ON Semiconductor Corporation

Good day and thank you for standing by. Welcome to the ON Semiconductor Second Quarter 2021 Earnings Conference Call. At this time, all participants are in listen-only mode. After the speaker's 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 further assistance, please press star 0. I would now like to hand the conference over to your speaker today, Mr. Parag Garhwal, Vice President of Investor Relations and Corporate Development. Please go ahead.

Thank you, Rain. Good morning, and thank you for joining our Semiconductor Corporation Second Quarter 2021 Quarterly Business Conference Call. I'm joined today by Hassan El Khoury, our President and CEO, and Thad Trang, our CFO. This call is being webcast on the Investor Relations section of our website at www.onsunday.com. A replay of this webcast, along with our 2021 second quarter earnings list, will be available on our website approximately one hour following this conference call, and the recorded webcast will be available for approximately 30 days following this conference call. Additional information related to the latest hour and markets business segments, geographies, channels, share count, and 2021 and 2022 fiscal calendar is posted on the investor relations section of our website. Our earnings release and this presentation includes certain non-GAAP financial measures. Reconciliation of these non-GAAP financial measures to the most directly comparable measures in the GAAP are included in our earnings release, which is posted separately on our website in the investor relations section. During the course of this conference call, we will make projections on other forward-looking statements regarding the future events or future financial performance of the company. The words believe, estimate, project, anticipate, intend, may, expect, will, plan should have similar expressions intended to identify forward-looking statements. We wish to caution that such statements are subject to written uncertainty that could cause actual events to our results to differ materially from projections. Important factors that can affect our business, including factors that could create actual results to differ from our forward-looking statements, are described in our most recent Form 10-K, Form 10-Q, and our filings with the Securities and Exchange Commission. Additional factors are described in our earnings release for the second quarter of 2021. Our estimates for 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. Our analytics date is scheduled for Thursday, August 5, in New York City. We look forward to seeing you in person later this week. Now, let me turn it over to Hassan. Hassan.

Thank you, Farag, and thank you, everyone, for joining us today. We delivered record results in Q2, driven by strong execution and broad-based strength and demand. We posted record revenue of $1.67 billion, an increase of 38% year-over-year and 13% quarter-over-quarter. The non-GAAP diluted earnings per share of 63 cents grew significantly year-over-year and quarter-over-quarter as a result of the work we have been doing to restructure the company and streamline our business. Our sharp focus on gross margin is beginning to show strong results with our Q2 non-GAAP gross margin increasing by 320 basis points quarter over quarter and by 760 basis points year over year. These sustainable improvements in our gross margin will continue as we rationalize our current portfolio and reallocate R&D investments to high growth and margin-accretive new product developments. To capture the full value of our products, we continue to evaluate our portfolio to eliminate any price-to-value discrepancies and focus our manufacturing on our strategic products. In addition, we continue to drive efficiency throughout our upstream and downstream supply chains and optimize our operations to reduce costs. The demand environment continues to be robust across all end markets. For the second quarter, we post a record revenue for the automotive and industrial end markets. In addition to the company's broad-based strengths in these markets, we are benefiting from the strong traction of our power and sensing products. The strong demand that we have seen over the last few quarters continue to outpace our ability to supply certain products, especially those manufactured by our foundry partners. Based on current booking trends and macroeconomic outlook, we expect that the demand will continue to outpace supply through the first half of next year. We are working collaboratively with our customers to ensure the uninterrupted supply of our products in the future, having entered into long-term supply agreements with many of them already and actively engaging in discussions with several others. Long-term supply agreements, or LTSAs, are a win-win for both customers and us by guaranteeing supply to the customer and at the same time providing better visibility and allowing us to better plan our capital allocation towards capacity expansion with a committed long-term demand outlook. Let me now discuss a few highlights of our strategic end markets starting with automotive. We set a new record for our automotive revenue in Q2 with revenue of $556 million. The success in automotive was driven by strength in our power and sensing product categories. We have emerged as a strategic supplier of highly differentiated technologies for electric vehicles with customers placing high value on the efficiency and footprint advantages provided by our power solution. Our engagement with leading global OEMs and Tier 1s continues to expand, and I am very bullish on our potential in the growing vehicle electrification market over the next few years. In addition to the industry-leading performance of our FETs, a key source of our differentiation is our expertise in packaging. which is critical for improving heat dissipation, increasing power output and a smaller footprint than our closest competitor, and reducing the weight and cost of a power module. The efficiency of our module allows our customers to make no tradeoffs between the cost of battery and the range of the vehicle. They get both. We continue to strengthen our leadership in automotive safety with new design wins and see the increased penetration of active safety features driving strong demand for our image sensors and ultrasonic sensors. In Q2, we secured significant wins for our image sensors on key platforms in Asia, and in a few cases, we displaced incumbents. With increasing sensor content, especially in new electric vehicle platforms, we remain bullish on our ADAS business. We recently announced that AutoX has selected our intelligent sensing technologies to enable 360 vision in its Generation 5 fully driverless robotaxi. On this platform, our 28 image sensors and four 3D LiDAR sensors eliminate blind spots and power full autonomy. The industrial end market, which includes military, aerospace, and medical, contributed revenue of $434 million in Q2, representing approximately 26% of our revenue. Excluding the impact from geopolitical factors related to a specific customer, Our second quarter industrial revenue increased by 29% year over year, driven by broad-based demand and strong performance by our power and sensing technology portfolio. We are seeing continuing momentum for our higher power modules and alternative energy applications. Given the investments in utility-scale solar installations, they're expected to grow worldwide to reduce the climate impact of fossil fuel-based power plants. With a broad range of power solutions and early engagement with key market disruptors, we are well positioned to grow in the market. On the industrial automation front, we saw steep year-over-year growth in our imaging revenue driven by machine vision and scanning applications. Now, I will turn the call over to Thad to provide additional details on our financial performance and guidance.

Thad? Thanks, Hassan. I'm pleased to announce a record quarter as we are seeing the early impact of our transformation initiatives and our financial results. Customer demand remains strong, and the design wind pipeline for our innovative power and sensing technologies continue to expand. We have been successful in securing additional supply from our internal manufacturing sites as we optimize our efficiency, which contributed to revenue at the high end of our guidance. Based on our current outlet, we expect strength and demand to continue through the first half of 2022. The company has been executing on long-term and sustainable actions that have resulted in record revenue, earnings, and free cash flow for the second quarter. In a few days, our analyst day, we'll share our long-term strategy and operational plans to realize the full potential of the company. So turning to the results for the quarter, we saw broad-based strength contributing to sequential revenue growth across all end markets, regions, and business units. Secular megatrends in automotive and industrial contributed to record revenue in both of these end markets and together comprised 59% of revenue. Total revenue for the second quarter was $1.67 billion, an increase of 38% over the second quarter of 2020 and 13% quarter over quarter versus normal seasonality of a sequential increase of 3% to 5%. Our automotive revenue grew 69%. year-over-year and 8% sequentially. Industrial revenue grew 24% year-over-year and 18% sequentially. Turning to the business units, revenue for the Power Solutions Group, or PSG, was $846.6 million. PSG revenue increased by 37% year-over-year due to strength in automotive and industrial end markets. Revenue for the Advanced Solutions Group, or ASG, was $607.6 million, an increase of 42% year-over-year. In addition to the strength in automotive, ASG benefited from strength in computing, especially in high-end graphics cards. Revenue for the Intelligence Sensing Group, or ISG, in the second quarter was $215.7 million, an increase of 28% year-over-year. Strength in ISG was driven primarily by automotive. Gap gross margin for the second quarter was 38.3%, and non-gap gross margin was 38.4%, a 760 basis point improvement year-over-year, a 320 basis point improvement sequentially. Our strong gross margin performance over the last few quarters has been driven by strong execution, a favorable mix to higher margin products, improved efficiencies in our manufacturing sites, and cost containment initiatives across the company. Our factory utilization was 83%, which was relatively consistent with Q1 at 84%. As we move forward, our fab lighter strategy will allow us to continue to reduce our manufacturing footprint and overall cost structure while increasing capacity to support the demand of our customers. Gap earnings per share for the second quarter was $0.42 per dilute share, non-gap earnings per share was $0.63 per diluted share as compared to $0.12 per share in the second quarter of 2020 and $0.35 in Q1. As noted earlier, this is the highest ever quarterly non-GAAP BPS reported by the company. Now let me give you some additional numbers for your models. GAAP operating expenses for the second quarter of 2021 was $357.9 million. Non-GAAP operating expenses were $314.2 million, a decline of $10.5 million quarter over quarter, as we continue to see the favorable impact of our cost reduction initiatives launched in Q1. Our GAAP operating margin in the second quarter was 16.9% as compared to 3.6% in the second quarter of 2020. Our non-GAAP operating margin was at the highest level since 2010, coming in at 19.6%, as compared to 7.4% in the second quarter of 2020 and 13.3% in Q1. Our GAAP diluted share count was 443.6 million shares, and our non-GAAP diluted share count was 435 million shares. Please note, we have included an updated reference table on the investor relations section of our website to assist you with calculating our diluted share count at various share sizes. Turning to the balance sheet, cash and cash equivalents was $1.09 billion, and we had $1.97 billion undrawn on our revolver. Cash from operations is $488 million, and free cash flow is $383 million, or 23% of revenue. Capital expenditures during the quarter of 2021 was $104.8 million, which equates to a capital intensity of 6.3%. As we indicated previously, we are directing a significant portion of our capital expenditures towards enabling our 300-millimeter capabilities at our East Fishkill staff. Accounts receivable, $669 million, resulting in DSO of 37 days. Inventory increased $13.8 million sequentially to $1.31 billion, and days of inventory decreased 8 days to 116 days. Distribution weeks of inventory decreased again by $42.6 million to 7.3 weeks from 8.4 weeks in Q1, which is below our target range of 11 to 13 weeks. Once again, we are proactively reducing the distribution inventory to hold more inventory on our balance sheet to support our customer needs rather than building inventory in the supply chain. Total debt was $3.3 billion, and we paid down $120 million in the quarter. So turning to guidance for the third quarter, a table detailing our gap and non-gap guidance is provided in the press release related to our second quarter results. let me now provide you the key elements of our non-GAAP guidance for the third quarter. As mentioned, we believe demand will reign strong for the remainder of the year. Although we continue to increase our supply through operational efficiencies, we'll be limited by supply constraints and are working with our strategic customers to provide long-term support. Based on current bookings trends, backlog levels, we anticipate the revenue for the third quarter will will be in the range of $1.66 billion to $1.76 billion. We expect gross margin between 39% to 41%, and this includes share-based compensation of $3.7 million. We expect non-GAAP operating expenses of $305 to $320 million, and this includes share-based compensation of $19.2 million. We anticipate our non-GAAP OIE, including interest expense, will be $26 to $29 million. So this results in non-GAAP earnings per share in the range of $0.68 to $0.80. We expect capital expenditures of $100 to $110 million in the third quarter of 2021. Our non-GAAP diluted share count is expected to be in the range of 436 million shares. So in summary, I'm extremely pleased with our early progress and the execution of our transformation initiative. I add my thanks to our worldwide teams for their hard work and unwavering commitment to our customers, and I look forward to seeing you all at our Analyst Day in New York in a few days. With that, I'll turn the call back over to the operator to open the line for Q&A.

Thank you. As a reminder, to ask a question, please press star 1 on your telephone keypad. To answer your question, press the pound key. Please stand by while we compile the cleaner roster. Your first question comes from Ross Seymour from Deutsche Bank. Your line is open.

Hi, guys. Thanks for letting me ask the question. Congrats on the results. Hassan, I want to talk a little bit about the demand and the shortage commentary you had. I believe last quarter you thought that the demand would kind of stabilize, the velocity of the increase might slow, but shortages would abate in the second half of the year. It seems like you've pushed that out into the first half of next year. So I guess what's changed with any color on the demand side, and how can you be confident that there's no double ordering within that?

Sure, that's a good question. Look, the demand environment, as we've always stated, is very dynamic. We see it basically... pushing out into the first half of next year. That's based on our backlog, based on customer interactions, and really based on the LTSAs that we have been engaging with on customers, either signed or in active engagement. Now as far as the double ordering, we're managing our supply chain to make sure that doesn't happen as far as having it in the channel. So we have been reducing and managing inventory very closely. that keeps the inventory on our balance sheet but allows us to service strategic customers as we see the demand from the end customer without really accounting for any, call it buffer stocking, that you may or may not see in the distribution channel or anywhere in between us and the OEM. So that's how we're managing, call it tactical, but that's what we need to do right now to make sure that we're not going to suffer from the double ordering. So that gives me the confidence, given the numbers of the inventory that have been reducing and building up on our balance sheet, that we are literally tackling end demand on a one-to-one basis with our direct customers.

Thanks for that, Kalar Hassan. I guess as my follow-up for either you, Arthad, on the gross margin side of things, that's probably the most impressive line, given where On's been historically and the challenges it's faced. Can you just talk a little bit about what drove the upside, even to your guidance? In the second quarter, similarly for the third quarter, and a higher-level question, how much of that do you believe is structural versus just you guys benefiting from some pretty strong cyclical tailwinds that, as we've learned in the past, can come and go at different times?

Yeah, I mean, if you look at the components of the gross margin strength, obviously we've always said in the first and second quarter now we have, you know, call it thousands of line items that we are structurally working on improving our operation and streamlining our business. That's going to drive gross margin expansion. Those have been firing on all cylinders, and we are seeing the benefit incrementally, and you're going to see that in our guide for Q3. So those I would call structural. If you look at utilization, utilization has been flat from last quarter, but you see a big gross margin jump. That also is what I would call structural. It's not really tied to utilization, per se, because utilization is flat. So the jump from Q1 to Q2 is on all the other work that we have been doing. So we continue to streamline our operation, take cost out of our products. And portfolio mix and portfolio rationalization A couple of quarters ago, I was asked if that would be delayed because of the demand environment. My commentary has been it's actually going to be accelerated because it's going to force us to shift faster to our strategic products that will drive higher margin. So you're seeing some of that portfolio mix happening earlier than we anticipated. So all of these components will tell you that It is structural, it is sustainable, and forward-looking, I'm very bullish on the capability of our gross margin expansion. Thank you.

Yeah, I would just, I think you know what they're on. I think if you look at the upside compared to our guidance, we were able to get more supply out of our manufacturing sites, and then obviously we're getting favorable mix out of that as well, which is helping with the gross margin. But I absolutely agree, it's structural changes that we're making inside the companies.

Thanks, guys.

Your next question comes from Charles from CD Group. Your line's open.

I think you got the wrong name, but I'll speak up for my unborn son named Charles. It's Chris. Hey, guys. Can you just be a little more specific on the gross margin drivers? Was there any pricing involved? Are you cutting specific product lines? It's just a big jump given that utilization rates didn't do anything. Any specifics there would be great.

Yeah, I mean, it's spread across the board. Of course, there is some, you know, what I refer to the price-to-value discrepancy. So we have been looking at our pricing from a strategic perspective, what products and what pricing they need to be in the market to extract the value that we provide for our customers. Cost is a big factor, not just product cost, but supply chain costs, you know, upstream and downstream supply chain costs. You know, some of the increases that we've seen, we've passed those on to customers, as I've described in prior calls. So it's really, Chris, it's across the board. There's not a big step function that I would anchor on because when we look at incrementally, it came from all of these swim lanes that we have been launching. and working on since really since the December timeframe. When I came in, I said we're structuring gross margin. I have a specific owner in the company that drives gross margin improvements for the company, and we have about, I'll call it 1,000 swim lanes that we are delivering to, and those are starting to come out now because it takes time to get those through the supply chain, and now is the quarter where we see it. And they're going to continue in the forward-looking quarters as well, given the Q3 guidance range.

Great. And then for my follow-up, you mentioned you expect the shortages to extend into next year. Can you just talk about where your lead times are these days or what they did sequentially? Did they extend during the quarter? Were they flat, up or down?

Yeah, Chris, the last quarter, our lead times were in the low 30-week range. We're now up to about 42 weeks, so they've gone out by about 10 weeks sequentially. Obviously, we're working on that, but, you know, that's another reason that it's giving us, on the one hand, giving us more visibility, but why we see the supply constraints, you know, being limited as we look forward. Great. Thanks, guys.

Your next question comes from Vivek Arya from Bank of America. Your line is open.

Thanks for taking my question and congratulations on the gross margin and especially the free cash flow improvement. My first question, Hassan, is that investors are trying to grapple with the situation where, as you mentioned, demand is strong. but will the supply environment stay disciplined? So the specific question is, how undersupplied is the industry right now? And you mentioned the situation could persist until the first half. Is that based on demand levels staying at current levels or what they could be next year? Just basically, what are your views about the supply response from ON and your peer group to give investors the comfort that the supply response from the industry is not going to change this very strong discipline and the pricing dynamic that your industry is benefiting from right now?

Yeah, that's a good question. I can really speak for Han and what we're doing here. Of course, the fear is the reaction you go and build capacity for across the board. But if you look at what we are doing specifically and why I'm comfortable with the forward-looking view of our margin and our posture, really, with the gross margin expansion, is we are selectively adding capacity where we see the growth in our strategic products forward looking. So we're not adding capacity for the sake of adding capacity. We are first shifting from a lot of what we call the legacy portfolio into the strategic growth and adding capacity there. So as we are increasing our top line given the supply relief that we're getting through our supply chain, those are coming from strategic growth products. So when I look at our strategic plans moving forward, and we'll give a little bit more color at Analyst Day, that's where we're expanding the capacity. It is not equal for all. So there are demand signals in our visibility and our customers that we are not servicing beyond what we can today. So I'm not adding capacity there. We're selective. We're very disciplined on where we add capacity, and we're adding it in our growth product that are strategic and those will be driving the gross margin forward-looking. So very selective, not a shotgun approach.

Got it. And for my follow-up, actually a clarification and a question. On the clarification side, any impact from shutdowns or COVID-related issues in Southeast Asia from a supply side? And then, Ahsan, you sound really, you know, very confident about ON's prospects in the electrification side. So could you help us understand what is your current exposure to EVs and what kind of content growth do you see both on the powertrain and on the ADAS side as the industry moves more towards EVs? Thank you.

You know, let me answer the EV first. You know, our exposure, obviously, this is starting to grow. I'm very bullish. You know, I'm not going to, I can't even hide it. So I'm glad you really picked it up. So I'm very bullish with our posture, both on the automotive safety and electrification. Electrification penetration is starting to pick up. We're well positioned with strategic OEMs directly, but also through their Q1 supply chain. So that is really forward-looking, how I look at the market, and really where our R&D investments are happening. If you recall, we did a big restructure at the beginning of the year. That's moving R&D and capacity and capital into those markets because I see the design wins. I have personally engaged with customers. We have LTSH as it relates to vehicle electrification. All of these make me very bullish, but more importantly, very excited on the potential of ON in these markets. For your question about the COVID disruption, yeah, we have seen disruption related to COVID in some of our supply chain, direct or indirect. But back to the demand environment, I think our operations and our manufacturing teams worldwide, we were able to really redirect and service more demand by shifting the mix again. There was disruption. We overcome that disruption, and now we're back on track. So let's call it a blip that we were able to sustain given the demand and given the work that we're doing on releasing more capacity. Thank you.

Your next question comes from Toshia Harry from Goldman Sachs. Your line is open.

Good morning. Thanks so much for taking the questions, and congrats on the strong results. Hasan, I had a two-part question on gross margin. You talked about addressing price-to-value discrepancies. Just curious, what percentage of the discrepancies have you been able to execute on in the form of price increases, and how much left is there to go? I'm guessing your tenure is on. I'm guessing it's still very early. innings, but curious how much is left. And then as my second part, in terms of the 300 millimeter transition, again, I believe it's very early in the process, but how do you see that evolving over the next couple of years and the impact on gross margins? Thank you.

Sure. So the first question as it relates to price value, obviously this is an ongoing effort. I would put it under the portfolio rationalization overall. So I don't break it out because of price or because of the shift, because all of those are material. If you start moving the shift to high-value products without touching the price, that's going to impact the value you provide to customers. So I would say, you know, like you mentioned, we're not done yet. That's a continuous improvement. Everywhere we look, there's opportunity. And more importantly, it's the momentum that the company is getting. You know, if you think about it, the first couple of quarters have been pushing a lot of that from the top. Right now, it's part of our culture. It's part of how the teams are thinking about pricing strategies from new products and moving forward. So it's not a... you know, a blip in time where, oh, because of that environment, we're able to extract the value. It is structurally how we're moving forward. So new products are not going to be having those issues of, you know, price-to-value discrepancies because we are pricing the new products and delivering the new products exactly at the value they provide customers. So that's really how I look at it. Does that help?

It does. And then the 300-millimeter transition. And sorry, as my follow-up, just on the OpEx side of things, I think you came in below the low end of your range for Q2, roughly 19% of sales. And then for Q3, your guidance implies an OpEx to sales ratio of around 18%. That compares with the prior management team's long-term target of 21%. So just curious, is 18% sort of the new normal? Is it going to be a little bit higher, a little bit lower? Any thoughts on OpEx going forward would be helpful as well. Thanks.

Sure. So on the 300-millimeter, obviously, it's a strategic asset. We have been working with Global Foundry on our transition. We have not taken ownership of that FAB yet. However, we're working very closely on starting to move volume into that FAB. So when we take ownership, we hit the ground running. And that, of course, is going to be supportive of our gross margin efforts from a product cost perspective. Where we are there, we're on track. I review this regularly as far as how many products have we qualified in the 300-millimeter fab. But more importantly, the customers that have qualified that fab for us to be able to ramp with them over 22 and into 23. So that's all on track. I'm happy with the progress. So that asset is going to be favorable for us in the long run, both from a capacity but also from a cost structure. And I'll let Thad comment on the OPEX.

Yes, on the OPEX side of things, to remind you, in Q1 we did a restructuring activity, and we said we'd realize the benefit of that cost savings over the course of the year. We accelerated that and were able to recognize some of that earlier, and that's the impact that you're seeing here in Q2 that's more favorable to our guidance. We still believe we're going to exit the year somewhere just north of $300 million on a quarterly run rate, and that becomes the new baseline. Obviously, you've got the reset of FICA and things like that going into next year, but that becomes kind of a run rate that we think we maintain. And then, obviously, as we grow, we'll add OpEx back at a much slower pace than our revenue growth.

Thank you.

Your next question comes from Harsh Kumar from Piper Center. Your line is open.

Yeah, hey, guys. First of all, strong congratulations. These are stunning results. Hassan, I'm going to push you a little bit. In the last five years of results, I think the peak happened at $1.5 billion, at 38.5% gross margin. I think it was like 2018 or something like that. You're now talking almost 1.7 billion, 40%. So my question is, you've got a higher run rate, higher margins. How much is it a function of the actions that you've done and the actions that you've implemented, in your opinion? I've got to follow up.

Sure. Of course, you know, there's only one answer to that. It's all based on the stuff that we've been working on. But let me talk about the timing of it. Of course, the demand environment has helped accelerate a lot of these, as I talked about before. You know, we've always had part of our structural or restructuring plan to start shifting portfolio and shifting that mix to high value, high margin, high strategic products in our target markets of, you know, auto and industrial. That is part of the actions that we have been taking and we started taking since I joined. They got accelerated with the demand environment because of the capacity constraints. What we've done is we've released capacity from what I would call the legacy commodity products that we've always wanted to move away from, part of my strategy, faster into putting that capacity on high-value, high-growth, and strategic products that will grow with us over the next five to ten years. So the actions are all there. The timing was accelerated and held by the current environment.

I got you. Does that answer your question, Mark? Yeah, it does. Thank you very much and very helpful. On following up on Toshio's question, want to talk fabs and cost cuts. So can you remind us the timing of when you will actually have products running through Fishkill? Because that could be a great benefit, also a great cost if things don't go well and you're running the fab sort of empty. So when will you be at a point when it's sort of utilized well from a timing angle? And then with that big 12-inch fab coming your way, how many fabs do you think you'll eventually need?

Yeah, so let me talk about East Fishkill first. We are running revenue and running volume today at East Fishkill. Remember, it's a shared FAB today with us and Global Foundry. We have capacity or allocation part of that capacity out of the FAB, and Global Foundry has their capacity part of our original agreement. We are already shipping qualified products to end customers that are generating revenue out of that FAB. That revenue will keep increasing through 22, as I mentioned, and we're on track based on customer quals and our own product quals. So that progression is there, and obviously we will be talking about utilization once we take ownership of that FAB in 23 and through 24. But right now it's more of an allocation because the FAB is still not owned by Onn. But I measure, in this case, are we shipping what we need to be shipping to our customers based on the quality? Because that's really the latency that you usually get, and we're on track with that. As far as how many fabs we need to run our operations, obviously, that's not something I can comment on today. My focus is really on rationalizing our manufacturing footprint. to going to a fab lighter. So we will have less fabs, but I will be ready to comment more on it as we're ready, and we have communicated plans to that specifically.

Hey, guys, very helpful. Congrats again.

Your next question comes from Mark from . Your line's open.

Hi. Thanks for taking my questions. First question, sorry to come back to the gross margins, but it sounds like there's something really different going on with ON than the last 10 or 15 years. So, Thad, in your script, I think when you talked about the gross margin upside, you said mix efficiency, execution, and cost containment. I don't think I heard pricing in there. And then, Hassan, you used the expression price-to-value discrepancy, which I thought was a code word we took prices up. But it sounds like you're shifting the mix on your limited capacity to the higher value product. So the question is, on the last, so I guess there's a clarification. I just want to make sure I got that right. And for me, the question is, over the last 10, 15 years, I covered on You know, when things are bad, you hear about, you know, 6% to 10% price, you know, pressure. And then when things are good, you hear about 5% to 10% price improvements. Is that part of your business gone? Is this on now a much lower volatility business and much less subject to pricing pressure? And then I had a follow-up.

So the short answer is yes. strategically, I think one of them, it was the first conference that I attended back in January, the CES conference, where I really put my focus on gross margin improvement through manufacturing footprint rationalization and product portfolio rationalization. Those are two strategic directions that I've set as far as what we need to do right now. So what does portfolio rationalization mean in the terms that you described, which are very accurate? One is look at which products are we going to grow in and which products are legacy where we're not going to be investing in. And start shifting that to the high strategic products where we want to play. Now that's more forward looking, meaning it is not a point in time where Those products are now better, mixed, and when the market goes the other way, we're going to have to see what you said, you know, the 6%. What we are seeing is we are shifting that to the strategic products that are starting even to grow and will maintain growth over the next, you know, 5 to 10 years. That's the structural portfolio mix that we have done. So what's different from the last 15 years is I don't need fat fillers. When you have fat filler products which are low-value, discrete, commoditized products, you keep shoving them in the fab, and they go up and down with the market. We're moving away from that. We're moving to strategic, high-value products that are going to grow over time, and that capacity has been taken away from the discrete commodity product that caused that volatility. So in summary, when you shift your mix to strategic growth products, that volatility disappears because that's a growth trajectory, and a growth trajectory only, whatever demand does, it's going to be growth. Maybe it's not high growth, but it's still growth. That's the structural impact of the portfolio rationalization. I'm ready for your follow-up.

Yeah, great. That's really helpful. Thank you for spelling that out for me. What are you looking at for leading indicators to tell you that customers are getting over their skis on their orders? And maybe can you talk about any dynamics you're seeing on any cancellations or push-outs or anything like that? Thank you.

Yeah, look, there are many signs that we look at. I have analytics to be able to see. Obviously, you're not always going to see 100% around the corner, but I'm comfortable with the visibility we get. Both Thad and I review it more than once a week in order to make sure we don't miss anything. But not to be joking about it, but the biggest gauge is how many escalation calls i get from customers is the biggest indicator when i when my phone start ringing off it stops ringing off the hook 50 times a day then i know we're not where we are today so both of these you have the analytics but you also have that that you know call it subjective uh feel that you get and both of those uh lead me to believe that this is going into the first half of 22.

And, Mark, just to add, we're not seeing any meaningful cancellations or push-outs at this time. We've also taken the inventory and the channels down so that we can manage that escalation process, whether that customer is in the channel or direct, and essentially making sure customers are getting the inventory just as they need it rather than stockpiling it. So we're doing our best to manage it, and I think we've got good analytics and visibility on what's happening right now.

That's great, Tyler. Thanks, guys. Really appreciate it.

Your next question comes from from and company. Your line is open.

Yes, thank you and congrats as well on great momentum across the board. Just picking up on your commentary around the inventory, I think last quarter you had talked about that you wanted to build inventory on your balance sheet while reducing inventory in the channel. that you're actively reducing channel inventory while holding more inventory on your own balance sheet in order to allocate the right products to the right customers and therefore preventing any excess inventory sitting in the channel. I'm wondering how that strategy is playing out this quarter, and how do we think about that over the next couple of quarters in a continuation of a supply constraint environment?

Yeah, so we were at 8.4 weeks in the channel last quarter. We're at 7.3 weeks this quarter. So on a revenue value, that was a decrease of almost $43 million in channel inventory. At the same time, our balance sheet inventory went up slightly in terms of dollars, about $14 million, but down in terms of days. It went down in eight days. So we're still executing to that strategy of closing that inventory. Obviously, as inventory becomes available, finished goods become available, we're showing them. So as we look forward, we think we'll continue the strategy through the remainder of this year. I think inventory in the channel is going to stay in this level, kind of plus or minus. And I think our inventory on our balance sheet will probably remain relatively flat to down slightly just depending on, you know, our capacity to get more supply. So, you know, through the remainder of this year, we don't see a change in our strategy of holding that inventory.

Just a couple more follow-ups if I can. You had mentioned that you had secured additional supply internally. I'm wondering if you could elaborate further on how much supply you're able to get. What were the steps that you did in order to kind of alleviate that supply and increase more supply, and how do we think about more supply coming online, whether internally, externally? And I guess, Hasan, I just have a question on the automotive revenue. You've had record automotive revenue. You obviously want to shift to electric vehicles, renewable energy infrastructure. Maybe give us some updated thoughts on your silicon carbide power products and power modules for charging stations and onboard chargers. Thank you.

Yeah, so Raji, in terms of the supply and what we saw, our utilization was relatively flat quarter to quarter, but we got more supply out. So this is really the optimization and efficiency of our manufacturing site. Now, we manufacture about 65% of our own product in-house, 35% outside. We still remain, you know, severely constrained on the outside, but we've got more control on the inside with what we can do. So, you know, as our manufacturing team has executed, we've been able to just squeeze more out of the existing footprint. And then if you look forward to our Q3 guide, which is, you know, up at the midpoint, you can see we're getting more supply coming in in Q3 as well. So, again, this is just really the optimization of that existing footprint.

yeah and as far as uh your your second question about our power products obviously you know i mentioned renewable energy i mentioned electric vehicles which for me is both traction and onboard charging so as the power demand goes up as far as the need from customers you know think about the fast charging whether it's onboard charging or the infrastructure you know the charger on the road or the traction where where we are winning and why we are winning is our highly competitive efficiency metric that comes from the prowess and technology that we are flexing, but more importantly, our packaging technology. When you put those two together, you get a lighter and more efficient traction module. Lighter is obviously good for EVs for distance. but lighter and smaller is also good for packaging. So we're able to get the same equivalent power output of our silicon and silicon carbide modules, and I talk about module being the device and the packaging, better than the equivalent competitor power output. That's where we win. You'll hear a little bit more about that at the analyst day, but that's what I tie our current wins to, And when I look at the funnel and talk to the customer, you know, since I've taken over, a lot of customers I call is, why do we win? Why do you pick on? And those are the ones that I'm pushing into our strategy to do more of. And where they say we lack, we're putting R&D in order to leapfrog the competition. So all of these give me the confidence, one, on our posture today, our posture with the design went forward looking, that's going to fuel our growth. And more importantly, where we are investing are indeed to sustain that momentum forward-looking.

Great. Excellent. Thank you.

Your next question comes from John Pitzer from Credit Suisse. Your line is open.

Yeah, good morning, guys. Thanks for letting me ask the question. Congratulations on the solid results. Asana, I'd like to go back to kind of the significant growth margin upside you've seen over the last couple of quarters. I'm just kind of curious, what inning do you think you're in as far as repositioning the portfolio to higher numbers? And I guess, was there any meaningful sort of advantage to kind of trying to price yourself out of certain businesses right now and customers didn't walk away so that we saw some cyclical pricing advantage to either the June gross margins or the September gross margins?

Yeah. So, look, as far as innings, Carl, we're in early innings as far as what we're able to do. You're starting to see the momentum of the work we've done in Q1 and Q2 starting to come about. We haven't seen the benefit from some of the manufacturing rationalization, you know, the actual fab divestitures that at least the ones that we've talked about, you haven't seen that benefit yet. So that's going to fuel our more of the gross margin expansion forward-looking. Right now it's on, you know, cost, product, product mix, product cost, product value, et cetera. All of those are what you're seeing today. So there's more to come as we deploy and execute our strategy forward-looking. So that gives me the comfort of where we are as far as in our trajectory in the gross margin expansion.

That's helpful. And then, Hasan, you know, the gross margins were impressive. I would argue the free cash flow was even more impressive. And if you look at your share schedule on your website, there's not a lot of dilution coming down as the stock price goes up. So I'm kind of curious how you guys are thinking about sort of the use of cash and cash return, given how strong the free cash flow generation looks like it was in the quarter and should continue to be.

Yeah, John, it's bad. You're right. You know, now that we took out that convert and swapped it out for a new convert, that old one was heavily in the money. So the solution impact isn't as significant as what you're seeing in the past. And if you look at our guidance, you know, for next quarter, 436 million shares, it's just up a small tip, right? So as we think about the cash generation, right now it's balance sheet flexibility. It's continued to pay down the debt long-term. We'll look at returning capital to shareholders, but right now it's reinvest in the business and have balance sheet flexibility.

Thanks, guys.

Your next question comes from Harlan Sur from J.P. Morgan. Your line is open.

Good morning. Congratulations on the solid results and execution. The image sensor business, again, undergrew both auto and industrial on a quarter-to-quarter and year-over-year basis. And I know most of this business is outsourced. You talked previously about being supply-constrained into the first half of next year. Has that supply normalization actually pushed out given the strong demand you're seeing? And then just given the strategic nature of sensing to your strategy and portfolio, is this a technology and product segment that the team is actually thinking about potentially bringing in-house?

Look, so you're absolutely right. This is a very constrained because the majority of all of it is foundry-based. Now, as far as over the long-term strategy about what we do outside or inside, we'll be talking more about that in our analyst day. But it is fundamental to our strategy, and therefore the supply constraint is not something we can solve right now. Right now it's more on optimizing the existing supply chain that we have. Because, you know, imagine that technology is not you can pick up a fab, whether internal or external, and get some expansion products. There's a lot of R&D work that needs to go into qualifying and running that image sensing technologies in very specific FAPs that require CAPEX and R&D. Obviously, we're looking at all options, but right now through call it the 22, it's what more can we get out of the foundry partners.

Got it. And then normally the team's December quarter from a seasonal perspective is flat to down slightly sequentially, but, you know, just given the strong demand velocity, given the backlog visibility, combined with your supply additions coming on in the second half, would the team anticipate a better than seasonal growth trend for the December quarter?

Look, Dave, I don't think we can talk about seasonality, but I'll let Fat comment. But, you know, seasonality at this point is really, we don't, we have the demand. Right now, our top line and our forward-looking is based on the supply and the mix we were able to get out of our footprint.

Yeah, so, you know, Hazan's right. We're limited by supply. The demand is there. So as we look into the fourth quarter, you know, we think we're going to be at the top end of our normal seasonality, which normal seasonality is kind of flat to down 2%. Great.

Thank you.

Your next question comes from Vijay Rakesh from Missoula. Your line is open.

Hi, as I said, congratulations on a great quadrant guide. Just wondering on the EV and ADAS, it looks like very strong growth there. If you would give us some color on how that grew sequentially. And as you exit the year, if you can talk to what the mix you see, especially with the traction on the EV side, how that EV and ADAS mix grows year on year as a person of rare news. Thanks.

You know, we're not breaking up, you know, by technology or by subsegment. We're just looking at the automotive. We expect automotive to maintain the growth. Obviously, it is limited by what I mentioned earlier in the prior question, you know, on the ADAS side from the supply and the imaging, which we are highly constrained on. As far as, you know, the rest of our power products, or call it the silicon non-imaging power products, That's going to be based on how much we are able to get more out of our supply chain footprint, as Thad mentioned, through the efficiencies that our supply chain team has been working on. So I still see the momentum there. There is growth built in. The demand is there. And right now it's how much of that demand can we service.

Got it. And actually, look out. I know Thad mentioned going into Q4 more like the top end, so Flattish. But I wonder if you can give some idea on how the book-to-bill is trending, you know, how it was in Q2, how you see Q3, Q4. We'll get some idea there in terms of how orders are coming in. Thanks.

Yeah, Vijay, I mean, the book-to-bill is strong, right? It's remained strong. We think it's going to continue through the remainder of the year. You know, again, it's supply that's the issue. we're not seeing major cancellations or push-outs. We're seeing just consistent strength right now. So we're not seeing any major swings in the book to bill.

Great. Thanks a lot.

Your next question comes from William Steen from Truist. Your line is open.

Great. I want to add my hearty congratulations to great results and even better outlook. And I appreciate your taking my questions. First, the compute end market was particularly strong in the quarter. I think you attributed that or you at least highlighted graphics cards to part of the success there. I'm wondering if you can talk about trends in that end market as we look out over the next couple quarters. There's been some concern about uh perhaps uh in aggregate inventories or mismatched uh bills of materials that might cause a hiccup in that in market I wonder what you're seeing in terms of the Outlook there and that I do have a follow-up yeah look we're seeing strength in in both cloud and and the server market so that you know

It's over market growth. If you look what customers are doing, there is more and more capacity for expansion in these markets, and that's what we're correlating on our demand. So I think the market took a pause in 2020 and maybe at the beginning of 21, and now it's starting to pick up from an investment side. I don't see that kind of slowing down. We're going to keep monitoring just like we are every other market. and our focus in these is limited to what we want to do on the product side. Those are what I would call adjacent markets where we have very compelling and competitive products that we are able to service in these markets, and we're going to be pushing that through to our customers. But from the signs and the data I get from our customers directly, there is capacity expansion on their side, and that gives me the visibility on the confidence in the demand that we have on our backlog for these markets.

And then as a follow-up, you talked about capacity expansion in the next few quarters. I may have missed it, but is there an aggregate sort of unit growth or dollar growth that's getting built in as we think about demand and supply perhaps rationalizing or coming into somewhat of a stasis in the first half of next year, as you've highlighted, what should we think about your total capacity as we progress into that timeframe?

Well, I would say that we've got a couple of things going on. We've got the 300 millimeter fast coming in line in 23. We're continuing to push, you know, production in there. We are supply constrained. We'll continue to optimize. But I would look at just our supply as being, at least through the time horizon you're talking about, the first half of next year, as being pretty steady with some small increase as we continue to optimize and get more output.

Thanks.

Your next question comes from Christopher Rowland from . Your line is open.

Congrats as well on all the progress you've made in just a few quarters, guys. The first question is for Hassan. Hassan, LTSAs were a big deal for you guys at Cypress. Can you expand there perhaps what end markets you're looking to do long-term supply agreements for, how they're being used strategically? And ultimately, do you guys have a goal of kind of what percent of revenue you ultimately want under long-term agreements?

Yeah, Chris. So obviously our focus is to start with number one, our strategic markets and two, strategic products and strategic customers in those markets. So that's kind of the priority that we are doing. And that's the start because think about it from a strategic perspective. I wouldn't want to lock in supply before I get all of my automotive customers taken care of, for example. And once that happens, then you start going automotive industrial and it's based on customers and the breadth of customer within Portland. Are they buying multiple products where cross-selling plays a big impact in our decision? Or is it a one product? So that helps us strategically assess where we are. Obviously, our goal is to remain and support all of the customers that we have. And that's how we're going to maintain the growth. But as far as LTSA, I'm starting with strategic markets, strategic customers, and breadth of customers because that's what's going to fuel, one, our growth, but more importantly, our stickiness. The broader we are, the more sticky we are because that's where the value comes in, not from a product but from a company perspective. So to answer your question about a percent, given that I really don't have a percent, target, what I want is to drive the right strategic behavior. Because if I throw a percent out there, I guarantee you we will need it. My view is I'm looking at it strategically. Whatever the percent ends up, it ends up. But we do have, based on the product lines, so not at the group level, but a click below that, they have kind of targets where, you know, we may not want to go up to 80%, for example, because you want to keep, you know, 20% or 30% dynamic for the growth that we get from new customers that are not yet at the level we want to do in LTSA. So there's a lot of play in there, and we're taking a very, very surgical approach on an account, market, and PD segment basis.

Excellent. And then a question around the FAB footprint. First of all, any updates on your existing FABs for sale? And then secondly, on East Fishkill, the prior management team talked about $2.3 billion in additional revenue. Do you have an update there in this environment? Do you think that could be substantially higher?

In terms of the FAB footprint, we continue to look at it. We're in deep discussions with quite a few parties, actually, on the two FABs that we publicly announced. So those are tracking along. As you know, it takes time to exit a FAB, right? Getting the structure in place is more important than the timing of the exit. So even though we haven't announced something, we're still along our path of timing, but it does take time, but things are progressing nicely there.

Look, on the EFK, on the East Coast scale FAB, obviously we are in a path to, we're changing even the mix of what goes in that FAB based on our new strategy and our new direction. I wouldn't put yet a number to it. Of course, we're getting it because it's going to drive incremental growth that is part of the strategy. but I'll be more comfortable disclosing that number and that target and how we progress against it once we have ownership of that FAP.

Great. Thanks, guys. Great progress.

Thank you. I would now like to turn the call over back to Mr. Hassan Khilhali, President and CEO.

Thank you all for joining us today. I once again thank our worldwide team for their hard work in driving our transformation and solid results. It's been an exciting few quarters and we are firing on all cylinders. We remain focused on our execution and our drive to streamline our business and unlock our value. I look forward to seeing you all at our analyst day in a few days for a deeper look into our strategy and our transformation.

This concludes today's conference call. Thank you all for joining.