increase year-over-year, primarily due to the Automotive shift to higher value sensors in our portfolio, such as eight-megapixel image sensors. Our GAAP and non-GAAP gross margin of 47.4% improved 60 basis points quarter-over-quarter driven by silicon carbide and despite the significant headwinds from EFK we disclosed last quarter. We continue to improve the cost structure of the fab, but we expect EFK to be dilutive to gross margins by approximately 250 basis points for the next several quarters. We remain committed to maintaining our long-term gross margin trajectory as we execute our Fab Right strategy of driving efficiencies and further consolidation in our internal, as well as our external manufacturing network. Now, let me give you some additional numbers for your models. GAAP operating expenses for the second quarter were $318.7 million as compared to $453.1 million in the second quarter of 2022. Non-GAAP operating expenses were $305.5 million as compared to $317.7 million in the quarter a year ago. GAAP operating margin for the quarter was 32.2% and non-GAAP operating margin was 32.8%. Non-GAAP operating margin increased 60 basis points quarter-over-quarter. Our GAAP tax rate was 15.3% and our non-GAAP tax rate was 15.8%. GAAP earnings per share for the first quarter was $1.29 as compared to $1.02 in the quarter a year ago. Non-GAAP earnings per diluted share was $1.33, flat year-over-year and above the high end of our guidance. Our GAAP diluted share count was 448.7 million shares, and our non-GAAP diluted share count was 438.7 million shares. In Q2, we repurchased $60 million of shares at an average price of $86.49 per share. And we remain committed to our long-term strategy of returning 50% of free cash flow to our shareholders. Turning to the balance sheet. Cash and cash equivalents was $2.6 billion and we had $1.1 billion undrawn on our revolver. In Q2, we proactively downsized our revolver by $500 million to $1.5 billion and extended the maturity to 2028 to align to our long-term needs and projected cash flow. Cash from operations was $390.8 million and free cash flow was negative at $39.8 million due to timing of investments in capital expenditures and growth in strategic inventory in the second quarter. We expect free cash flow to return to positive for the remainder of the year. Capital expenditures during Q2 were $430.6 million, which equates to a capital intensity of 20.6%. As we indicated previously, we are directing a significant portion of our capital expenditures towards silicon carbide and enabling our 300-millimeter capabilities at EFK and expect our capital intensity to be in the mid to high-teen percentage range for the next several quarters. Accounts receivable of $944.4 million increased by $63.5 million, and days sales outstanding was 41 days, consistent with the first quarter. Inventory increased by $149.5 million sequentially and days of inventory increased by four days to 163 days. This includes approximately 54 days of bridged inventory to support fab transition and the silicon carbide ramp. Excluding these strategic builds, our base inventory declined seven days quarter-over-quarter. We continue to proactively manage distribution inventory. Distribution inventory increased $20 million sequentially with weeks of inventory at 7.7 weeks in Q2 versus seven weeks in Q1. Total debt remained flat at $3.5 billion and net leverage is 0.27. Let me now provide you key elements of our non-GAAP 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. Our business continues to strengthen with improved visibility, and we expect to recognize approximately $6.4 billion of committed revenue from our long-term supply agreements over the next 12 months in addition to our non-cancelable and non-returnable orders. Given the soft macro environment, we are taking a cautious stance in our guidance. We anticipate Q3 revenue will be in the range of $2.095 billion to $2.195 billion. We expect Automotive and Industrial to increase quarter-over-quarter with other markets down mid to high-single digits, as we plan further exits in our non-core markets. We expect non-GAAP gross margin to be between 46% and 48% due to lower factory utilization, EFK headwinds and the dilutive impact of silicon carbide, which remains ahead of plan. This also includes share-based compensation of $4.4 million. As we have previously stated, 2023 will be a transition year for our gross margin and we expect to maintain our trajectory as we manage these temporary headwinds. We expect non-GAAP operating expenses of $300 million to $315 million, including share-based compensation of $29 million. We anticipate our non-GAAP OIE will be negligible for the quarter. We expect our non-GAAP tax rate to be in the range of 15.5% to 16.5% and our non-GAAP diluted share count for the third quarter is expected to be approximately 439 million shares. This results in non-GAAP earnings per share to be in the range of $1.27 to $1.41. We expect capital expenditures of $440 million to $480 million, primarily in brownfield investments in silicon carbide and EFK. To wrap up, the structural changes we've been implementing since the start of our transformation have improved the resiliency of our business and enabled us to better navigate the soft market environment. We have delivered another quarter with results above expectations, reinforcing that consistent, reliable execution is our path forward to achieving our long-term model. We have reduced the volatility in our financials and held to our commitments while navigating short-term market dynamics and we plan to continue to deliver for our shareholders one quarter at a time. With that, I'd like to turn the call back over to Liz to open for questions.

Hey, this is here for Chris Danley. Sorry, you went dark for a second. Hey, guys. My first question is just on the overall cycle. Hassane, how would you compare taking silicon carbide out, just pure semiconductors now versus three months ago? Would you say it's gotten a little better, a little worse? Any comments on visibility and the overall semiconductor cycle now compared to last quarter?

Yeah. I mean, I'll tell you auto and industrial remains healthy. Even if you take out silicon carbide, that business is up. And that's really the way we position both of these businesses in a lot of the mega trends that are underlying it with the EV and energy infrastructure. So when you put both of those without silicon carbide, that's also supporting growth in general for our, what I would call, the silicon business. So strength in these markets is sustained.

And how about non-auto industrial?

Auto and industrial, we’ll see it slightly down, flat slightly down. And that's a lot of our peers that are more exposed to those businesses are seeing and we see the same thing.

Yeah. Our non-auto and industrial segment saw a slight increase, but as Hassane mentioned, we expect a decline in the mid to high-single digits in Q3.

Yeah. Great. And for my follow-up, any changes in — on specific lead times and shortages quarter-over-quarter? Has your lead times gone down, gone up — stayed the same, shortages up, down, stayed the same versus three months ago?

Yeah. On the lead times, if you look at our average lead time, it's very consistent quarter-on-quarter. There have been pockets where lead times have decreased a few pockets where they've increased. But on average, they’re relatively flat quarter-on-quarter.

Great. Thanks, guys.

Thanks.

This is Blake Friedman from Vivek Arya. Thanks for taking my question. So first, I just want to start off with that onsemi has signed a number of silicon carbide long-term supply agreements. So I was hoping you could provide the mix of autos versus non-autos? And then looking further into the industrial market, your growth is up 5% year-on-year, which is certainly well above other peers down 10% to 20%. And I know silicon carbide is a partial contributor. But I was hoping you can describe maybe what you're seeing versus what peers aren't?

Yeah. A couple of things. On the silicon carbide, it's still within the same mix, we've talked about before about 90% is auto, about 10% is industrial. The long-term supply agreements that we talked about in industrial are the $1.95 billion, that's for the whole market. So that includes silicon and silicon carbide or IGBT because we talked about the hybrid modules, we're able to provide that's driving that $1.95. On the industrial side, specifically, what really breaks us apart is the fact that we are extremely focused on the growth markets within industrial. We talked about energy infrastructure, which includes renewables and includes charging. All of that is driven by those mega trends underlying the industrial and in my prepared remarks, I talked about our focus on the medical side of the business, which is also under the industrial. And that's seen its own transformation from the hearing aid going over the counter to continuous glucose monitoring being part of the reimbursement scenarios. All of these are driving underlying growth, but they're very specific to where we have chosen to put our strategy from a company perspective; that's where our investments have been and the growth is coming specifically. So that's the reason I can pinpoint exactly what is specific to onsemi versus the general peers.

Got it. And then as a follow-up, I was just hoping you can provide an update on the progress of in-sourcing silicon carbide substrates and your timeline to be fully in-sourced. And I understand the strategy has been focusing on brownfield investments, but with industry silicon carbide supply expected to trail demand for the foreseeable future. Would management ever consider building its own greenfield facility down the road?

So the - I'll answer both of these separately. So the progress is still on track. I reiterated the fact that we're going to be exiting this year with a majority coming internally. So we're still on track. That business is actually performing better than we expected. So high confidence in our commitment that we've made about six months to nine months ago, so we're going to exit this year with a majority internal. As far as brownfield, greenfield, we have a lot of runway with the brownfield. We have a great fab and back end exposure. And what we're doing is, we're going to utilize it. We don't see that needing to go to greenfield at any time in the future. Of course, that's dependent on business and economic sense. Right now, with all the wins that we have disclosed, those are we are able to support those with brownfield, specifically as we embark on our fab right strategy that Thad described in our Analyst Day and that's going to be supporting all the LTSAs that we've disclosed. And look, if business is even better than what we are talking about today, and we have to go to greenfield, then that's a really good reason to do it. But for now, brownfield is the path and we're able to support it. And that really highlights the good ROIC that we've been able to deliver.

Thank you.

Hey, guys. Can you hear me, okay?

Yeah.

Okay. Hey, guys. First of all, congratulations. This is yet another fantastic quarter and guide from you guys, so congratulations. And I had two questions, Hassane. I'm seeing a little bit of a change in your business. I used to see sort of transactional business in silicon carbide; you get orders, you get customers, but now we're seeing really large orders, really large customers, multiyear, multibillion-dollar deals. Is this happening because of the competitive environment recently or is this happening because you are much more comfortable taking on these orders? And if so, why are you more comfortable taking on these kinds of orders? And then I know you've said that you never want to sell wafers, but I just want to clarify, are these orders strictly all 100% chips or is there a portion of wafers you're involved as well? And then I've got a follow-up.

We're not interested in selling what we refer to as substrates; our focus on substrate manufacturing is solely for internal use, and that has not changed. The demand we've discussed engages all of our substrate operations, and we are increasing that capacity just ahead of revenue and customer ramp-up. This focus remains unchanged, and our operations are performing ahead of schedule, which makes me very satisfied with the team's efforts. Regarding strategic engagements with customers, our readiness to take on this business has always been there, and we have consistently communicated our capabilities and ramp-up plans. The landscape has changed, as we are now the only supplier scaling up quickly in silicon carbide, a fact that is increasingly recognized by our customers. Those who have long-term supply agreements with us have received what they need with no issues in ramp-up, technology, or expansion, so they are returning to expand those agreements as they secure more business with our products. This creates a mutually beneficial situation.

Fantastic. And for my follow-up, I know investors always look forward and kind of want you to deliver on the next thing. So the question on 8-inch wafers. We hear a lot from investors about the cost disruption that, that might bring supposedly lower costs. Curious if your customers bring this up with you at all at this point in time, and then I know you have plans for 8-inch wafers. Maybe you could update us on those while you're at it. And then Hassane, I also had a clarification on your previous question. Are you shooting for more than 50% internal by the end of the year for silicon carbide or the vast majority?

We expect to end the year above 50%, but our goal is actually higher than that, which we aim to achieve in 2024. We'll finish this year over 50% and continue to grow into 2024, updating you on our outlook based on market conditions and dynamics. As for the first part of your question... We remain consistent and on track with what I've previously described. We are currently manufacturing 8-inch wafers to establish a baseline yield and overall production. This allows us to prepare for a rapid and successful ramp-up, similar to what we've accomplished with 6-inch wafers. Our customers prioritize maintaining a competitive cost structure and the capacity to ramp up as needed. We are fulfilling these commitments for both 6-inch and 8-inch wafers. Our customers have reviewed our manufacturing capabilities on-site and are confident in our ability to deliver, as evidenced by long-term supply agreements that include 8-inch wafers.

Congrats again, guys. Thank you.

Thank you.

Hey, guys. Can you hear me?

Yeah.

We're cutting out here at the end of the introduction; I apologize. I appreciate the fact that you're probably going to increase your silicon carbide revenue for five-fold this year. Then maybe if you can speak to a preliminary view for fiscal year '24 considering supply constraints. It sounds like you're not demand constrained, but maybe focusing primarily on the supply side?

Yeah. We're not going to guide for 2024, but you can basically, when we get to Q4, you can take the exit rate, which is going to be healthy and then project forward. But we're not projecting into 2024; it will be substantially higher.

Okay. And maybe if you can give us an update on any sort of government subsidies, chipset funding, equivalents, elsewhere, specific to the silicon side of the business. And then as well, so can carbide, I understand there really weren't CHIPs Act support for silicon carbide, but I think you had an opportunity to comment on that. Maybe if you can give us an update on where that stands?

Yeah. Look, we're engaged in all parties, not just in the U.S., but of course, in Europe and we have a big operation in Korea, which has their own or variant of the CHIPs Act. So we're engaged in all three. We've announced a $2 billion investment for an end-to-end silicon carbide manufacturing, which will be the only one in the world really from substrates all the way to wafers on the same site. And we're considering all three of these regions because we have brownfield capabilities in all three of these regions. We talked about a decision made between now and the end of the year of where it's going to be. And part of the decision is, well, the main decision is purely economic and financial. Therefore, the funding from the government plays a big role in swinging it one way or another for depending on which site. We're in the process and the discussions of all of these, but that one is specifically related to silicon carbide to comment on your question. As far as in general, we have made comments on silicon carbide, specifically in the CHIPs Act, but that's really up to them to what they do with it, and that's part of our decision-making process. We're going to go where it makes sense to get the best return on investment capital for our investments, and that's how we create shareholder value. That remains the top of our priority and we're going to make that decision between now and the year of where it goes.

Thanks, Hassane.

Hey, guys. Thanks for the question and great quarter. So my question is around your strategy; you’re thinking about co-investment on SEC. Some of your competitors are looking for $1 billion almost financing through these commitments. I know you did well with like Vitesco and Magna here for smaller amounts. But I'm really wondering about the strategy here. Are they investing in new capacity? What are they getting out of this? Are they getting a haircut on wafers or is it just dedicated capacity? How are you thinking about this? And the amount you want to take in overall from your customers as well to help finance this?

I will begin with a broad perspective. One of the key factors that sets onsemi apart is our ability to fund our own investments through the cash flow generated by our operations. We are not reliant on external funding to grow our business and enhance our capacity. When you examine our balance sheet, cash position, cash from operations, and capital expenditures, you'll see that all of these can be supported by our operations. This gives us a distinctly advantageous position regarding capacity expansion. From a strategic standpoint, the relationship with customers is mutually beneficial. There is no greater commitment in a long-term supply agreement than when customers co-invest alongside us. These co-investments come with various scenarios, depending on the specific customer and the challenges or opportunities they face. This isn’t about reducing costs; it essentially serves as an offset for depreciation, without altering our cost structure concerning the value we deliver. It simply offsets depreciation, whether it involves our books or theirs, based on asset ownership and how we apply that investment. Moreover, these engagements are strategic, tailored to what each customer is aiming to address, and we collaborate closely with them. However, securing that funding is not a prerequisite for us to scale up. We are capable of scaling independently, and these are strategic investments that reflect a very different playing field for us.

Great.

And the reason for the delta in dollars that you see is, again, goes back to brownfield versus greenfield. We're investing in brownfield, which Thad had talked about at Analyst Day about a 40% better CapEx than a greenfield. So that gives you kind of the delta, why we're able to ramp so quickly much higher in output for much lower cost.

Yeah. We definitely understand the efficiencies there. I also wanted to talk about solar. I wasn't expecting $2 billion in long-term supply agreements from solar, which is, I believe, part of industrial. Are you expecting industrial SiC now to ramp faster? And then just as a follow-on there, just talking about gross margins for SiC overall. You said they doubled in the first profitable quarter. Talk about this progression? Is this all moving faster than you would expect? And is it in part because of these industrial as a percentage of SiC as well? Thank you.

Yeah. So on the revenue ramp for industrial, specifically on the energy infrastructure, the $1.95 billion is both silicon and silicon carbide. Remember that market is being serviced by a very unique value proposition we have. Simon talked about in the Analyst Day, the hybrid module, where we're able to put the best technology required into a single module to provide those customers. So that $1.95 billion is on both power technologies, IGBT or silicon and silicon carbide. As far as the ramp, look, they'll be ramping in tandem together. But the automotive number, given the total addressable market in automotive, we'll just ramp up to a higher number. But as far as percent ramp, they're both going to ramp. And if you recall, last year, we talked about how that business ramped 70% growth for the last two years. So it's pretty healthy growth. But from a dollar, of course, it's going to trail the automotive purely because of the total addressable market that we're addressing. But both growth, both CAGR are very healthy and will remain healthy over the next five years as we execute those long-term supply agreements.

We are very proud of the accomplishments in our silicon carbide business, especially in doubling gross margins quarter-over-quarter and achieving our first profitable quarter on a fully loaded basis. This performance is impressive. We have a clear view of our progress and it is ahead of schedule due to effective ramping. All metrics indicate we are ahead of our plans. We have reached profitability sooner than originally anticipated, and we expect to see continued expansion moving forward. As our revenue grows, it will increasingly benefit our bottom line.

Thanks, Thad. Congrats again, guys.

Thank you.

Hey, guys. Thanks for taking my questions and congrats on the results. I did want to follow up on the last one. So you mentioned in the prepared remarks, I think it's high-teens operating margin for silicon carbide. Any way to disaggregate the levels internal substrates versus external and should we expect, as you ramp internal substrates over the coming quarters, should that continue to move higher? Because I would imagine, at least initially, it could be a headwind to margins. Thank you.

Yeah. Look, we're not breaking up as what it is. You can take it as an aggregate totally mix adjusted is what the number is. And it's going to keep going up, of course, as that business absorbs the start-up costs because look, there's still start-up costs in that business. So as we scale that business, start-up costs will be more absorbed and that is how we will be continuously improving the gross margin trajectory, which consequently will improve the operating margin. So that financial milestone that we have achieved is not the destination. It's just a milestone. We have always had line of sight to it, like Thad said, we achieved it earlier than we expected, but the ramp or the, call it, the slope of that improvement will just continue from here, and we'll continue to improve on all financial metrics as that business scales and as that mix changes.

Got it. Thanks for the color. I'm going to try to ask a question that involves the other 80% of your business now. East Fishkill headwinds for two quarters in a row have come in higher than anticipated. Can you walk us through just what's going on there? Why are they higher for longer and should we expect it to sort of trough in the beginning part of 2024? Is that the right time frame? Thank you.

Yeah. I think if you go back to what we disclosed and what we announced last quarter, it's very consistent, right? We got a surprise in the cost structure there. We've now been spending six months really getting our arms around it and understanding what we need to get that cost structure back in line. Look, we've got a large manufacturing footprint, we know how to run fabs efficiently, we’ve benchmarked, we know exactly what we need to do. As I say, this is like locking and tackling of what we need to do to take the cost structure out, but it takes time. It’s hard to take cost out when you're running a fab at full capacity. So the time horizon is little bit longer than we expected. It will be from the next several quarters. I think – you think about this as been probably a year maybe slightly more than a year of headwind for us as we continue to take the cost out. But we expect by the time we exit 24 we've got that fab at parity and running efficiently.

But one thing I would also highlight is, yes, the headwinds are higher than we expected. But to use your words, if you look at all the other operational metrics that we've delivered reflected in the reported gross margin and the guidance we're able to absorb it and then some, given the beat this quarter and the rates for next quarter. So back to Thad's point, we know how to fix this stuff. We've been fixing it for the last two years. That's just another thing we're going to work on. We have line of sight to just going to take time. But of course, the rest of our business is operating stellar, including the underutilization that we've had to do. So our margin is structurally very different from what it used to be. And that I can say I’m very, very comfortable, happy and confident about.

Understood. Appreciate the color. Thank you.

Hi, Hassane and Thad, congratulations on the nice results. Thad, I guess I just wanted to see if you could give us a little bit more color on the gross margin. Revenues trending up; sounds like SiC margins are moving higher. So I'm just wondering, are there any particular headwinds in the third quarter for the 40 basis point decline in gross margin at the midpoint?

Yeah. Look, so we've got a number of things, right? We just talked about EFK. So clearly that's a headwind. You've got utilization dropping down slightly in Q2 from 71% to 70%. As we look forward, we think about utilization being kind of in that flat to down category. So we may have a little more headwind on that. But the key contributor to that margin stepping down just slightly is the ramp of silicon carbide. So even though the margins have doubled, it's still dilutive to the corporate average. So as revenue increases, you have more of a dilutive impact on Q3. So I would think quarter-over-quarter, really the delta is a little bit more underutilization charge and then this impact of the ramp of silicon carbide.

Great. And just a quick follow-up. Do you expect quarter-to-quarter the SiC margins to improve understanding they’re still below corporate average?

Yeah, absolutely.

Hi. Thanks. Do you have any update to the $4.5 billion long-term supply agreement from 2023 to 2025 and kind of anything to help us think about what silicon carbide could be next year and into '25?

Yeah. No, we're not giving an update. Our focus right now is obviously, this year, we will be given an outlook on 2024 as we get for reporting of the fourth quarter, given the run rate and where we are. Of course, we have the number in long-term supply agreements, but we're not talking about it yet. We're not guiding for it. It will be substantially higher than where it is in 2023, given the long-term supply agreements and the ramp. But right now, we're focusing on the execution in the short term.

Great. And then, Hassane, how do you think about the captive versus external mix? You did say you're going to be more than 50% this year. But when you sort of lay this out longer-term, how do you weigh where you want to take that number to longer-term, given some of the investments that some others are making particularly in China? Is there like an upper range of where you want to push that 75% or how do you sort of think about balancing that? Thanks.

There are several factors we consider in balancing our approach. Our primary goal is to support our customers. With long-term supply agreements, we need to manage supply resilience and assurance as well. We do not aim to be completely self-sufficient; I've mentioned before that we could target around 80%, but this depends on various conditions, especially since we can't overlook geopolitical issues when sourcing from China, which doesn't currently provide a reliable supply assurance given the current environment. Additionally, we have a factory that is operating efficiently at scale, so seeking external supply must also be economically viable compared to our internal capabilities. We consistently evaluate all these scenarios, but you can estimate that the target will be around 80%, subject to the factors I've discussed.

Yeah. Thank you. This is Jeremy here for Tore. I guess a couple of follow-ups on the earlier questions on the co-investments. Can you help us understand what the mechanics of this are, the impact potentially to gross margins, maybe cash flows? Just wondering how the $40 million or the $250 million co-investment can be played out in the financial statements? Thank you.

Yeah. As we — this is Thad. So as we receive the cash from customers, obviously, that goes on the balance sheet. The way that it gets accounted for is, it gets amortized over the life of the agreement. So if you think about a long-term supply agreement that maybe has five to 10 years, you can think about that dollar amount getting amortized over the life as those products are shipped; it actually is recorded through revenue. So actually, it's a bump in margin over that timeframe. But you can think about the cash coming in, in advance as we make payments going out, hopefully, it's favorable from a cash flow standpoint. That's the intent that we get cash before we make the commitment to the equipment. And again, just as a reminder, all of the capacity that we're bringing on is to support these long-term supply agreements on those committed revenue. So we're not building capacity on the hope that we can fill it. So in these situations, as Hassane mentioned earlier, these customers are co-investing for assurance of supply with us. But the accounting works that actually hits the revenue line over time.

Thank you. I have a quick follow-up to that. This is a revenue prepayment, not an ownership of the equipment. Are there any limitations regarding whether this is specific to the equipment, or are there restrictions on using it for other customers?

Yeah. Every situation is a little bit different. What I just described there is a prepayment rate, if you think about it, a customer deposit. We do have situations where customers will consign product or selling equipment to us and that situation is a little bit different. It's just a lower depreciation off of our books, and that sits on their books. But every situation is a little bit different, depending on the customer situation. Obviously, we want as much flexibility as we can have as we develop these things. So we try not to tie up capacity for one customer and have the ability to move our production on any of the lines on any of the locations. So it's designed to have the ultimate flexibility for us.

Great. One last question, if I may. Given the slightly different free cash flow results this quarter, along with the high-teens capital intensity that appears consistent with your targets from Analyst Day, is there any long-term change in the 2027 targets? Are you experiencing any higher costs or challenges in achieving the necessary headcount to ramp up this capacity? It seems like that has been a problem with other fab ramp-ups globally. Is this concern relevant for you at this stage? Thank you.

I don’t think we’re experiencing a labor shortage. We're utilizing our existing investments and workforce effectively. There is no change to our long-term capital intensity plan; this situation is more of a short-term issue. I mentioned that our free cash flow will turn positive for the rest of the year. The focus is on the timing of equipment acquisition and increasing our strategic inventory to support our fab transitions and the silicon carbide ramp. Our long-term capital intensity targets remain unchanged. We expect to maintain a capital intensity in the mid to high teens for the foreseeable future, gradually decreasing over time, as we have previously discussed.

Great. Thank you very much.

Hi. Great. Thank you for taking my question. Congrats on the great results and outlook. Hassane, at the Analyst Day, you discussed your emerging products in digital power control. I think that is likely related to servers that are focused on AI, maybe you can confirm that understanding and also remind us of your targets and traction towards that?

Yes, our focus on drivers and controllers includes both server and cloud infrastructure, which definitely relates to AI. However, the majority of our efforts are aimed at our core markets, specifically in the automotive and industrial sectors. With each switch or silicon and silicon carbide switch, we can leverage the flywheel effect that Sudhir mentioned to enhance our content. We are on track with this initiative. In terms of technology, we already have some products for internal performance and are making significant progress toward sampling early next year. This progress mirrors what we achieved with silicon carbide. We are committed to this direction and are ready to start delivering on it. This will be our successful approach for this new business. Please look forward to more updates as we move into Q4 and Q1 of 2024.

Great. And then a follow-up, if I can. You've reiterated many of the goals around the ramp of silicon carbide today, but there's one I'm not sure I heard you talk about yet, and that's the margin exiting the year. I think in the past you've said it will be neutral to the enterprise level. Is that ready for an update? Is it possible you could do better than that or any reason you're backing off that goal? Thank you.

Will, this is Thad. No, our expectation remains the same. As I was saying earlier, Q3 is the highest dilution impact of silicon carbide just because of the ramp and, again, the margins being below the corporate average. We believe by the time we exit the year, we'll have those margins at the corporate average, as we've stated previously.

Thank you.

Thank you.

Thank you again for joining our call. We plan to continue to put our winning formula to good use with deliberate execution and operational excellence as we continue to navigate the soft market environment. Through it all, we remain committed to delivering value for our shareholders and confident in our long-term outlook of outgrowing the semiconductor market by three times through 2027. Thank you.