ON Semiconductor Corp (ON) — Q3 2023 Earnings Call Transcript

Thank you, Kevin. Good morning, and thank you for joining onsemi's Third 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 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 Relations section of our website. Our earnings release and this presentation include certain non-GAAP financial measures. Reconciliation of these non-GAAP financial measures to the most directly comparable GAAP financial measures and a discussion of certain limitations when using non-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 future financial performance of the company. We wish to caution that such statements are subject to risks and uncertainties that could cause actual results or events to differ materially from projections. Important factors that can affect our business, including factors that could cause actual results to differ materially from our forward-looking statements, are described in our most recent Form 10-K, Form 10-Qs, our other filings with the Securities and Exchange Commission and in our earnings release for the third quarter of 2023. Our estimates for other forward-looking statements will change, and the company assumes no obligation to update forward-looking statements to reflect actual results, change assumptions or other events that may occur except as required by law. Now let me turn it over to Hassane. Hassane?

Thank you, Parag. Good morning, and thanks to everyone on the call for joining us. This morning, we are pleased to announce another quarter where we delivered revenue of $2.18 billion, non-GAAP gross margin of 47.3% and non-GAAP earnings per share of $1.39, all exceeding the midpoint of our guidance. Our Automotive and Industrial segments achieved record revenue, driven by demand in both silicon and silicon carbide. Despite these results in the third quarter, we are taking a very cautious approach as we are starting to see pockets of softness with Tier 1 customers in Europe working through their inventory and increasing risk to automotive demand due to high interest rates. It has been nearly three years since the start of our transformation, and our worldwide employees have been relentless in their pursuit of operational excellence. The structural changes we have made across the company have allowed us to maintain our performance and deliver predictable financials. We have built the resilience required in our business to navigate a dynamic macro environment, and we remain focused on controlling what we can: Our execution and our commitment to our customers. And silicon carbide has been a prime example of our execution. Our factories in Hudson, Roznov and Bucheon all had record output for silicon carbide in Q3. Acquiring GTAT two years ago was a strategic investment that allowed us to produce our own substrates internally and accelerate our path to becoming the world leader in silicon carbide power devices. By the end of 2023, we expect to have more than 25% market share of the silicon carbide market. We are now producing more than 50% of our own substrates internally, one quarter ahead of schedule, and we plan to continue to do so through 2024 even as we transition furnaces for 200-millimeter production. In fact, last week, we announced that we completed our expansion of the world's largest silicon carbide fab in Bucheon. At full capacity, the state-of-the-art facility will be able to manufacture more than 1 million 200-millimeter silicon carbide wafers per year. Our manufacturing output continues to exceed expectations, and the acceleration of our ramp resulted in achieving a $1 billion run rate quarter in Q3, increasing nearly 50% over Q2. However, for the full year, a single automotive OEM's recent reduction in demand will impact our $1 billion target, and we now expect to ship more than $800 million of silicon carbide in 2023, 4x last year's revenue. In '24, we expect the growth of our silicon carbide business to double the market growth. Over the past few quarters, we have accelerated the broad deployment of silicon carbide solutions, and the design activity has been robust across all regions. So far in 2023, we have shipped to more than 500 unique customers that will continue to ramp through 2024, further expanding our geographical customer distribution. Additionally, we have design wins and/or LTSAs with the leading automotive players who have over 50% share of the global EV unit sales, which includes LTSAs with 4 of the top 5 China EV customers. NIO is among them. And in Q3, they made onsemi their prevailing silicon carbide supplier by signing an extension to their multiyear long-term supply agreement, doubling down on 1,200-volt EliteSiC technology as they transition into 800-volt battery solutions through 2030. As we navigate the current market conditions, LTSAs continue to provide demand visibility and stability in pricing. EV traction remains the fastest-growing part of our SiC business, with 70% growth sequentially. Most recently, an OEM awarded onsemi a platform for their 750-volt and 1,200-volt EV traction inverters previously awarded to an incumbent. Opting for superior technology and a vertically integrated supply chain, this leading OEM has now signed an LTSA with onsemi through 2031, putting us in a position to support higher volume production. Energy infrastructure remained healthy in Q3, driven by the continued adoption of solar and energy storage solutions. We remain on track to our full year projections with nearly 70% revenue growth over 2022, and we expect the growth to continue in '24 as demand for our hybrid modules with silicon and silicon carbide solutions for this high-growth industrial megatrend remains strong. Our medical revenue, which is reported within our industrial end market, also remains healthy, driven by the improved accessibility of continuous glucose monitoring and hearing aids. We have deep, long-standing customer engagements and high-margin, high-growth areas of continuous glucose monitors in hearing health, where we have leading market share with our technologies. Our CGM business increased nearly 38% quarter-over-quarter, driven by a ramp from the top 2 leaders in the market. onsemi is #1 in automotive image sensors and #1 in industrial scanning. In the industrial end market, our design activity has already surpassed all of 2022. This is a good indicator for the business, given that more than 40% of our image sensing revenue comes from new products. Last month, we introduced another 8-megapixel image sensor with the world's smallest, lowest power family of Hyperlux products that can extend battery life by up to 40% for industrial and commercial cameras. In fact, our 8-megapixel revenue more than doubled year-over-year in the third quarter as the business is shifting to higher resolution, higher ASP image sensors.

Thanks, Hassane. At the start of our transformation, we committed to delivering intelligent power and sensing technologies for the sustainable ecosystem. This meant tailoring our investments, our portfolio, our manufacturing footprint and our resources to focus on the high-growth megatrends in automotive and industrial, such as electric vehicles, ADAS and energy infrastructure. This has become our winning formula, allowing us to deliver the greatest value for all our stakeholders. Combined, intelligent power and intelligent sensing now account for 72% of our business, as compared to 68% in the quarter a year ago. In the third quarter, our financial results exceeded the midpoint of our guidance, demonstrating the resilience in our business in a challenging market environment. Revenue of $2.18 billion increased 4% sequentially, and non-GAAP operating margin was 32.6%. Revenue from intelligent power and intelligent sensing combined increased 5% year-over-year. As for the end markets they serve, we had another quarter of record automotive revenue with nearly $1.2 billion in Q3, increasing 9% sequentially and 33% year-over-year, driven by silicon as well as silicon carbide as the need for electrification and advanced features and vehicles continues to rise. In industrial, our record revenue of $616 million increased 1% sequentially and was up slightly year-over-year with continued strength in energy, infrastructure and medical. The rest of our businesses decreased 4% sequentially and 42% year-over-year as we exited $46 million of noncore business, which was below our expectations and is highlighting the resiliency of this business and the value of our full portfolio delivers for these customers. As always, we'll continue to be opportunistic in these noncore markets where margins are favorable and engagements are strategic with our customers. Looking at the split between operating units. Revenue for Power Solutions Group, or PSG, was $1.2 billion, an increase of 10% year-over-year, with more than 60% increase in auto and 50% increase in energy infrastructure. Revenue for the Advanced Solutions Group, or ASG, was $622 million, a 15% decline over Q3 '22, driven by deliberate exits and continued softness in noncore markets. Revenue for the Intelligent Sensing Group, or ISG, was $329 million, a 4% decrease year-over-year due to lower revenue in industrial applications. Our GAAP and non-GAAP gross margin of 47.3% was down 10 basis points sequentially and 200 basis points as compared to non-GAAP gross margin in Q3 '22, primarily due to headwinds from our East Fishkill fab and factory utilization, offset by strong manufacturing performance in silicon carbide. Total utilization increased slightly to 72% as silicon carbide utilization improved, while silicon utilization trended lower as planned. For the next few quarters, we expect to proactively lower utilization to the mid- to high-60% range while maintaining our gross margin above mid-40%. This is a direct result of our fab-liter strategy of divesting 4 fabs in 2022, which is reducing our fixed cost footprint while we continue to consolidate operations in larger, more efficient fabs. As we move to our Fab Right strategy to optimize and drive efficiencies across our manufacturing network, we expect to generate incremental cost savings over the next few years. We continue to identify opportunities to drive operational efficiencies and remain committed to our long-term gross margin trajectory. Turning to silicon carbide. As Hassane mentioned, our silicon carbide manufacturing output is exceeding our internal expectations. And thanks to the tremendous efforts of our team around the world, we have accelerated our gross and operating margin trajectory. Our Q3 gross margin for silicon carbide was greater than 40% with strong fall-through on a fully loaded basis, including all start-up costs. And as we previously highlighted, we expect our silicon carbide business to be at the corporate gross margin in Q4. Further, the yield improvement learnings we're getting from our 150-millimeter wafer production ramp is increasing our confidence in our 200-millimeter capability and validating our strategy of driving cost savings through brownfield investments. This incredible execution and improved manufacturing output on 150 millimeters enables us to slow our capacity expansion and lower 2024 capital intensity from the high teens to the low teens percentage points ahead of our original plan and closing in on our long-term model. Now let me give you some additional numbers for your models. GAAP operating expenses for the third quarter were $344 million as compared to $634 million in the third quarter of 2022. Non-GAAP operating expenses were $322 million as compared to $304 million in the quarter a year ago. The increase in operating expenses is attributable to a reserve against the receivable balance with a manufacturing partner. GAAP operating margin for the quarter was 31.5%, and non-GAAP operating margin was 32.6%. Our GAAP tax rate was 16.4%, and our non-GAAP tax rate was 15.6%. GAAP earnings per diluted share for the third quarter was $1.29 as compared to $0.70 in the quarter a year ago. Non-GAAP earnings per diluted share was near the high end of our guidance at $1.39 as compared to $1.45 in Q3 of 2022. Our GAAP diluted share count was 451 million shares, and our non-GAAP diluted share count was 439 million shares. In Q3, we returned 75% of our free cash flow through $100 million of share repurchases, 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 $2.7 billion, and we had $1.1 billion undrawn on our revolver. Cash from operations was $567 million, and free cash flow was $134 million, or 6.1% of revenue. Capital expenditures during Q3 were $433 million, which equates to a capital intensity of 19.9%. 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. Accounts receivable of $958 million increased by $14 million, and DSO was 40 days, down 1 day from the second quarter. Inventory increased by $120 million sequentially, and days of inventory increased by 3 days to 166 days. This includes approximately 64 days of bridge inventory to support fab transitions and the silicon carbide ramp. Excluding these strategic builds, our base inventory declined 7 days quarter-over-quarter to 102 days. We continue to proactively manage distribution inventory. Disti inventory declined $25 million sequentially with weeks of inventory at 6.9 weeks versus 7.7 in Q2. Total debt remained flat at $3.5 billion, and net leverage is 0.25x. As we look forward, I'd like to highlight that onsemi today is a completely transformed company as compared to ON Semiconductor of the past. The structural changes in our business model have eliminated the historical volatility in the margins and earnings of the company. We remain fully committed to delivering strong operational and financial performance for our shareholders in all market conditions. Now let me provide you the key elements of our non-GAAP guidance for the fourth quarter. A table detailing our GAAP and non-GAAP guidance was provided in the press release related to our third quarter results. Given the current macro environment, we are taking a cautious stance in our guidance. We anticipate Q4 revenue to be in the range of $1.95 billion to $2.05 billion. We expect a mid-single-digit decline in automotive given the softness in Europe that Hassane described, with greater sequential declines in industrial and other end markets. We expect non-GAAP gross margin to be between 45.5% and 47.5%, primarily due to lower factory utilization and continued EFK headwind. Our Q4 non-GAAP gross margin includes share-based compensation of $4.3 million. We expect our non-GAAP operating expenses of $300 million to $315 million, including share-based compensation of $28.5 million. We anticipate our non-GAAP other income to be a net benefit of $4 million, with our interest income exceeding interest expense. This benefit is a result of the debt restructuring activities we completed over the last 2 years, reducing a historical drag on the P&L while effectively eliminating exposure to elevated rates going forward. 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 fourth quarter is expected to be approximately 438 million shares. This results in non-GAAP earnings per share to be in the range of $1.13 to $1.27. We expect capital expenditures of $425 million to $465 million in brownfield investments, primarily in silicon carbide and EFK. On a final note, given the market uncertainty, we are taking a cautious approach as we exit 2023 and plan for 2024. We are taking proactive actions to set ourselves up for success, and we remain focused on our execution. The structural changes we have brought to our business have already proven effective in these market conditions. We have been exiting volatile businesses, lowering utilization, managing channel inventory, controlling wafer starts, and we plan to continue to seek opportunities to improve our efficiencies as we navigate through the current market conditions.

Sure. In Europe, there is a significant concentration of Tier 1 companies. This situation is primarily driven by end demand, and while we've noted that there may be some inventory remaining stable due to normal demand, the softening of demand from high interest rates is extending the time it takes to reduce that inventory. We've always mentioned that the long-term supply agreements help us anticipate these changes. As a result, we are proactively positioning ourselves to allow customers to reduce their inventory while we maintain our levels across our shelves, distributors, and balance sheet. There is no change in the long-term trend for electric vehicles. Electric vehicles are expected to grow, and we anticipate growth in the fourth quarter as well. However, it won't be at the pace we had anticipated. We are all aware of the current headlines regarding electric vehicles. I believe electric vehicles represent a long-term growth opportunity, despite the various challenges we are facing. Customer interest in designing and transitioning to electric vehicle platforms remains strong. I view this situation as temporary while the macroeconomic factors, such as interest rates and the costs associated with purchasing electric vehicles, are resolved. All these factors have an impact, but we maintain our long-term positive outlook on the electric vehicle opportunity. As I mentioned, we expect growth in the fourth quarter, just not at the rate we initially projected. Yes. In 2024, we expect silicon carbide to grow at approximately twice the market rate, which aligns with the targets we communicated during Analyst Day. We still have clear visibility for this growth in 2024. On the silicon side, we anticipate flat to slightly declining performance, depending on market conditions. We are not expecting a recovery in the first half of 2024. As I mentioned last quarter, we see 2024 as relatively stable, with growth in silicon carbide for us. By the end of this year, any business we haven't exited will remain with us, so we won't be discussing exits from the legacy business in 2024. This is all included in the silicon outlook I provided.

As you know, we guide one quarter at a time. I think given the macro uncertainty, we're not going to try and forecast 2024 at this point. We feel really good about our pipeline, our design pipeline and our LTSAs at this point. But I think it's too early to provide guidance on '24.

No. So I would say the majority of the weakness in Q4 is the silicon carbide, obviously. But the rest of the business is kind of exactly where we expected it at the end of the year. As far as the outlook in the silicon carbide market in general or the EV market in general, it really has not changed our outlook. Our investments that we have been putting and even the investments we announced in Bucheon are not investments for '23 or '24. Those are long-term investments. And that adds to the confidence we have in that market being a megatrend market for us, and that's what we're investing in to gain that leadership in that market as it evolves. So no change in the outlook and the strategy. At a high level, end demand is driven by two main factors. One is financial, specifically the higher interest rates we've been experiencing, which are impacting end demand. The other is the growing uncertainty that consumers are beginning to feel. Considering these factors, we assess inventory levels across the board, including our own internal inventory. We have consistently operated with a proactive approach. Therefore, our decisions and outlook are guided by a cautious perspective focused on what we can control, particularly our execution. This involves reducing our utilization to avoid excessive inventory buildup. We have significantly reduced inventory levels in the channel, positioning us well for any potential market shifts. All these proactive measures serve us well in the short term while better preparing us for the long run. I believe the comments I made about inventory, particularly regarding Tier 1 suppliers in Europe, reflect a broader perspective on the automotive sector. Regarding electric vehicles, it is indeed from a single customer and not widespread in this immediate quarter. However, we anticipate growth in Q4. I want to clarify that this does not indicate a decline or any demand issues for electric vehicles. Demand for EVs is expected to increase, both in the fourth quarter and into 2024. It simply didn't grow as much as we had anticipated, and that's due to demand factors. We will need to monitor things as we approach 2024 to see if there are any changes in short-term demand or other influences. So we are looking at capacity transition in silicon carbide, yes, we're moving to the 200 millimeter in our roadmap over the next couple of years. We have been ramping up our capability, especially in our substrates with GTAT acquisition driving that for us.

Yes. So the expectations for capital expenditures for silicon carbide for next year will be consistent with our long-term strategy. We anticipate continued investment but not at the levels initially planned for 2024, adjusting as needed based on market conditions and the overall business outlook.

Yes, I believe so. It will be from our side due to a high demand for silicon carbide solutions. We expect to transition smoothly and manage the operational cadence closely as we execute. The strategic inventory for the fab transition typically involves a committed backlog. We refer to this as no change, no return. Therefore, we establish a bridge inventory to meet customer needs during the transition from the old fab to the new one. We consider this a very low risk and expect it to reduce over a few quarters as we phase out the old fab. Before we begin operations at the new fab, we will reduce inventory to a manageable level, then gradually increase it back into other fabs. Consequently, we do not view this as an inventory risk, which makes us more comfortable with the elevated inventory levels.

Just to be clear. On the silicon carbide, the expectation of being over $800 million, the impact there is one customer. It’s the recent demand softness at one customer.

The outlook is not related to returning to a turns business. We have complete visibility on where the Q4 revenue will come from, including full backlog coverage. What we are discussing is getting ahead of the call, which is the advantage of the long-term supply agreements we continue to mention. Customers assess their consumption expectations, and if their consumption is lower than anticipated, we are not here to push inventory and worsen the situation for them. Therefore, we work towards a mutually beneficial agreement with each customer. Yes. I would say the major impact is due to the reduction in demand from a single customer. This customer’s shift directly affected our projections, but overall, we still remain optimistic about the broader market.

We believe the demand trends will remain somewhat stable as we navigate through Q4 and enter 2024. The efforts we have taken will keep us positioned better than the broader market competitors.

Thank you again for joining our call. As always, we aim to deliver consistency and transparency in our results, and we thank you for your support along the way. The executive staff and I are incredibly proud of our team's continued performance, dedication to our customers and commitment to delivering shareholder value. Our employees all over the world are solving complex technology and business problems for customers. Congratulations to the team, and thank you all.