ON Semiconductor Corporation (ON) Earnings Call Transcript & Summary

Good morning, everybody. My name is John Vinh. I cover semis here at KeyBanc Capital Markets. We're delighted to have the Onsemi team with us today. We've got Hassane El-Khoury, CEO; and Thad Trent, CFO. Welcome, guys.

Thank you.

Maybe I'd like to start off is maybe talked about the earnings call, you talked about prioritizing data center demand over autos and industrials. And I'm wondering if you could just unpack that comment a little bit because I didn't think that short-term capacity was fungible, right? Because as you think about parts that you supply into the data center is very much different. I mean the parts you supply in autos and industrial. So maybe we can start there.

Sure. So the comment I made, obviously, we also framed it into a temporary adjustment that we've made, not a strategic redirect. And we expect that to normalize, call it, over the next couple of quarters when the impact of utilization that we took up will start coming out from material. But to comment -- to answer your question more directly, at a product level, it is not fungible. And what I would call a product is when the product is fully assembled because then it's a footprint and has to go on a certain board, a certain physical form. But from a fab perspective, not just from a fab all the way to technology, it is fungible. When we talk about 1,200-volt silicon carbide, it is the same 1,200 volt that we supply, for example, in automotive or in 800-volt systems and AI data center. It is fully fungible up until it gets to almost die, which is 2 weeks away from finished goods. If you think about a 2-week cycle time for finished goods, all the way up until that point where it gets its, call it, marketing part number or MPN, it is fungible. So that's the decision we made. So when you get orders in short time and you have to make priority calls as long as those priority calls are on a kind of a 2-week -- now if it's packaged and it's kind of ready to go, you can't just change the mailing address. So that's the flexibility. Now compare that 2-week change in end product to a little over 30 weeks of lead time, we're able to make those decisions while we start those new wafers for the auto and industrial orders that we got, but that takes about, call it, 3 to 6 months to come out. So that's why I said it will normalize in the next couple of quarters, just a matter of time. You saw utilization went up. So we already took utilization in response to that demand, but the output is yet to come.

Great. Other than increasing utilization, is there anything else from a supply perspective that you're doing to respond to this uptick in demand that you're seeing?

No, not from a -- we have the capacity. We talked about we took utilization up to 83% fully utilized. You can think about it in the 92%, 93%. So we're not fully utilized. We did a step function based on the demand that we saw, but that's not fully utilized, meaning we're not capped out on capacity. What we are managing now is the slope of the orders that came in. If you get a lot of orders within 13 -- let's say, everything is a 30-week lead time. If you get a lot of short lead time orders, you're just not going to service them, just a matter of fact from a lead time perspective. So it's not like we can't do the capacity and we need more CapEx. Our CapEx remains unchanged. CapEx remains mid-single digit. We will take up utilization as we see demand coming in. And even when we get to that 92%, 93% utilized, we can flex to the outside. So it's not like CapEx is going to have another CapEx cycle built in here. So we feel pretty comfortable with the growth trajectory that we have for the company overall. and the flexibility we have. And remember, as utilization goes up, the margin gets the tailwind from the utilization. And that's our short-term margin expansion, and you start to see it in Q3, even throughout this year.

Great. Maybe on that front, Thad, maybe can you just remind us just what the puts and takes on gross margins over the next 6 to 12 months? Is it primarily going to be driven by utilizations? Or are other puts and takes that we should be thinking about here?

Yes, utilization is going to be the primary driver. If you think about where we've gone with utilization, exiting last year, we were at 68%. Last quarter, we're at 83%. So you can see how quickly we've taken that utilization up. every point of utilization is 25 to 30 basis points of gross margin improvement just 2 quarters later, right? So you saw our margins step up in Q2. We guided a significant step-up in Q3. I expect more because of the utilization tailwind. I expect more in Q4. And based on the visibility, we're getting much better visibility than we were a year ago from our customers. So we got good visibility into '27. In some cases, we have customers even starting to layer in backlog into '28. So it gives us that confidence that utilization will continue to improve. Now we will get over that hump, as Hassane said kind of that cycle time, that fab cycle time. But I expect further gross margin improvement into next year as well. The one thing that we've had as a headwind is the input cost to hit the P&L where the pricing hasn't yet. So we did our first round of price increase April 1. We're doing a second round now. That will take several quarters for it to fully layer in, but that's a nice tailwind kind of in the short term. Longer term -- well, let me back up to Q2. Q2 had 650 basis points of underutilization charges. So if you get from that 83 to 92, 93, there's 650 basis points right there if you just do the math that I was giving you. So you've got that as a tailwind. You've got the fab right initiatives. So we've said that's about 200 basis points of gross margin improvement. We announced last quarter the divestiture of 2 manufacturing sites. That's 50 of the 200 basis points. Some of that will start to layer in, in '27, most of it in '28. We get favorable mix, and we'll talk about the products, the differentiated products. So over a multiyear period, there's another 200 basis points of improvement there. And then if you go back to the fab divestitures that we did a few years ago, we built that bridge inventory that we're burning through. You can see we actually burned through quite a bit of that last quarter. As we start manufacturing that inside, that's another 200 basis points. So if you start doing that math, you get over 50% pretty quickly. Utilization is the biggest short-term driver though.

Great. You talked about increasing backlog. I assume like your lead times are extending, backlog is getting better. Maybe, Hassane, can you just talk about what you're seeing from a restocking perspective, specifically from your automotive customers at this point?

Yes, it's not very consistent. So we've had -- obviously, I -- last earnings -- or Q1 earnings call, I made the comment of we need to see the backlog in automotive, while we haven't seen a replenishment cycle, we haven't really seen an uptick in demand per se. SAAR has been very flat, sometimes slightly down. So overall, we haven't seen the replenishment cycle, which is the reason for concern. A couple of things. One is when demand does pick up in automotive with no replenishment, the constraint that we're seeing today will get even worse. That's point number one. So we haven't seen that yet. And point number two is OEMs are no longer waiting for the Tier 1s. So typically, the replenishment cycle will happen through the Tier 1s placing orders ahead of an OEM demand cycle. OEMs are concerned about the fact that the Tier 1s have drawn down on their inventory because even their balance sheet can support a small inventory build. So they're buying directly from us. Now not enough to solve the potential constraint with the demand uptick, but at least there's a realization that things are not healthy in -- from an inventory perspective in the supply chain in automotive that OEMs are starting to take a little bit control of the situation. Now that tells you the Tier 1 business model needs to change. If we need to go down a path of you have to have inventory when you have AI data center competing with the same capacity, the fungible capacity, as I mentioned earlier, that business model is going to change. I think some of the OEMs are realizing that, and they're working directly with us on direct orders. So we ship to the OEM. When the OEM has the demand, they decide which Tier 1 gets it. So they're doing the allocation.

How broad-based is that in terms of OEMs?

Not very broad-based. Obviously, the -- I'm going to call the disruptors, A lot of the Chinese OEMs, North America EVs, that's their business model. They started. We deal directly with every single one of them. So that model is kind of the new model. The traditional OEMs, I would say it's not enough, not enough to make it a trend yet. But look, I think when constraints or that challenging environment will happen with the demand, I think there will be OEMs that will get through it very nicely and OEMs that will not. And that's going to be like, hold on, what was different? Well, they bought direct and they held the inventory. And that's going to become kind of a lessons learned. I communicate as much as I can to make the lessons learned, be pre-error versus post-error, but sometimes companies want to make their own mistakes to learn, but that's not mine to judge.

So from a cycle perspective, I'm just wondering, is there anything unique and different about this cycle versus past cycles? Or as you alluded to, is this just going to be history repeats itself?

I would say I wish it was history repeating itself. At least you know what the heck is going on. I don't -- it is cyclical, but I don't think any cycle in the last, call it, 3, 4, 5 years have been anything -- I mean, you've seen the up, you've seen the down. We've all seen many ups and downs. That has a very different feel to it, not because every cycle is different, but the technology and the breadth of technology is just very unique. You don't have typically a lot of secular growth, very aggressive secular growth that are all converging on a technology. Let me give you kind of where -- and it's actually a good opportunity for us, not just today, but over a longer period of time. It is the convergence around power. If you think about it, everything translates into gigawatts of power installed. Whether you talk about AI data center, everybody measures the overall capacity in gigawatts. If you think about automotive and the kilowatt per car translates into a gigawatt deployment in automotive, everything is measured -- the unit of measure of the secular, the same thing in industrial, SSDs, ESS, it's all measured in gigawatt deployment. The fact that every secular growth market in every end market that matters is being measured in a unit of power is unique, and it puts us in a much unique and a favorable market because that's what we do. We do power and we do power conversion, translating that gigawatt overall into whatever end use cases. You've seen us do it in automotive very successfully and get a dominant share. And you've seen us doing it in AI data center today, and we'll continue to do that. Industrial, I think we talked about being #1 in energy storage already. That's going to continue. We talked about a 40% growth even in this environment. So we feel very good about the cycle and what it means to a technology basis and the fact that it lands in the technology domain that we are really good and strong at.

That's great. Speaking of secular growth, I think you highlighted that your data center -- AI data center business is going to more than double this year. I think that you had raised that a little bit from previously just doubling. Can you just help us understand how you're participating in the AI data center power tree, right? You've got high voltage, Stage 1, Stage 2 power. Help us understand where you're benefiting along that power tree.