ON Semiconductor Corporation (ON) Presents at Morgan Stanley Technology, Media and Telecom Conference (Transcript)

ON Semiconductor Corporation (NASDAQ:ON) Morgan Stanley Technology, Media and Telecom Conference March 7, 2023 5:05 PM ET

Company Participants

Hassane El-Khoury - President and CEO

Thad Trent - CFO

Conference Call Participants

Joe Moore - Morgan Stanley

Joe Moore

Great. Welcome back, everybody. I'm Joe Moore from Morgan Stanley Semiconductors. Very happy to have the executive team from ON Semiconductor, Hassane El-Khoury and Thad Trent, CEO and CFO, respectively. Just quickly, I have to read this disclosure. For important disclosures, please see the Morgan Stanley research disclosure website at www.morganstanley.com/researchdisclosures. If you have any questions, please reach out to your Morgan Stanley sales representative.

Question-and-Answer Session

Q - Joe Moore

So guys, thank you for doing this. I appreciate it. Maybe if we could just start off kind of general. If you could talk about the dynamics you're seeing in your end markets. You've talked about strong automotive, some choppier trends elsewhere. Can you just kind of talk to what you're seeing in the market right now?

Hassane El-Khoury

Yes, look, nothing different from our last earnings call where we still see automotive holding up. Obviously, that's expected given a lot of the content, a lot of the megatrends that are going into automotive as far as electrification, content growth, whether it's level 2+ autonomy or EVs, whether it's drivetrain or all the content that replaces under the hood. We see that sustaining.

We've had strong last couple of years, and we see that strength sustaining, not really tied to SAAR, but tied to more on penetration of these megatrends into the general population of vehicle.

We still see the softness in the consumer and compute. We started seeing that softness in -- think about it in the second quarter of 2022. And we proactively took utilization down, so we're able to navigate and manage through that very, very well, and we'll continue to do so until the outlook changes.

And then in the fourth quarter, we started looking at softness in the industrial market, but more on the consumer side of industrial. I think power tools, more that is indexed to consumer, but remaining strength in, for example, our core industrial, like our energy infrastructure or energy storage, specifically, where that actually accelerated in the second half of the year where we started the year at 50% growth from 2021 and we ended at 75% growth. So, that momentum will continue through 2023 as that infrastructure builds up.

So, overall, it's where we expected it to be and where we have been very proactive in managing through it, and we'll continue to do so until we see a different knee in the curve.

Joe Moore

Great. And if you put this in the context of kind of the larger journey that you guys are on, when you came in, you talked about a strategy of exiting businesses with less sustainable profit pools. And I think you've now exited, if the number is right, $294 million in total, $17 million last quarter. You remain committed to that, which I think is impressive for people to see, given that you have seen utilization come down.

You would see contribution margin hanging on to those businesses. Can you just talk to the general progress there? And then the fact that you're taking $75 million out this coming quarter, the quarter that we're now in, is a bigger increment. Can you talk about what's driving that?

Hassane El-Khoury

Yes. Look, I mean, obviously, we thought we'd be way done with the exits that we planned, but the market environment has delayed it. So that $400 million that we still have, obviously, it's accelerating. We talked about the $75 million in the first quarter. That's because we've always said it's market dependent, where as soon as customers are able to get that capacity elsewhere from any of our peers, they're going to get it elsewhere.

So, with the softness that we talked about in the consumer and compute, which is where a lot of these products are, we expect those customers are going to be able to get that capacity elsewhere, given the overall demand. So, that's the reason for the acceleration. However, it remains market dependent.

And look, we stayed the course, like you said. The softness in the market did not deviate because although that business today is, call it, the last -- the 294 is in the 20% margin, this one is, call it, high 30s, low 40s. But in a normalized environment, when there is supply and supply comes from other, that business is 20% margin to negative margin.

So, the reason I don't believe nor does the company anymore talk about contribution margin is because there is no such thing. When you're in the 20s, that's zero to negative. It's highly dilutive. And now you're putting stuff in the fab that is what I call it's empty calories revenue.

And when we have constrained capacity and we have growth into those businesses, we want to make sure that we don't have anything in the fab that is dilutive for margin. Every wafer we do has to be incremental. So, our new products, which are margin accretive, that's the stuff we want in the fab.

And if I hold on to that dilutive revenue, well, what happens when I need that growth? Then you end up exactly in the same spot. So, we would rather take the more responsible approach, which is take utilization down or able to absorb it because of the strength in the rest of our company -- structural strength in the rest of the company and then navigate through it. So, the growth on the other side is a much better margin overall.

Joe Moore

Yes, I mean we've been in this great cyclical environment for the last couple of years and now kind of plateauing, but your view would be that the businesses that you're focused on are -- it's a sustainable source of gross profit that's in line with your overall--.

Hassane El-Khoury

Absolutely. Absolutely. And even if we think about 2023 being a transition year from our margin perspective, we've shown the sustainability of our margin net of these headwinds that we have just momentarily in this year.

And that's what's going to drive, not only getting to the 48% to 50%, but our new products are accretive to margin. And as those new products become a bigger percent of revenue, we're on a very, very good trajectory that we're very comfortable with.

Joe Moore

Great. And then you mentioned fab utilization coming down a bit. You've been pretty disciplined around that, around working capital. How are you -- what's the end goal of that? Are you trying to prepare for an uncertain environment, prepare for some of this weakness to persist? I mean how are you thinking about -- I'm not asking for a forecast, but how are you doing the planning?

Hassane El-Khoury

Look, if you think about it, we look at uncertainty. If there's certainty, and it was soft, you can manage to it. If it's softer and there's uncertainty, then you have to take all necessary precautions so you don't get caught with it.

And what does that mean in our terms and what we've done from an inventory perspective? The worst thing you can do is get into a softer market that lasts longer than you think, and you piled up a lot of inventory. Because then what happens is, one, you start reserving and writing stuff off, so negatively impacting your margin. You still have to put a very hard stop on your manufacturing, which hurts the margins even more because utilization drops very quickly. There's a no-win situation of trying to hold on and be in denial. So, as soon as we started seeing that softness in those end markets, again, back in Q2 of 2022, we started taking inventory down.

And look, if we got it wrong, we'll have to ramp back up, and there will be a few escalation calls more than I have today. That's not a problem. I got used to it. But if you get it right and you end up getting there with no low inventory, whether it's on the balance sheet or in the distribution, you're going to come out the other side much stronger than you went in, and that's the position we're in today.

So, we're set up beautifully not by accident for what it's -- so, as soon as the market starts becoming better than we think, we just ramp back up, and that's actually a tailwind to margin.

Joe Moore

Great. And then before I get into the end markets, the role of long-term supply agreements, you've talked about over $16 billion -- $16.5 billion secured so far. You had $2.5 billion incoming last quarter, which is an impressive number. Can you talk about the reason that people are placing those and what the visibility that gives you in the business?

Hassane El-Khoury

Yes. So, long-term supply agreements started off in the middle of the shortages the large customers to solidify what they need and get what they need. We were supply constrained. We're not building on backlog. When customers wanted those highly constrained technologies, we had an engagement with the customer of, well, what do you need over a multiyear period? Because what we needed is the visibility. Do we need to invest in CapEx in order to sustain the growth, given everything I talked about, about the megatrends and auto? Those are sustainable markets as far as growth.

So, in order to do that, you can't really do that with whether you need in the next six months and the next six months, we have to have a much longer view. So, we started establishing those long-term supply agreements. And in essence, the customer says, here's what I need. They commit to what they need, meaning take-or-pay commitment to what they need over a long period of time. In return, we will invest in order to have the capacity to support their growth as well. So, it's a win-win when you do it right. So, that's what those -- that's how they started.

Now, fast forward, we're -- we talk about Phase 2 and we talk about revisiting a lot of the LTSAs. The $2.5 billion, where does that come from? Where it came from is existing LTSA customers that in the last few years, they've gotten what they need, and they came back and say, I know we have it on 10 products that were highly constrained. We have -- we discovered -- we buy 300 products from onsemi. We want all of them, and we'll give you the commitment of all of these parts in the LTSA and we will go for five, six, seven, sometimes 10 years.

That visibility is absolutely what we need for us to confidently deploy capital because we're not deploying capital based on a market share aspiration or some forecast that may or may not happen, it's a contractual obligation that we have with the customer.

The other one is customers that came in and said, we love it. We want to extend it. So, it's a rolling kind of four year. We've had two years, they want to extend it. And customers that in the last few years did not get what they want and they realized it's time to make a commitment. So, they came in and said, we're ready to commit for five years. We need to get the products, especially the new products that onsemi has, net-net, $2.5 billion, totaling $16.5 billion, and we keep adding.

Thad Trent

The other thing I'd add there, Joe, is this has got pricing, quantity and timing all set up over the duration of these long-term agreements. So in the soft market, there's no discussion about pricing. Pricing is holding, pricing is very stable. If a customer needs help with quantity and we can allocate that somewhere else, we may do that. But we're not having a discussion on pricing.

They can't come to us and say, I can get it cheaper somewhere else. So, -- it's legally binding. So -- the pricing environment is extremely stable right now. And even as we saw consumer and compute get soft early last year, it's not a pricing discussion right now.

Joe Moore

Okay. And I know you've said that even if there's a flexibility on timing, you get more of an advanced notice on those kind of risks?

Hassane El-Khoury

Yes, I've always -- the anecdote I always use is, guess what, I'm going to get a phone call because it's legally binding and it's take or pay. As soon as the customer gets that feel of, hey, I think in six months, I don't see the demand on my customer's backlog. They pick up the phone and they give me a call and say, I don't think we need this in six months. It gives me time to react by like.

If I have another customer that sees strength for the same part, I'll just move it. We're whole. The customer will work with us on, okay, is there another part that we can get more share on? So, net-net, it's a win-win.

Joe Moore

Great. We can pivot and talk about the end markets a little bit, starting with auto. And before we get into some of the submarkets that you're addressing, what are you seeing from the automotive industry in terms of supply chain management? Is there a desire for those guys to put inventory in place either at the OEM or Tier 1 level? Is there desire to secure capacity from domestic vendors? Like, what are you seeing as a reaction to the shortages over the last two years?

Hassane El-Khoury

Look, the biggest thing I would say is a night and day from where -- I've been in automotive, my whole career. But the difference that I see now is the OEMs have and want full visibility all the way to the silicon semiconductor suppliers. Because what they realize is there's this chasm, this big gap of what they had visibility to what -- I mean I've had conversations with customers saying, we had no idea how many products we bought from onsemi.

But the focus for the OEM is really not how to solve the problem. Okay, we need to get inventory here or it needs to be localized because what we realized is the disruption that we've had into two years was agnostic to region, right? It was agnostic to inventory -- sucked up inventory immediately because it was beyond that.

So, what they realize is how do we work together on that sustainability. A lot of people focus on supply assurance. My conversation with customers is supply assurance and supply resilience. And with our manufacturing footprint that a lot of it is geographically distributed already, we are in a very good position to also discuss with customers on supplier diversification.

You don't have to go to two suppliers anymore. You can go to onsemi from two different fabs that are geographically distributed. You get the same supply resilience and assurance. That's the focus of the conversation that we're having with the OEM at a much bigger and strategic level. And if you look at a lot of the announcements, they've been made with OEMs, which is a very different scenario that we've historically have had.

Joe Moore

Great. Thank you for that. So, can you talk about some of the incremental auto opportunities? Maybe start with ADAS. Silicon carbide gets a lot of the attention. But ADAS is obviously a big opportunity for you as well through primarily image sensors. Can you talk to how you see that opportunity scaling over time?

Hassane El-Khoury

Yes. Look, I mean, if you think about ADAS, if you rewind 4 or 5 years, everybody -- we should have flying cars that drive themselves today. Well, that didn't happen because there are nontechnical just challenges in it.

But let's take the autonomous driving as a vision, but talk about Level 2+, which now is the penetration that we talked about, where although the car is not fully autonomous, where you still need a driver, the content that's in there, whether it's for 360, whether it's for occupant detection, whether it's in order to have the hardware in the vehicle that you later can upgrade into more autonomous functionality, that content is what's driving our image sensing business today.

So, the content is being driven, that's incremental. The penetration into the automotive market, where there are more Level 2+ functionality going into production vehicles. So, penetration is up.

Number of cameras have doubled in the last five years and will double again in the next five. So, again, content on top of SAAR for ADAS. And on top of all of this, there's an ASP expansion because of resolution. Right now, the world is moving to 8 megapixels from one, two and sometimes five megapixel, eight megapixel is a bigger higher ASP than the other ones. So, that lift is also incremental to the growth.

So, those are the variables that are going to sustain our growth in that market and sustain our leadership in that market. We're number one in the market today, and that growth is going to maintain that momentum.

Joe Moore

And you're seeing that growth like this year or is that more down the road where you see.

Hassane El-Khoury

No, no. It happened last year, and it will continue to happen.

Joe Moore

Great. And then silicon carbide, obviously, a big story for you guys. When you first gave the $1 billion guidance for this year, it was a pretty surprising number. That's taking shape now as we've seen a bunch of the customer announcements.

But can you talk to us about why you're doing well in that market? Is it the capabilities that you had already in silicon and IGBTs and modules that are bringing their way into this world? And just how are you securing all these wins relative to people who were bigger than you last year?

Hassane El-Khoury

Yes. So, look, in general, and we've been very consistent in our approach in this market. What you need to win in the market is you need compelling and competitive technology. And I've always said I defined technology as the device and the packaging. We're talking about power semiconductors.

If you have the best device when you pump a lot of power in it, if you can't cool it effectively in a small form factor and so on, you end up putting a lot of costs at a system level. So, you have to have the two -- and you have to have the two tenants very competitively in order to win in the market, and we have that. The testaments from all the announcements that we've made with the customer are about us winning against everybody out there.

That's for a few reasons. One, we decided to heavily invest in silicon carbide and the packaging capability, but it's not a new investment. It's an acceleration of a decades of IP and decades of know-how into that market that we are just reapplying from silicon power to silicon carbide. So, we have that core competency that we have redirected and invested and accelerated in silicon carbide.

And on top of that, we are able to go to the customer and say, okay, now that you have evaluated our products, evaluated it in your system and you have concluded that it is superior than everybody else's.

Therefore, we get awarded the business -- we get awarded a bigger share of the business because they come and review our supply chain, all the way from our substrate capability, all the way to our fab. And they say, yes, you got it, you can scale with us and you got the award.

Because the worst thing you can have is you do all the technical work and the customer says, great, we are successful in the market. It's actually surprisingly better than what we thought, you need to scale. And we go, sorry, we can't, because we don't control our own destiny. They're not going to double down with you.

Our ability to have that vertical integration allows those customers to double down with us. And then as we get more visibility, we will implement that capacity and scale it accordingly, just slightly ahead of them. And that's why we've always said we deploy CapEx for LTSAs. We're not putting CapEx for some market share dream that we have. We have customers, we will put LTSAs and we will ramp those customers ahead of when they need it.

Joe Moore

So, you mentioned the vertical integration. You did the GTAT acquisition, allowing you to build your own substrates. We've hold to the facility, which was really impressive. Does that make it more difficult to ramp? Are the end customer -- the OEM customers aware of what's an internal wafer versus a Wolfspeed wafer? Or at this point, is it sort of they're just looking to qualify the device?

Hassane El-Khoury

It's a device. Qualification happens at a device and package. So you change a device or you change the package, there's a qual. Anything before that is not qual. Because it's like -- which is the same as silicon, by the way. And that's why I put the -- our Hudson facility or the GTAT facility as a supply assurance and vertical integration, not what -- why we're winning. Why we're winning all of the volume and all of that is because of the supply insurance, where we're able to provide that.

But the first anchor point you have to win on your device and packaging capability because, look, if you have all the substrates in the world, and you can't get the efficiency at a system level, the customer is not going to care because they're not going to be competitive in the market if they don't have the range that our efficiency brings them. So, we win because of technology. We build, scale, and win the platforms that you've seen us announce in the last few months because of the vertical integration.

Joe Moore

Great. And then I think when we talked probably in December, we did 1 of these, and we said, how can we haven't announced any customers. And since then, we have Tesla, JLR, BMW last night, I guess, VW. A lot of customers now.

Hassane El-Khoury

Mercedes.

Joe Moore

Mercedes, yes. And so it still seems like $1 billion is a lot. You're talking about close to a couple of million vehicles. Do you take a lot of time thinking about this bottom up relative to the size of the market? Or do you -- I mean you know where your customer demand is.

Hassane El-Khoury

100% bottoms up. What we have is what we're building to. We already are qualed in these accounts. So, it's not -- and we already started ramping.

Joe Moore

And all those customers are bringing up production vehicles now.

Hassane El-Khoury

Yes.

Joe Moore

Okay. Tesla made some comments last week that people found unsettling that they're reducing content, 75% of silicon carbide. It seemed like they were speaking about a future vehicle rather than across the board.

But can you -- I don't want to put you in a perspective of seeing anything about a customer you want to say. But just in general, when you look at the content, do you see that content coming down in certain parts of the market over time?

Hassane El-Khoury

No, it's not coming down. Silicon carbide is a net positive growth story. And therefore, even with the announcement, what I will tell you is there is absolutely no change to our $1 billion or the $4.5 billion in LTSA -- committed revenue LTSA that we've been talking about.

Why? If you go back to a lot of commentary I've said publicly or in forums like this, we've always said when we engage with a customer, we engage at a system level. What is the customer trying to accomplish from range, performance and so on? And we will drive down of what technology we offer, whether it's IGBT or silicon carbide.

So, the benefit of where we are with our portfolio is we're able to support both at the most optimal price point for the required performance the customer needs. We don't walk into an account saying, we got silicon carbide, you got to design it in because it is more expensive.

And if the customer doesn't need the performance, maybe IGBT is more suitable. And I've also said that there are some customers that are opting or will even opt in the future of the front axle, like the non-drive axle being IGBT and the drive axle being silicon carbide because that's where you need the performance.

So, take all of those in context to the state -- the commentary made last week, and they're the same, right? When you talk about a $25,000 vehicle, you're not talking about a 500 range vehicle, right? So, having that vehicle actually will increase adoption of electrification, which means it's incremental for us, even the amount of silicon carbide in that, whatever percent it is of the current generation, is incremental to what the industry has.

Forget about where we play here. The benefit for us is, obviously, it's incremental for silicon carbide and it's incremental for ITBT because it opens up yet more IGBT lifeline. And our IGBT business, we're still investing in it. We just transferred IGBT to our 12-inch fab in East Fishkill in North America.

So, you have localized supply back to your localized supply here on 12-inch, and our road map is not stopping because we have silicon carbide. We still have a road map on IGBT. So, I know how the angst that was around the announcement. But when I saw them, I looked at it going, it's great because it's incremental and it's favorable for us, especially because we have both.

Joe Moore

Great. Let me pause and see if we have questions from the audience. We have three more minutes. One right here.

Unidentified Analyst

Hi everybody. Hey Hassane. So, just a quick question on that. If Tesla is able to reduce the amount of silicon carbide that they need, do you think that you could see ASP compression at either the silicon carbide traction level or at the onboard charger level? Like could that $500 ASP come down to $300 or anything like that if they do require less silicon carbide?

Hassane El-Khoury

No, because -- look, because that's all incremental. You need less silicon carbide. But again, I've always -- if you remember, when people ask me about ASPs and content, I would say, well, what kilowatt are you talking about?

So, the content doesn't scale with the price point of the vehicle. We have to be very, very clear. If you have a 100-kilowatt vehicle and you have a 500-kilowatt vehicle, you're using way less silicon carbide in that one versus the top one. That's how it's going to scale, but it's kilowatts. It's proportional to kilowatt, not to anything else.

By definition -- look, our efficiency, by the way, when we engage with a customer, they come in and they have their model about their packaging and so on. And let's say we have 10 die of silicon carbide in there. And we go in to the customer and we model our packaging, our capability. And sometimes we end up with nine or eight, so you can argue there's a 20% reduction right there. But we do that already. Why? Because what is the kilowatt that you want to get out. That's what the ASP is compared to.

So, when I look at ASP, I normalize it to a kilowatt -- dollar per kilowatt. That will scale ASP. So, it goes from $500 to $300, but not at equal kilowatts. That's why the vehicles are -- I always talk about platform with a lot of our customers. Every platform and even in the VW conversation, every platform is a different range platform. We have a high-range platform, high-performance platform. Every single one of them is a different trade-off. The trade-off is what's going to drive the ASP, not the content of what silicon carbide is in there.

Joe Moore

It's time for one more question. Maybe you could just talk to -- I mean you mentioned gross margins being at your corporate average minus some headwinds. Can you talk about the headwinds of silicon carbide start-up expense, how quickly does that wind down and your conviction in the sustainability of those margins in an uncertain--?

Thad Trent

Yes, let me take that. So, the silicon carbide in 2023 -- so we think about 2023 as a transition year. So, we've got headwinds from silicon carbide. It's 100 to 200 basis points. We think by the time we exit the year, that will subside, and we're back to kind of -- we've always said at scale, our silicon carbide gross margins are at or above the corporate average.

So, we think we'll start to achieve that by the time we exit the year. We also have a 50 to 70 basis point headwind from the EFK, the East Fishkill fab acquisition, as we provide foundry services to GLOBALFOUNDRIES. That will go over three years, but it steps down each year. So, 23% is actually the worst of all with the lined up.

So, if you actually pull all that out, we're in our 48% to 50% gross margin range, right? We're also really comfortable with our floor given what we've been doing with utilization of saying our floor should be in the mid-40% range.

So, I think we've got a nice kind of boundary conditions on our margin with nice tailwinds going forward in 2024 and beyond. We also have the exiting of the four subscale fabs, where there's $160 million of fixed cost -- annualized fixed costs that come off over a three-year period. That starts to kick in, in 2024 as well. So, we got a tailwind there as well as ramping new products and things like that. So, 2023 is a transition year for us.

Joe Moore

Great. All right. Thank you so much. I appreciate you guys.

Hassane El-Khoury

Absolutely. Thank you.