ON Semiconductor Corporation

Ladies and gentlemen, thank you for standing by, and welcome to the On Semiconductor Third Quarter 2020 Earnings Conference Call. At this time, all participants are in a listen-only mode. After the speaker presentation, there will be a question-and-answer session. To ask a question during the session, you will need to press star 1 on your telephone. If you require any further assistance, please press star 0. I would now like to hand the conference over to your speaker today, to Mr. Parag Agarwal, Vice President of Investor Relations and Corporate Development. Thank you. Please go ahead.

Thank you, Dinam. Good morning, and thank you for joining our Semiconductor Corporation Third Quarter 2020 Quarterly Results Conference Call. I'm joined today by Keith Jackson, our President and CEO, and Bernard Goodman, our CFO. This call is being webcast on the Investor Relations section of our website at www.allsemi.com. A replay of this webcast, along with our 2020 third quarter 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. The skill for today's call and additional information related to our end markets, business segments, geographies, channels, share count, and 2020 and 2021 fiscal calendars are also posted on our website. Our earnings release and this presentation include certain non-GAAP financial measures. The consideration of these non-GAAP financial measures to the most directly comparable measures and the GAAP are also 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. The words believe, estimate, project, anticipate, intend, may, expect, with, learn, should, or similar expressions are intended to identify forward-looking statements. We wish to caution that such statements are subject to risk and uncertainties that could cause actual events or results to differ materially from projections. Important factors which can affect our business, including factors that could cause actual results to differ from our forward-looking statements, are described in our Form 10-K, Form 10-Qs, and other filings with Securities and Exchange Commission. Additional factors are described in our earnings list for the third quarter of 2020. Our estimates or other forward-looking statements may 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. During the fourth quarter, we plan to attend two virtual conferences. This includes NASDAQ 43rd Virtual Investor Conference on December 1st and Wells Fargo TMT Summit 2020 on December 2nd. Now, let me turn it over to Bernard Goodman, who will provide an overview of our third quarter 2020 results. Bernard?

Thank you, Bharat, and thank you, everyone, for joining us today. During the third quarter, we saw strong recovery in business conditions due to sharp acceleration in global economic activity, especially in the automotive market. Border activity has picked up meaningfully across end markets and geographies. Manufacturers are striving to meet the upsurge in demand, which was previously disrupted by the COVID-19 pandemic. Along with strong micro-driven recovery of our business, momentum in our key strategic growth areas in industrial, automotive, and cloud power end markets is accelerating. Our design wins are accelerating, and the design funnel is expanding at a rapid pace. As we stated earlier, gross margin improvement is the primary strategic priority for the company. We're on track with our manufacturing consolidation plan, and discussions are ongoing with various parties regarding the previously announced intended sale of our fabs in Belgium and Jakarta, Japan. In the near term, revenue tailwinds from the ongoing recovery in business conditions and favorable end market mix shifts should help drive margin expansion. Now, let me provide you details on our third quarter 2020 results. Total revenue for the third quarter of 2020 was $1.317 billion, a decrease of 5% as compared to revenues of $1.382 billion in the third quarter of 2019. The year-over-year decline in revenue was driven primarily by a slowdown in global microeconomic activity due to the COVID-19 pandemic. Gap net income for the third quarter was 38 cents per diluted share as compared to a net loss of 15 cents per diluted share in the third quarter of 2019. Non-gap net income for the third quarter of 2020 was $0.27 per diluted share as compared to $0.33 per diluted share in the third quarter of 2019. GAAP gross margin for the third quarter of 2020 was 33.5% as compared to 34.4% in the third quarter of 2019. Non-GAAP gross margin for the third quarter of 2020 was 33.5% as compared to 35.8% in the third quarter of 2019. The year-over-year decline in gross margin was driven primarily by lower revenue, as discussed earlier, and COVID-19-related costs. Our GAAP operating margin for the third quarter of 2020 was 9% as compared to negative 3.2% in the third quarter of 2019. Third quarter of 2019 GAAP operating margin included the impact of $169.5 million related to the intellectual property settlement with power integrations. Our non-GAAP operating margin for the third quarter of 2020 was 12%, as compared to 13% in the third quarter of 2019. The year-over-year decline in operating margin was driven largely by lower revenue and the impact on gross margin due to COVID-19 pandemic. GAAP operating expenses for the third quarter were $322.2 million as compared to $519.1 million in the third quarter of 2019. Third quarter 2019 GAAP operating expenses included $169.5 million related to the intellectual property settlement with power integrations. Non-GAAP operating expenses for the third quarter were $283.6 million as compared to $314.3 million in the third quarter of 2019. The year-over-year decrease in non-GAAP operating expenses was driven primarily by strong execution on the cost front and by restructuring and cost-saving measures undertaken by the company. The third quarter free cash flow was $101.8 million and operating cash flow was $163.4 million. Capital expenditures during the third quarter were $61.6 million which equates to a capital intensity of 4.7%. As we indicated previously, we are directing most of our capital expenditures towards enabling our 300 millimeter capabilities in the East Fishkill FAB. We expect total capital expenditures for 2020 to be in the range of 370 to 390 million. We exceeded the third quarter of 2020 with cash equivalents of 1.654 billion as compared to $2.06 billion at the end of the second quarter of 2020. The decline in cash balance was primarily due to the paydown of amounts drawn under our revolving debt facility as a precautionary measure in response to the COVID-19 pandemic. At this time, with cash balance of approximately $1.6 billion, we are very comfortable with our liquidity positions. In the fourth quarter, we expect to use approximately $690 million to pay off our 2020 convertible note principle at maturity. At the end of the third quarter, days of inventory on hand were 133 days, down seven days as compared to 140 days in the second quarter of 2020. In the fourth quarter, we intend to continue to reduce our balance sheet inventory. Therefore, we plan to run our factories at current levels of utilization despite expected higher revenue levels in the fourth quarter. In the third quarter, distribution inventory decreased by approximately two weeks as sales through the distribution channel increased significantly quarter to quarter. Instead of shipping products in the distribution channel for revenue, we brought down channel inventory, even though it was within our comfort zone. Now let me provide you an update on the performance of our business units, starting with the Power Solutions Group, or PSG, Revenue for PSG in the third quarter was $647.4 million. Revenue for the Advanced Solutions Group, or ASG, for the third quarter was $494.6 million, and revenue for Intelligent Sensing Group, or ISG, was $175.3 million. Now, I would like to turn the call over to Keith Jackson for additional comments on the business environment.

Keith? Thanks, Bernard. Let me first update you on our manufacturing optimization plans, and then I will provide an update on our current business environment. We are in discussions with various parties regarding the planned sale of our Belgium and Niigata fabs. We are working diligently to get quick resolutions on these fabs, but we do not have an announcement to make at this time. The process for ceasing operations of our fab in Rochester, New York is progressing as per plan. and we expect to begin seeing annual savings of $15 million starting in the first quarter of 2021. We achieved major milestones in the third quarter as we recognized our first revenue from our 300-millimeter products. We continue to make solid progress in our manufacturing transition to 300-millimeter fab in East Fishkill, New York. As I have indicated earlier, yields for our 300-millimeter manufacturing processes have been spectacular, and we expect to see a meaningful positive impact on our gross margin as our 300-millimeter manufacturing ramps in the coming years. Additionally, our 300-millimeter manufacturing capability in the East Fishkill Fab has afforded us significant flexibility, which has enabled us to optimize our network. We continue to make substantial progress in our key initiatives to expand gross margins. We are driving shift towards higher margin products by aggressively winning designs in automotive, industrial, and cloud power in markets. At the same time, we continue to optimize our portfolio to drive margin expansion. The fundamentals of our cost structure remain unchanged. With ongoing recovery, as our revenue and factory utilization increase, we expect to see meaningful increase in our gross margins. The benefits from manufacturing optimization, mix shift, and portfolio optimization should be additive to fall through we see from incremental revenue. Now let me comment on the current business environment. We've seen meaningful acceleration in order momentum in the third quarter, and we expect that business activity will continue to grow at above seasonal levels in the near term. Along with improving global macroeconomic environment, Our accelerating design winds in automotive, industrial, and cloud power end markets are key contributors to our momentum. From a geographic perspective, we are seeing acceleration in demand from all regions. Economic data such as PMI and GDP point towards a strong recovery in industrial activity and in the overall business environment across the globe. Although COVID-19 pandemic temporarily affected our business, the underlying fundamentals of our business and secular trends driving our business remain unchanged. We continue to see strong momentum and key strategic initiatives for electric vehicles, robotics, factory and warehouse automation, cloud power, and ADAS. We are well positioned to benefit from ongoing recovery with our highly differentiated power, analog, and sensor products, which enable key secular trends in automotive, industrial, and cloud power in markets. Now I'll provide details of the progress in our various end markets for the third quarter of 2020. Revenue for the automotive market in the third quarter was $419.2 million and represented a 32% of our revenue in the third quarter. Third quarter automotive revenue declined by 6% year over year, primarily due to COVID-19 driven decline in automotive production. We are seeing strong momentum for our silicon carbide offerings with additional design wins at leading OEMs and Tier 1 customers. In addition to winning new designs, we are expanding our engagement with new customers for silicon carbide and are currently sampling products to many of these customers. On the ADAS front, we continue to win designs with major global automotive players. We are also seeing a higher level of attach rates for both ADAS and viewing applications. We are very well positioned to benefit from technology transition in automotive LIDAR to newer SIPM and SPAD technologies from APD technology. We are seeing strong traction for our LIDAR products with leading customers. Other areas of automotive were strong as well in the third quarter. We saw strong growth in our lighting, ultrasonic, and actuator solutions. From a geographical perspective, we saw strength across all regions. Despite steep increase in automotive production, It appears that dealer inventories are low. We expect current recovery and the global automotive production to continue in the near term. Based on our outlook and third-party reports, we believe that our 2020 annual automotive revenue growth rate should exceed 2020 global light vehicle annual production growth rate by a wide margin. Revenue in the fourth quarter of 2020 for the automotive end market is expected to be up quarter over quarter as we expect to see continuing recovery in global automotive production. The industrial end market, which includes military, aerospace, and medical, contributed revenue of $327.6 million in the third quarter. The industrial end market represented 25% of our revenue in the third quarter. Year over year, our third quarter industrial declined 7%. This decline was driven by reduction in global industrial activity due to the COVID-19 pandemic and geopolitical issues related to a specific customer. In the industrial end market, we are seeing strong adoption of our silicon carbide modules for solar power-related applications, and we are rapidly expanding our customer base in the alternative energy market. On the industrial power front, we are seeing increasing design activity for motor control and building automation. Energy efficiency regulations that are slated to be enacted in 2021 and beyond are driving power management and motor control related activity. Our medical business grew strongly quarter over quarter in the third quarter as the pace of electric procedures picked up. We continue to work with leading market players to design in our image sensors for automation and machine vision applications. We have secured an additional design wins from large format image sensors for professional movie camera applications. Revenue in the fourth quarter of 2020 for the industrial end market is expected to be up quarter over quarter. The communications end market, which includes both networking and wireless, contributed revenue of $255.4 million in the third quarter and represented 19% of our revenue during the third quarter. Third quarter communications revenue declined by 7% year over year. We saw strong year-over-year growth in our 5G infrastructure business in the third quarter. Our smartphone business declined year-over-year in part due to geopolitical factors related to a customer. Revenue in the fourth quarter of 2020 for the communications end market is expected to be flat or to down quarter-over-quarter due to expected revenue decline from customer-specific geopolitical factors. The computing end market contributed revenue of $172.2 million in the third quarter. The computing end market represented 13% of our revenue in the third quarter. Third quarter computing revenue increased by 12% year-over-year due to strength in both server and client businesses. We are seeing strength in our server power business with increasing content and new server platforms and share gains. Most leading processor makers are projecting higher current requirements in their next generation products. We expect this trajectory to continue in the near to mid-term due to increasing demand for computational capabilities driven primarily by artificial intelligence. Revenue in the fourth quarter of 2020 for the computing end market is expected to be up quarter over quarter. The consumer end market contributed revenue of $142.9 million in the third quarter. The consumer end market represented 11% of our revenue in the third quarter. Third quarter consumer revenue declined by 9% year-over-year. Year-over-year decline was due to broad-based weakness in the consumer electronics market due to the COVID-19 pandemic and our selective participation in this market. Revenue in the fourth quarter of 2020 for the consumer end market is expected to be up quarter over quarter. In summary, we are accelerating our efforts to drive margin expense. We are rationalizing our fixed cost footprint. At the same time, we are also aggressively winning designs to drive mix shift for automotive, industrial, and cloud power in markets, which have higher margins. Ramp up of our 300-millimeter manufacturing processes at East Fishkill FAB should further help in gross margin expansion. In the near term, strong revenue growth driven by ongoing recovery in our business should contribute to margin expansion. Business conditions have improved meaningfully, and we expect the improvement to continue in the near term. We are seeing broad-based recovery across most end markets and geographies. Key secular megatrends and long-term drivers of our business remain intact, and we are excited about our medium to long-term prospects. We are seeing accelerating momentum in our key strategic initiatives for electric vehicles, robotics, factory and warehouse automation, cloud power, and ADAS. Now I'd like to turn it back over to Bernard for forward-looking guidance. Bernard?

Thank you, Keith. Based on product booking trends, backlog levels, and estimated terms levels, we anticipate that whole-ounce semiconductor revenue will be in the range of $1.3 to $1.4 billion in the fourth quarter of 2020. For the fourth quarter of 2020, we expect GAAP and non-GAAP gross margin between 32.9 and 34.9%. We expect total GAAP operating expenses of $315 to $333 million. Our GAAP operating expenses include the amortization of intangibles, restructuring, asset impairments, and other charges, which are expected to be $32 to $36 million. We expect total non-GAAP operating expenses of $283 to $297 million in the fourth quarter. The expected increase in our fourth quarter operating expenses as compared to those of the third quarter is driven by planned reinstatement of salaries and benefits that were reduced due to decline in our business resulting from the COVID-19 pandemic. In our 2020 operating expenses, the variable component of compensation was not significant. However, as we enter into 2021, we plan to approve meaningful variable compensation with the expectation that 2021 will be a strong year. Consequently, we expect an increase of about 25 to 30 million quarter-over-quarter in our operating expenses in the first quarter of 2021. We anticipate fourth quarter of 2020 gap net income and expense, including interest expense, will be an expense of 41 to 44 million, which includes both non-cash interest expense of 9 to 10 million. We anticipate that both Net other income and expense, including interest expense, will be an expense of $32 to $34 million. Net cash paid for income tax in the fourth quarter of 2020 is expected to be $22 to $28 million. For 2020, we expect cash paid for taxes in the range of $52 to $58 million. We expect total capital expenditures of $100 to $120 million in the fourth quarter of 2020. We are currently targeting an overwhelming proportion of our CapEx for enabling our 300-millimeter capability at an accelerated pace. We expect share-based compensation of $16 to $18 million in the fourth quarter of 2020, of which approximately $3 million is expected to be in cost of goods sold, and the remaining amount is expected to be in operating expenses. This expense is included in our non-GAAP financial measures. Our GAAP-deluded share count for the fourth quarter of 2020 is expected to be 425 to 426 million shares based on our current stock price. Our non-GAAP-deluded share count for the fourth quarter of 2020 is expected to be 413 million shares based on our current stock price. Further details on share count and earnings per share calculations are provided regularly in our quarterly and annual reports on Form 10Q form and key respectively. With that, I would like to start the Q&A session. Thank you, and Dylan, please open up the line for questions.

Thank you, sir. As a reminder, to ask a question, you would need to press star 1 on your telephone. To withdraw your question, please press the pound key. Due to the essence of time, we ask that you please limit yourselves to one question and one follow-up. Please stand by while we compile the Q&A roster. I show our first question. It comes from the line of Russ Seymour from Deutsche Bank. Please go ahead.

Hi, guys. Congrats on the results, and thanks for letting me ask a question. I wanted to focus both my questions on margins. So the first one is on the gross margin side of things. I see that you're guiding to about a 50% incremental gross margin in the fourth quarter. Given that you're not changing utilization, I understand that, but I guess, first, why aren't you changing utilization given the strength in the business? And then if we go beyond the first quarter, can you just talk about how the FAB closures, the utilization increases, and the 300-millimeter ramp all layer into the gross margin? Because I would assume it would need to be above that 50% incremental that you've guided to historically and even in the fourth quarter.

So, thank you, Ross, for your question, please, Bernard. We are also intending to continue working on our inventory in the short term. Ergo, we don't plan on increasing our utilization substantially to keep working on that. And you're correct. As we start getting the benefits of the factory closures, we have talked about $75 million of annual savings coming from those closures or sales. The Rochester closing is on its way to being completed, and as a result, we expect to get about $15 million of annual savings starting in the first quarter of 2021. The other two is a function of what we end up negotiating with the intended buyers of these two fabs, and that's ongoing and in progress right now. So yes, the answer is yes, we should expect to see better than 50% fall through as we go throughout 2020.

Great. Thanks for those details. And then as my follow-up question, again, sticking on the margin front but moving to the OPEX side of things, I think everybody understands why you had variable comp down this year and why it would step up sequentially in the first quarter. But if I look at it year over year, it's basically flat is what you're guiding. There might have been some COVID-related impacts in the first quarter of 2020 that But given the structural changes and cost cuts you guys announced earlier this year, I'm still struggling to figure out why the guide for OPEX in the first quarter of 21 would be flat year over year.

So as I said, as we said in the prepared remarks, we have no variable comp in any quarters in 2020 as well as 2019. So we're basically, we did take significant cost reduction actions, some temporary and some permanent, and right now the variable comp will be layered. Obviously, that depends on the business results. If next year points in the direction of being a strong year, which is what our assumptions are, then we should have a significant addition on variable comp. If obviously the year is not in that direction, then we will not.

Thank you.

Thank you. I show our next question comes from the line of Chris Dainley from Citigroup.

Please go ahead. Hey, guys, just a quick clarification on the gross margin. So why was it 50 basis points better than the guide? Was that all revenue upside, or was there some mix or pricing or something else that was driving it higher?

Mostly revenue upside.

Got it. And then any update on the CEO search?

It's ongoing, and there's nothing to announce at this time.

Okay, thanks. Thank you. Our next question comes from the line of Chris Castle from Raymond James. Please go ahead.

Yes, thank you. Good morning. Just a question on inventory and what you're planning on doing with production. Could you give us a sense of where you would like both the channel inventory and your internal inventory to get to before you increase utilization? And generally, what's the reason for the more cautious approach to inventory right now?

So the inventory we have on the channel, we said in prepared remarks, we took it down in two weeks. We are within our comfort range. So we feel good going into next year that we are at an appropriate level for that. In general inventories, we peaked in the second quarter at 140 days, decreased it to 133 days in the third quarter, and we think there's still room to continue gradually decreasing it into the fourth quarter.

All right. As a follow-up on the automotive market, I guess that now you're running sort of down mid to high single digits year on year. Last quarter you talked about anticipating that the customers would be running at full production annually. in the second half of the year. Could you give us an update of that? Where are your customers running regarding, you know, their own production? And I guess with that, what's the gap between, you know, if the customers are kind of getting back to normal and you're still down year on year, what's the delta there and what kind of gets you back to, you know, flat year on year and then eventually growth?

Yeah, so we believe that the auto customers will be largely running at pre-COVID levels, excuse me, here in the fourth quarter. And really, the only difference, if there's any, would be change in inventory in the supply chain. There was definitely some caution in the supply chain as that COVID-19 went in, and I would expect that in 21, it would start replenishing even above auto rates.

Thanks. Thank you. I show our next question. It comes from the line of Raji Gill from Needham & Company. Please go ahead.

Yes, thank you, and congrats as well on solid results. Regarding the momentum in the automotive business, you talked about outgrowing auto production by a wide margin. Obviously, we're going to see a rebound in auto production post-COVID-19. But on top of that, what's driving the wide margin commentary, specifically in sensors and EV? Any color there would be helpful in terms of how much semiconductor content you're going to layer on top of that rebound production.

Yeah, so I think you hit on the two topics. From an ADAS perspective, we're seeing a significant amount of the production move to level two, which has quite a bit more dollar content It kind of goes from $10 at level one to $150 at level two. So we're seeing that transition would drive a very significant growth above the SARS rate. And then on the electric vehicles, there will be more electric vehicles still dominated by internal combustion, but nonetheless more vehicles. And again, the content there goes from $40, $50 up to $500. So those, if you look at both of those things, they're an order of magnitude change. And so as a result of that, we would expect very significant outgrowing.

And just for my follow-up, I know you can't provide more guidance, but if we're looking at gross margin trajectory, if you look at the margins in 2019, you know, they were kind of at 36% for the year. And obviously it took a big dip. in the first half of this year because of COVID, but you're kind of moving back. So how do we think about, you know, the margins in 2021, getting back to kind of normal, maybe more normalized levels, what we saw in 2019, and then kind of moving beyond that? Is there really going to be a function of the revenue? I know you talked about the closure of that FAB, the sale of that FAB. But should we be expecting to get back to kind of 2019 levels and beyond as we progress into 2021?

Depends on a lot of factors, but the same premises that we have put forth in the past whole two, we do expect the 50% fall through on just a few revenue change and expect that 2021 will be a good year in terms of revenue. We will layer on top of that mixed savings with the premise that the revenue growth in automotive and industrial and cloud power, which all have better than corporate average gross margin, will contribute to tailwinds on gross margin. And as mentioned earlier in response to another question, we do expect to get the savings from the factory sale or closures that we have announced previously. And last but not least, we do still have some lingering COVID costs in our numbers. We expect that most of those will take a while to get those through, mainly logistics and freight costs. As the pressures from that eases out, we should also get a little bit of tailwind in addition to what I just mentioned earlier. Thank you.

Thank you. Aisha, our next question comes from the line of Vijay Rakesh from Mizuho. Please go ahead.

Yeah, hi. Good morning, guys. Just a couple of questions here. On the disty side, I know you talked about September quarter disty inventory coming down two weeks. Typically, 4Q inventories go down in the chat. Just wondering what you're seeing in terms of distributor inventories exiting 4Q versus where normal levels are. Thanks.

I'm not sure I got all of that question audio issues on our side, but We brought the DISTI inventory down in the third quarter to kind of the low end of our normal operating ranges. So we're not looking to take it down substantially from there, but kind of hold it toward that lower end. We think this does give us more flexibility, particularly if the market is more robust than we're seeing right now. So that's the plan. Did that get your question, Vijay?

Yeah, it does. Thanks a lot. And one other question here. On the gross margin side, obviously, there's some near-term costs, logistics, COVID logistics costs and operational costs. Just wondering what the headwind from those are, and do you see those subside as you go into first half next year? Thanks.

They are definitely much less than what we had in the first and second quarter. The lingering costs are more logistics. It will normalize when we see airlines flying again, so that's mostly commercial, so that's a big question mark. So probably it's going to be more protracted, but it's much less than what we have seen in the first half of the year. So it's just some lingering headwind, not significant.

Thanks a lot.

Thank you. I show our next question. It comes from the line of Christopher Rowland from Susquehanna. Please go ahead.

Hey, guys. Thanks for the question. I guess first following up on the automotive side of things and silicon carbide, can you talk about the pipeline there after your win on silicon carbide and then also how we should think about IGBTs and your position there?

So we continue to see wins for both IGBTs and silicon carbide. You know, it's maybe oversimplified, but in the lower lifetime or smaller cars, the IDBT is still the dominant solution. In the more powerful cars designed with much longer range, silicon carbide is becoming the predominant solution. So we have wins at many different levels. Tier 1s and OEMs at this stage for both IDBTs and silicon carbide.

Great. And I was wondering if you could give us an update on your footprint consolidation. I guess any update on Belgium and any other updates in terms of targets or potential opportunities.

In Belgium, we are having what I would call the final round of negotiations right now, and I expect that we, during the quarter, will be able to find solutions there. In Niigata, there's still a process ongoing, and that will probably ease into the new year.

Great. Thanks. Thank you. Our next question comes from the line of Craig Ellis from B. Reilly Securities. Please go ahead.

Yeah, thanks so much for taking the questions. And I'll just ask a couple of follow-ups. First on gross margins, so it's clear that it's hard to handicap the exact timing of a fab sale. But, gentlemen, I'm wondering if you can just help us scope the amount of the $75 million in COGS efficiency gains that you'd expect to get in calendar 21, not by quarter, but just overall, how much of that could be realized in 21, and then how much would come through in calendar 22?

It's a tough question, Craig. Definitely, we can talk about the Rochester one, which is the first $50 million that will start immediately in Q1. The other is still a function of what we end up negotiating with the buying parties terms of MSA that will drive what those savings are. Typically, a closure of a fiat take somewhere in the 18 to 24 months, but obviously we have been already working on it.

Got it. And then if I could just bundle two follow-ups together, Bernard. The first is to Ross's question. Beyond the first quarter, which not only would include discretionary comp, but also things like FICA, what should we expect from 2Q through 4Q? Do you actually get some OPEX decreases in the back half of the year as FICA goes away? And then with the debt pay down in the fourth quarter, the convert, what should we expect for interest expense in the first calendar quarter?

Let me start from the last question first. The Interest expense, we tend to continue paying down debt as we generate a good amount of free cash flow yet next year, so it's just a function of how much that debt is paid down. Definitely the pay down of the $690 million will take a little bit of interest away, so I expect the trend of interest expense to go down over time. Okay. The OPEX trend, we expect this step function improvement or increase in OPEX in the first quarter. And indeed, you're correct. In addition to that, there is within that assumption a timing or seasonality of FICA and other U.S.-based payroll expenses. So I don't expect that the expenses will go up materially for the rest of the year. They trend mostly flat.

Got it. Thanks, guys.

Thank you. Our next question comes from the line of Matt Ramsey from Cowan. Please go ahead.

Hi, this is Josh Buckhalter on behalf of Matt Ramsey. Congrats on the results, and Keith, congratulations on your retirement. I guess I wanted to start on the last call you mentioned you weren't expecting to see any underutilization charges in the second half. Can you confirm that this is still the case, given you're keeping utilization flat and inventories, it sounds like, are going to trend downward?

Yes. Obviously, with the disclaimer that we don't control what governments do. So at this stage, we don't expect there is no mandated shelter in place, mandates from governments. So if that continues, which we expect it to, we will not see any additional COVID-related issues. period expenses. Sure, understood.

Okay, thank you. And then I guess a bigger picture question. When you made the plans to invest in the 300-millimeter fab, it was obviously a very different environment. I'm just wondering if any of your strategic assumptions or plans changed for the new environment of porting volumes through this fab since the deal was announced a year and a half ago. Thanks and congrats again. Thanks.

No, we continue to be excited about that addition to our network. And so from that perspective, we continue to get qualifications of products, processes, and customers through there and continue to enjoy the ramp that we envision. The only change I would get is maybe a little more acceleration on closure of some of the other factories. has been brought about by the overall lower environment that COVID brought.

Thank you. I'm sure our next question comes from the line of Toshia Harry from Goldman Sachs. Please go ahead.

Hi, good morning. Thanks for taking the question. I had two as well. First of all, you guys talked about geopolitical factors. having impact on your business in Q3, and I believe in your Q4 guidance as well. If you could confirm how meaningful the headwinds were associated with geopolitical factors in Q3, and what's embedded in your Q4 guidance, that would be helpful. Thank you.

In Q3, there certainly was an impact, but primarily in Q4, until licenses are granted, the answer is there's no business at all, and They were one of the top customers.

Got it. And then as a quick follow-up, I wanted to double-click on gross margins as well. In the past, you guys have talked to a 40% plus long-term target for gross margins. I guess, A, is that still the case? Is that still very much intact? And, B, to the extent it is, I was hoping you could rank order the drivers that get you there. I think throughout this call you talked about obviously Rochester, which is done. You've got Belgium. You're rationalizing or optimizing your portfolio. You've got the 300-millimeter transition. And obviously you've got the COVID costs, which hopefully go away over time. So if you can rank order some of the drivers there. As you think about gross margin expansion over the next couple of years, that would be helpful. Thank you.

You pretty much summarized that very well for us. Thank you. Definitely, when we did our model, which actually was 43%, it's predicated on a $7.1 billion revenue. We believe that that still holds true. So we do have a good amount of catch-up from the current levels of 5.15 to that level. With the fact that we have... that we have a good fall through on that that still holds through. Footprint consolidation as well as the benefits of the 300 milliliter in the out years will also be a significant factor. And MIX as a third one is the one that will also help us get there.

Thank you. Thank you. Our next question comes from the line of Harsh Kumar from Piper Sandler. Please go ahead.

Yeah. Hey, guys. Congratulations, first of all. Two questions. First of all, would you be able to give us some color on particularly the automotive and the industrial markets? I know you said those should be up, but maybe help us think about how we should think about modeling them. And then another part of that same question, you talked about distribution inventory and auto. How many weeks' excess do you think, if at all, there is in the system, particularly in auto?

Okay, I'll start with auto. I believe that distribution and entire supply chain there, there is no excess going into fourth quarter. I think that's largely been taken care of. In fact, if anything, may have undershot and set us up for next year having to do replenishment. So that market... The supply chain there is lean at this stage, and I don't know any pockets of fatness. As I mentioned earlier, we expect auto production rates in Q4 to be largely back to where they were in 2019. So, again, by quarter over quarter, that is still an improvement from Q3. From an industrial perspective, we're seeing recovery there. We think, again, largely the excess supply is out of the channel, but there's no rebuilding that we can see, so moderate recovery on industrial.

Understood. And then your closure of fabs, you mentioned you cited three, I think, in total. Maybe help us understand where is this production going to? Is it going to fish scale? And, you know, on a scale of 1 to 10, if you say, you know, prior to UP, getting control of Fishkill, if 10 is kind of like where you want to be, where do you think you are at this point in time?

So most of the production in those two particular factories are going into our other internal fabs. And what we're doing is taking selective high-volume runners out of the other internal fabs and moving into East Fishkill. So a little bit of a two-step process to get into EFK. And relative to, you know, if 10 is full ownership and full running, we are at this stage down around two. We're just starting our ramp and manufacturing there in the third quarter and ramping from there.

Thanks, guys.

Thank you. I show our next question comes from the line of Mark Lippis from Jefferies. Please go ahead.

Hi, thanks for taking my question. I had a question about the process of shutting down or selling a factory. When you're transferring parts from your old facilities to your new facilities, can you describe what the qualification process is like? How long does that take? Or is it a matter of practice for you that parts that you have primarily make at one factory also are always qualifying them at other factories just for redundancy's sake, and that's not a big deal to re-qualify parts. That's the first question. I had a follow-up to it.

Okay. So, for the first one, most of our high-volume processes have more than one factory to run in, just from a supply chain risk perspective. For those products, you, in essence, take these specific products that you're running that may not be in the alternate factory and You have to run some reliability tests, and you have to run those by your customers. And for those processes, it's anywhere from 180 days to a year. For other processes that don't have as much volume, you do have to first bring up the process in the new factory. That can take anywhere from nine months to a year. Then you have to run the same qualifications. So that gets you kind of out in the two-year range for that. We had started moving things for the factories that we're talking about here before we announced those transactions. And so we're well into that second phase now of getting the customers qualified. By the selling of the factories... in our customer agreements. There will be some amount of time required where we'll still take product from those factories, but you're now down into that kind of 18-month or so range.

Gotcha. That's very helpful. And longer term, Keith, as you work your way to your gross margin bogey, does you think that translates to a higher internal mix or higher outsource boundary mix on the front end?

So the front end, yeah, the front end part will become more external, but that's less to do with consolidation and more to do with some of our fastest growing products, used nodes that we use boundaries for.

Gotcha. Thank you very much. Very helpful.

Thank you. Our next question comes from the line of Harlan Sir from J.P. Morgan. Please go ahead.

Morning. Thanks for taking my question. Has the East Fishkill FAB been auto-grade qualified? And if not, when do you guys expect to achieve qualification? And then in terms of revenues today from Fishkill, what products and end markets are you shipping into?

So today we're shipping primarily into industrial with some automotive content out of EFK, so we are qualified for more.

Great. And then, Keith, with 13 to 15-week lead times on average, you know, you guys are booking into the March quarter. You also have a good view on customer forecasts as well. I believe normal seasonality for the team is flat to down a couple of percentage points in March. You talked about above-seasonal demand trends near-term. I'm wondering if you're seeing this in the orders for the March quarter.

Yes, orders are good, and the comments we've made on above-market seasonality will extend past this year.

Thank you.

Thank you. Our next question comes from the line of John Pitzer from Credit Suisse. Please go ahead.

Yeah, thanks for letting me ask the question. Keith, maybe just to follow on there to Harlan's second question, when you think about the calendar first quarter, is there enough leverage above seasonal revenue growth and gross margin leverage that you can have op margins be flattish despite the increase in op-ex? And if that's not the case, why isn't variable comp more tied to profitability? Why not wait until later on in 21 to reestablish some of the variable comp?

So we really don't want to give guidance for Q1. We do it one quarter at a time. What I will tell you is certainly we would expect revenues to continue to increase nicely throughout next year. And the way accounting works, you have to accrue for the entire year at the expected rate for the year, even though you may have a quarter somewhere in there that doesn't fully meet the objectives.

That's helpful. And then back to the auto side. When you look calendar year 17 to 18, SARS was down a little bit in 18, but you guys significantly outgrew the market almost by kind of 10 percentage points. I'm just kind of curious, given how weak the auto sector has been for you and the overall semi-market since really the end of calendar year 18, 19 was down, 20 is going to end up being down. How are you viewing your outgrowth to SARS as we go into calendar year 21? And do you have kind of a view you can give us on what you think SARS growth will be next year?

So the answer is, yeah, we have a white margin, as I mentioned in my comments, very significant, with the drivers being more level 2 cars on ADAS and a higher percentage of EVs. From a SARS perspective, we tend to try and be conservative on that and look for kind of 2019 levels next year on a SARS basis. But again, we think we have been outperforming the overall SARS. In 2020, we think the supply chain did lean out, which took some of that margin away. But in 2021, as I mentioned earlier, we think there may have to be some restocking to hit the full levels as appropriate.

So, Keith, if in 18 you outgrew SARS by 10 percentage points, do you think 21 is setting up to be an 18-esque year for you?

I think the opportunity for double-digit outperformance is there. Thank you very much.

Thank you. I show our next question. It comes from the line of Kevin Cassidy from Rosenblatt Securities. Please go ahead.

Thanks for taking my question. Just going back to factory utilization, is there any more efficiency coming in? Can you get higher gross margin at the same utilization, say, compared to a couple years ago?

There is some help that comes from mix, as we have talked about. But definitely we depend a lot on revenue increases.

I would just add that as we're looking forward, the other traditional lever is pricing. And, of course, 19 was not necessarily a good year, but as we're seeing, or 20, excuse me, was not a good year, but 21 is shaping up to be a little better pricing environment.

Okay, great. And just One follow-up, kind of on that qualification process, you can have your internal qualifications. Has there been any change in the qualification process relative to the customers? Do they just agree with your data from your manufacturing, or do they want to test the parts too?

Most of them agree with our reliability data. but they do need to verify the products are still functioning exactly the same way in their applications. So that takes them, you know, that's part of the six-month kind of check that they've got to do on their side.

Okay, great. Thank you.

Thank you. I show our next question comes from the line of David O'Connor from Exane BMP Priority Virus. Please go ahead.

Great, good morning, Anna. Thanks for taking my question. Maybe to go back on the 10-point outperformance, Keith, that you mentioned, you talked about ADAS and EP being the main contributors. As we exit 2020, can you give us a sense of how big these are now for the business? And I have a follow-up.

So sensors, the ADAS sensors, about 20% of our total are automotive. The Electric piece is always smaller, and we haven't disclosed how much it is, but we know it's going to ramp up at a very strong and fast pace in 21 and beyond.

That's helpful. And then maybe as my follow-up, on the 300-millimeter East Fiscal FAB, you talked about the spectacular yields there. Which are those high-volume products where you're seeing these yields, and is there an opportunity to pull in the ramp up there, given you seem to be ahead of schedule? Thanks.

Yes, so our first products to ramp there are medium voltage MOSFETs and then followed by our IGBTs. And we are ramping that pretty much at the pace our customers are qualifying at this stage.

Thank you.

Thank you. I see our next question comes from the line of Tristan Gare from Baird. Please go ahead.

Hi, good afternoon. Given the lead times that are still somewhat elevated in parts of your business, at least industry-wide, and given your utilization rates below normal level, are there opportunities for you to gain actually market share because your utilization rates being below will actually be an opportunity to other ship in areas where some of your competitors may be tight or am I not looking at this the correct way?

No, I think we do have some upside opportunities with extra capacity in the factories where actually the inventory positions we're taking are really ensuring that that excess capacity can go directly to the customers that may have opportunity to grow a little faster And I mentioned earlier the ADAS and EE side of it, particularly those we think may be due for some additional inventory in the channel.

Okay, great. And then just a quick follow-up. I know you haven't quantified the dilution from Quantena. Is it fair to assume that it's now worse than the initial dilution that the business was incurring right after the close? And are you giving any consideration to taking additional action on that business besides just waiting for the new product ramp?

So there's not been a appreciable decline in that business, if that's where you're headed. So I'm not sure where that came from. So we're not seeing additional declines, and we are seeing the backlog and design pipeline picking up.

Great. Thank you.

Thank you. Ayesha, our next question comes from the line of Vivek Arya from Bank of America. Please go ahead.

Thank you for taking my question. Keith, I had a conceptual question on gross margins. You know, when I look at gross margins in the power discrete industry, they tend to be at best around high 30%, even for the largest companies. in the space, you know, such as Infineon, who have been running 300-millimeter fabs for quite some time. And when I look at OWN's history, gross margins have never really exceeded 38%, 39%. And even then, quarterly revenues were much higher than current levels. So how much of the gross margin dynamics are just the result of selling certain kinds of products, which says that, you know, there is a limit to how much you can expand gross margin, regardless of revenue levels or fab closures or 300-millimeter fabs. So I just wanted to run this hypothesis by you.

So simple answer there is when we gave our expectations for being able to reach 43%, it fully comprehended the product mix and market mixes that we see here. And while there's some number of bips which we disclosed on mix per se, but from a product perspective, we still think you can get over 40%. It does take a leaning out of our manufacturing, which we are in the process of, and getting the utilization rates up. But we don't think inherently that power business is stuck in the 30s. We definitely think we can get that in the 40s. The other piece of that equation is a lot of the new EV stuff is in modules. And there we think the opportunity for the modules is for better margin than the discrete devices.

Very helpful. And Keith, as my follow-up, in terms of the competitive landscape, just given U.S. and China trade tensions, do you see any headwinds to gaining share in China, i.e. that share perhaps going more to your European or Japanese competitors? Other than Huawei, have you seen any effect of trade tensions so far, or do you anticipate any effects going into next year? Thank you.

I think there will be more reluctance for customers to accept sole source positions from U.S.-based companies as a result of the trade tensions. I still think they're very wise economic buyers, and they're going to do the best thing for their company, but they certainly don't want to be completely reliant on the U.S. supplier. But do you see shares shifting to European competitors? Yes. We certainly saw it at the account you mentioned. Elsewhere, we have not seen it. Okay.

Thank you. Thank you. Our next question comes from the line of Sean Harrison from Loop Capital. Please go ahead.

Hi. Good morning. Thank you for taking my question. Keith, for you, are you seeing anything either on the raw material supply or kind of I guess the, uh, the foundry supply as well, given kind of, you see the speak to distributors, you're reading the press about some pre-buying of either your materials or capacity next year, just given the trade tensions.

Um, so we've seen some, um, tightness and some things like substrates, um, uh, in the communications market. Uh, I think that's a fairly widespread. Um, I think the, um, The expansion there is slower than the market itself has been growing. And there's certainly some tightness in spot areas in the foundry market. But overall, the supply chain is in pretty good shape.

Very helpful. And Bernard, as a follow-up, just if you could speak to how you're thinking about the return of the share buyback in 21. What's either maybe a leverage ratio you're looking at or some type of metric before a share buyback could return?

Sure, Sean. Historically, what we have done is we have focused on paying down debt until we reach about a two times net leverage. Obviously, I need to get concurrence from our board to continue with the same strategy, but that would be the general approach towards a share buyback.

Thank you.

Thank you. Our next question comes from the line of Nick Todorov from Longbow Research. Please go ahead.

Yeah, thanks. Good morning, everyone. Once you guys complete the three front-end FAB optimizations, can you maybe talk about approximately a revenue level you will be at full utilization of your non-300-millimeter footprint?

That's a difficult question. I'm not sure I have the answer for that because a lot of it will depend on the mix. Definitely, it will move us upwards towards our sweet spot of 80% to 85%, which is where we like to operate at.

Got it. Thanks.

Thank you. Our next question comes from the line of Craig Hetzenbach from Morgan Stanley. Please go ahead.

Yes, I had a question on silicon carbide. Naturally, a lot of the discussion is around EVs, but Keith, from an industrial perspective, can you talk about any interesting applications or opportunities you see in the industrial market?

Yeah, we're seeing big pickup in solar energy. The pickups that you get there from an efficiency perspective are pretty significant. We have an opportunity for about $650 worth of silicon carbide there. And then in EV charging, so not the traction inverters, but actual charging stations, we're also seeing opportunities for up to $500 there.

Got it. And then just a follow-up on just the geopolitical issues with the customer. Is that something that you expect? Ultimately, revenue will go to another OEM, and that could be opportunity at some point next year?

The way the rules are written, it's unclear if anyone can ship without a license. And so that's at least our interpretation. And so I think right now... The license process is most critical to answering who might be providing that supply.

And we should benefit if the share is shifted to other customers of ours. There is the opportunity for us to also take advantage of that and widen, get that wider in our approach.

Got it. Thanks.

Thank you. I show a next question comes from the line of Craig Ellis from B Reilly securities. Please go ahead.

Yeah. Thanks for taking the followup questions. Keith, I wanted to start just going back to some of your end market commentary. You mentioned that in cloud power there should be some server share gain and content gain. So I wanted to see if we could get some specifics around that for calendar 21 and then also in cloud power. What is your interaction with base station customers signaling for base station production next year, and what does that mean for growth in that part of cloud power?

Okay, so one is kind of share gain and generation change cloud power content, and the second one is what kind of ramps we're seeing in base stations, if I got that correct.

Right, yep.

So kind of going from the back one, the base station, basically China is driving most of that growth, and we do see some significant growth there in China. U.S., maybe late in 21, moving into 22 would become much more substantial. cloud server perspective, we get about $60 out of the current generation in power content, and it goes to $75 with the VR14s, which are coming out next year.

That's great. And then the follow-up is on IMM. So it seems like right now medical, military, and energy efficiency are good areas of strength, but We know that in industrial there are areas of weakness, too, energy extraction, et cetera, et cetera. No different than 2009 when industrial broadly was probably the last in market to come off the bottom. The question is this. When do you think that segment broadly will be back to good growth? Is that something that could happen in the first half of 21, or is that really something that would happen later next year? Thank you.

Yeah, okay, so the broad-based piece of it should improve. We've always seen that kind of following the GDP in general. What we do see different in industrial this time, Craig, is that the automation has actually been, I believe, accelerated by COVID-19 and the experiences companies had there. They're looking for much more automation, both in assembly and in their warehouses, to kind of make its dependence on people less. And so that would be kind of like in automotive. We see electric vehicles and ADAS being a supercharger. I think in this case, automation is the supercharger for industrial.

That's helpful, and congrats on the retirement, Keith.

Thank you. Thank you. I share no further questions in the queue. At this time, I'd like to turn the call back over to Mr. Parag Agarwal, Vice President of Investor Relations and Corporate Development, for closing. Please go ahead, sir.

Thank you, everyone, for joining the call today. We look forward to seeing you at various virtual conferences during the fourth quarter. Goodbye. Ladies and gentlemen, this concludes today's conference call.

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