ON Semiconductor Corporation

Ladies and gentlemen, thank you for standing by. My name is Brent and I will be your conference operator today. At this time, I would like to welcome everyone to the on semiconductor third quarter 2021 earnings conference call. All lines have been placed on mute to prevent any background noise. After the speaker's remarks, there will be a question and answer session. If you would like to ask a question during this time, simply press star followed by the number one on your telephone keypad. If you would like to withdraw your question, again, press star 1. Thank you. I would now like to turn today's call over to Mr. Parag Garwal. Sir, please go ahead.

Thank you, Brent. Good morning, and thank you for joining OnSummit's third quarter 2021 quarterly results conference call. I'm joined today by Hassan El Khoury, our president and CEO, and Fred Trent, our CFO. This call is being webcast on the investor relations section of our website at www.onsami.com. A replay of this webcast, along with our 2021 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. Additional information related to our end markets, business segments, geographies, channels, share accounts, and 2021 and 2022 fiscal calendar is also 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 with the most directly comparable measures under 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, will make projections or other forward-looking statements regarding future events or future financial performance of the company. The words believe, estimate, project, anticipate, intend, may, expect, will, plan, 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 that can affect our business, including factors that could cause actual results to differ from our forward-looking statements, are described in our most recent Form 10Qs and other filings with the Securities and Exchange Commission. Additional factors are described in our earnings release for the third quarter of 2021. 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. Now, let me turn it over to Hassan. Hassan?

Thank you, Parag, and thank you everyone for joining us today. We delivered yet another quarter of record results driven by exceptional execution by a worldwide team and strong demand for intelligent power and sensing products. We posted record quarterly revenue and non-GAAP operating margin and EPS. With our results and outlook, we have made a solid start towards achieving our financial target model. Even though our Q3 results and Q4 outlook significantly exceed expectations, we believe that we are just in the early innings of transforming the business. As we make further progress in our transformation initiatives, And as our intelligent power and sensing design win-win with automotive and industrial customers, we expect to see sustained revenue growth and margin expansion. Today, we announce the close of our acquisition of GT Advanced Technologies, or GTAC. As we outlined at our analyst day, our goal is to provide our customers in the industrial and automotive end markets with highly differentiated intelligent power and sensing solutions and we are investing to achieve that goal. With GTAT's market-leading silicon carbide substrate technology, OnSemi is now the only silicon carbide player in the industry with end-to-end capabilities encompassing modules, devices, and substrates. Our acquisition of GTAT has been a catalyst for our key automotive customers to engage in long-term strategic partnerships with us, and we can expect GTAT to be a critical enabler of our impending ramp in our silicon carbide business. In fact, in Q4 2021, we will be shipping silicon carbide product-based revenue utilizing the GTAT substrate. I am also excited to announce that GTAT has delivered 200 millimeter bulls, which we have processed at our Onsemi manufacturing facility and will be sampling our first devices in January 2022. We welcome the GTAT team to the OnSemi family and look forward to expanding its capacity to support our silicon carbide growth plan. On a year-to-date basis, our power design wind funnel grew by 75% year-over-year. At the end of the third quarter, we have signed LTSAs for committed revenue of $2.5 billion over three years for our power solutions. Over $2 billion of this committed revenue is for our silicon carbide solutions for automotive and industrial applications, and two-thirds of this committed revenue is for traction inverters for electric vehicles. We expect to exit 2023 with silicon carbide revenue run rate of above $1 billion. The demand of our intelligent power and sensing solutions in our strategic end markets continues to outpace our current supply capabilities. The strength in demand is driven by secular megatrends such as vehicle electrification, ADAS, industrial automation, and transition to alternative energy from fossil fuel-based power generation. For the third quarter, automotive and industrial end markets together grew 42% year-over-year. On a year-to-date basis, our design wind funnel for these end markets grew 55% year over year, giving us excellent visibility into future revenue. In addition to secular factors, demand for our products is being driven by industry-leading performance of our products in both intelligent power and sensing. Consistent with our strategy outlined at our analyst day, we are driving a mixed shift towards automotive and industrial end markets to drive margin expansion. For the third quarter, automotive and industrial together contributed 60% of our revenue as compared to 56% in the quarter a year ago, and we will continue phasing out low-margin non-core revenue into next year. Looking forward, we expect demand to remain robust and outpace supply through most of 2022. We are selectively investing in our operations to relieve capacity bottlenecks for our strategic product lines while working with our foundry partners to obtain a higher allocation of capacity. At the same time, we are shifting our production to strategic high value mix of products. Longer term, we are qualifying products in the 300 millimeter East Fishkill facility to increase the efficiency of our FAB network while executing our FAB lighter strategy. Along with expanding supply, we are working collaboratively with our customers to ensure uninterrupted supply of our products, and we have entered into long-term supply agreements with many of them. These LTSAs commit a multi-year revenue stream with stable and sustainable margin. Coupled with our expanding design wind pipeline in the automotive and industrial end markets, we have outstanding visibility into our revenue and margin in support of our target model. Along with entering into LTSAs, many of our largest automotive and industrial customers are co-investing with us. These investments solidify the strategic nature of our LTSA and enable us to support our customers by ensuring supply and providing development support. Let me now discuss a few highlights of our key strategic end markets, starting with automotive. We set a record for our automotive revenue in Q3 of $575.6 million, Automotive represented 33% of our revenue in Q3 and grew 37% year over year and 4% quarter over quarter. The strength in automotive was driven by both our power and sensing product categories. We are seeing strong momentum in our electric vehicle business for both silicon carbide and IGBT-based solutions. We have signed LTSAs for committed revenue for EVs of little less than $2 billion and over the next few years, starting the ramp in Q4 2021, and approximately doubling year over year for the next few years. Over 80% of this committed revenue is for silicon carbide solutions for EV traction inverters. As we have indicated earlier, 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 weight and cost of a power module. The efficiency of our modules allows our customers to make no trade-offs between the cost of battery and the range of the vehicle. They get both. Our automotive imaging revenue grew more than 10% quarter over quarter and 45% year over year. We continue to see momentum in automotive safety with new design wins and increasing content for our CMOS image sensors and power management. Year-to-date, our automotive imaging design win funnel grew by 75% year-over-year. As ADAS systems shift to higher pixel density and the need for automotive safety requirements around power management increases, our content will increase as these solutions have higher ASPs. This increase is further compounded by a higher number of sensors and power ICs per car and increasing number of cars with active safety features. The industrial and market, which includes military, aerospace, and medical, contributed revenue of $478.5 million in Q3, representing approximately 27% of our revenues. Our third quarter industrial revenue increased by 48% year-over-year and 11% quarter-over-quarter, driven by strong demand for intelligent power and sensing solutions. We are seeing a more than 2x growth in our design wind funnel from alternative energy customers for our power solution and expect the alternative energy market to be a long-term driver for our business as utility-scale power plant installations are expected to grow worldwide to reduce the climate impact of fossil fuel-based power plants. Industrial power tools are another area of growth as power tools are transitioning from brushed motors to brushless motors and from AC to battery-powered, both trends driving significantly higher content for us. The demand for our imaging products and industrial automation applications remain strong with 20% quarter-over-quarter growth. Industrial customers are investing in automation at an increased pace to improve efficiency and to reduce volatility in operations due to social distancing mandates and labor shortages. We have leveraged our experience in automotive to offer our industrial customers rugged high resolution and high image quality sensors for the most demanding industrial applications. Now I will turn the call over to Thad to provide additional details on our financials and guidance. Thanks, Ahsan.

I'm pleased to announce yet another quarter of record results. As Ahsan mentioned, we posted record quarterly revenue and record non-GAAP operating margin in earnings per share while generating free cash flow margins of 20% for the quarter. All three of our business units reported record quarterly revenue and are targeted automotive and industrial in-markets grew sequentially, achieving record revenue levels. With a rapidly expanding design wind funnel of intelligent power and sensing solutions and ongoing structural changes to our business, we are well positioned to make sustained progress towards our targeted financial model. While the OnSemi team has accomplished a lot in a short period of time, we have From a revenue perspective, we are in the early innings of the ramp in our vehicle electrification business and expect EVs to be a significant driver of our long-term growth, complemented by increasing demand for ADAS, industrial automation, and alternative energy. We are pleased with our performance thus far and remain focused on margin expansion as we execute our transformation initiatives, including the portfolio optimization and our FabLighter strategy. Turning to the results for the third quarter, total revenue for the third quarter was $1.74 billion, an increase of 32% over the third quarter of 2020 and 4% quarter over quarter. The sequential revenue growth was driven by our ability to increase our supply both internally and externally, shipping 3% more units than in Q2, and favorable mix in pricing across all end markets. Revenue for our intelligent power and intelligent sensing products were also at record revenue levels, increasing sequentially 3% and 8% respectively, while accounting for 62% of total revenue in Q3. Our automotive revenue grew 37% year-over-year and 4% sequentially. Industrial revenue grew 48% year-over-year and 11% sequentially. Automotive and industrial contributed a total of 60% of revenue in Q3 as compared to 56% in the year-ago quarter. Turning to the business units, revenue for the power solutions group, or PSG, was $892.2 million. PSG revenue increased by 38% year-over-year due to strength in automotive and industrial end markets. Revenue for the advanced solutions group, or ASG, $613.5 million, an increase of 24% year-over-year. In addition to strength in automotive, ASG benefited from strength in computing, especially in high-end graphics cards. Revenue for the Intelligence Sensing Group, or ISG, for the third quarter was $236.5 million, an increase of 35% year-over-year. Growth in ISG was driven by both automotive and industrial end markets. Gap gross margins for the third quarter was 41.4%, and non-gap gross margin was 41.5%, an 800 basis point improvement year over year, and a 310 basis point improvement quarter over quarter. Our gross margin expansion is ahead of our original plans, with improved efficiencies at our manufacturing sites, favorable mix, and improved pricing as we continue to examine our portfolio for price-to-value discrepancies. Over the last two quarters, we have exited approximately $100 million of non-core revenue at an average gross margin of 15% and allocated this capacity to strategic products with accretive gross margins. Over 60% of this exit occurred in Q3, and we expect to continue phasing out our low-margin non-core revenue over the next two years, as we outlined at our August Analyst Day. Today, we have been successful in navigating rising input and manufacturing costs by adjusting pricing to our customers. While we will likely see more cost increases in early 2022, we don't expect these increases to have a negative impact on our gross margins. Our factory utilization was 80%, down slightly from Q2 level of 83%, due primarily to COVID-related slowdowns affecting our back-end facilities in Southeast Asia. As our operations stabilize, we expect utilization to remain in the low 80% range consistent with previous quarters. GAAP earnings per share for the third quarter was $0.70 per share. Non-GAAP earnings per share for the third quarter was $0.87 per diluted share as compared to $0.27 per share in the third quarter of 2020 and $0.63 in Q2. As noted earlier, this is the highest ever quarterly non-GAAP EPS reported by the company. Now let me give you some additional numbers for your models. GAAP operating expenses for the third quarter of 2021 were $321.6 million as compared to $322.2 million in the third quarter of 2020. Non-GAAP operating expenses were $296.2 million, a decline of $18 million quarter over quarter, as we continue to restructure our operations to align with our new strategy and reduce investments in our non-strategic areas. While we saw benefits of lower OpEx in Q3, we expect to redeploy capital into our strategic areas in Q4, and therefore, there will be an increase in spending back to normal run rate levels while achieving our 17% operating expense target. Our GAAP operating margin for the third quarter was 22.9% as compared to 9% in the third quarter of 2020. Our non-GAAP operating margin was at a record level of 24.5% as compared to 12% in the third quarter of 2020 and 19.6% in Q2. Our GAAP diluted share count was 440.7 million shares and our non-GAAP diluted share count was $435.7 million. Please note, we have an updated reference table on the investor relations section of our website to assist you with calculating our diluted share count and various share prices. Turning to the Q3 balance sheet, cash and cash equivalents was $1.39 billion, and we had $1.97 billion under on our revolver. Cash from operations was $448.9 million, and free cash flow was $355.7 million, or 20% of revenue. Capital expenditures during the third quarter were $93.2 million, which equate to a capital intensity of 5.4%. As we indicated previously, we are directing a significant portion of our capital expenditures towards enabling our 300-millimeter capabilities at the East Fishkill FAB and expansion of silicon carbide capacity. Accounts receivable was $720 million, resulting in day sales outstanding of 37 days. Inventory increased $18 million sequentially to $1.3 billion, and days of inventory increased three days to 119 days. The increase in inventory was driven primarily by an initial build of bridge inventory for FAB transition and work-in-progress inventory of finished wafers that could not be processed due to back-end capacity constraints. Distribution inventory decreased $39 million to 6.8 weeks from 7.3 weeks in Q2. 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 $3.1 billion, and our net leverage ratio is now approximately at 1 times. Turning to guidance for the quarter, a table detailing our GAAP and non-GAAP guidance is provided in the press release related to our third quarter results. Our guidance includes our expected results for roughly nine weeks of the GTAT acquisition after closing last Thursday. Let me now provide you key elements of our non-GAAP guidance for the fourth quarter. Based on bookings trends, we believe demand will remain strong through much of next year. We continue to increase supply through operational efficiencies and working with our external partners to obtain additional capacity. We are also accelerating product qualification at our 300 millimeter fab at Neese-Fishkill. Despite these efforts, we will be limited by supply constraints and we are working with our strategic customers to ensure long-term uninterrupted supply. Based on current bookings trends and backlog levels, we anticipate that revenue for the fourth quarter will be in the range of $1.74 billion to $1.84 billion. This includes expected GTAP revenue of approximately $3 to $4 million for the quarter. We expect non-GAAP gross margins between 42% and 44%, and this includes share-based compensation of $3.6 million. We expect total non-GAAP operating expenses of $298 million to $313 million and includes roughly $4 million in OpEx for GTAT and share-based compensation of $18.6 million. We anticipate our non-GAAP OIE, including interest expense, will be $24 to $27 million. So this results in non-GAAP earnings per share to be in the range of $0.89 to $1.01. This includes the impact of GTAP business, which is roughly one cent diluted for the quarter. We expect total capital expenditures of $130 to $140 million in the quarter. Our non-GAAP diluted share count for the fourth quarter of 2021 is expected to be approximately 437 million shares. So in summary, I'm extremely pleased with our progress and the execution of our transformation initiatives. I add my thanks to our worldwide teams for their hard work and unwavering commitment to our customers. With that, I'd like to start Q&A. I'll turn it back over to Brent to open the line for questions.

At this time, I would like to remind everyone, in order to ask a question, press star followed by the number one on your telephone keypad. Your first question comes from Ross Seymour with Deutsche Bank. Your line is open.

Hi, guys. Congratulations on the strong results. Hassan, my first question is for you, and that's on the transformation on the revenue line. At your analyst meeting, you talked about exiting 10% to 15% of your revenues over the next couple of years. I wanted to see if we can get an update on that, and how much of that is a headwind today, or is that still yet to come?

Hey, Ross, it's Matt. I'll take that. In my prepared remarks, I talked about we've exited approximately $100 million over the last two quarters, 60% of it being in the third quarter. and the average margin for that business was roughly 15%. We plan on continuing to exit that business over the next two years. As we've talked about, it'll be kind of a, I think, about being fairly linear for the next two years as we continue to execute, and we shift that capacity into higher value products and higher value capacity.

And then just to add to that, you know, you talked about the headwind. We're able, of course, with the demand environment, we're able to shift that capacity to demand in our strategic market with our strategic customers. And that's the mixed shift that we are going through, and we'll keep going through that for the next couple of years.

Great. Thanks for those details. And I guess the follow-on to that would be on the gross margin side, great job upsiding even your expectations there. Can you talk about how much of that do you view to be structural versus cyclical? And I know you're going to say it's structural because of everything you just answered in my first question. But how much of a cyclical tailwind are you getting with price increases, et cetera, that you think are truly sustainable going forward?

Yeah, look, Kate, this is Pat again. We think the majority of it is structural. We've been making changes to our manufacturing operations, driving efficiencies there. It's the mix shift as well. There's definitely a pricing component of it. It's a favorable pricing market. As I stated, we've been passing on the cost increases coming our way. We believe that we'll continue to get the gross margin expansion. Our target remains at 45%, you know, over time here. And like I said, most of it is structural in nature.

Yeah, at the end of the day, customers pay for value. We have been reducing the price-to-value discrepancy like we talked about. And, you know, the LTSAs provide a longer-term visibility on both revenue and margins. And when we talk about long-term, we're talking about an average of three years.

So that gives you kind of the structural nature of it and the sustainability of it moving forward. Thanks, guys.

Ladies and gentlemen, in the interest of time, please limit yourself to one question and one follow-up question. Thank you. Your next question comes from the line of Vivek Arya with Bank of America Securities. Your line is open.

Thanks for taking my question and congratulations on the strong results and the very impressive execution. Hassan, how do you see the interplay between automotive production, which has been kind of flattish, very weak this year, versus content and pricing? I mean, there's a lot of concern that auto chip suppliers are maybe shipping a lot to inventory rather than benefiting from content or pricing or a mix. I would just love your views on that from an industry, but then obviously from an on-specific perspective, that what's giving you the confidence that your sales that are exceeding units so much are really being driven by content or mix of pricing as opposed to sitting in inventory somewhere?

Yeah, look, I can speak for Adsemi first. You know, we track content based on design wins that we have had over the last few years that are starting to ramp and have ramped beyond what we expected in the 21 timeframe. That's why we kind of can't support the demand. So from that point of view, I know exactly how much content has been going up for our customers using our products. So that ties and that gives me the confidence that it is a content growth story. Now, as far as people talk about inventory being built out, look, I gauge that. We have a lot of data to gauge it, but to me, the main gauge is the escalations that we're getting. We're still getting an intense level of escalations from our customers in order to ensure that parts go into cars and cars go out of the lot. That is a pretty good gauge for where the economy is and where our content is going. I can tell you it's not being built up. It's going to cars. Because if we don't ship, the cars don't ship. That's a one-to-one correlation that I can personally validate given all my conversations with my peers that are customers. So both of these tell me that we are still in a supply constraint. There's not inventory. Are there pockets, you know, maybe one or two weeks of inventory here and there? Yes. Because we sometimes will pre-ship and the customers we know is not able to kit it, but that lasts for about one or two weeks until they get our next shipment. So all of these things are manageable. We have full visibility on it, and we track it internally and with our customers. So it gives me confidence.

Got it. Very helpful. And for my follow-up, Pat, great job on the gross margin side, but when I look at the incremental margins in Q3 and then the midpoint of Q4, it's over 100%. I imagine part of it is the exit from the non-core areas, but could you help us bridge what your original assumption was for kind of gross margin? You know, why is it coming at these levels? But then also importantly, you know, you're at these kind of low 40s gross margins already before completing a lot of the actions that were supposed to take you to the 45% journey. So is 45% still the end kind of destination of this journey, or do you think that this very strong start gives you confidence that there are maybe levers to gross margins beyond what you have contemplated? Thank you.

Yeah, hi Vivek. We've always said 45% was a milestone, right, and that we would talk once we got there. We're not changing that target. The improvement that we've seen has been through operational efficiencies, variable mix, and then clearly pricing. If you go back to the chart that I showed in analyst day, we provided the bridge. The next big piece of the improvement is really the manufacturing, the fab lighter footprint, right? And that's the part we've always said that would take the longest and would be the hardest to get. And it's about exiting the fabs and consolidating into more efficient fabs, ramping the 300-millimeter fab, and that's the next leg that we've got to execute on. So I think what we've been able to pull forward on is favorable mix, operational efficiencies, and then clearly a good pricing environment has helped. But what I think is going to get us to that next level of 45 is the manufacturing piece, and then once we get there, we'll talk about what the end goal should be. But we've never stated 45 would be the end goal as much as it was a milestone that we'd be looking to achieve.

Thank you.

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

Good morning. Thanks so much for taking the question and congrats on the strong results. Hassan, in your prepared remarks, you talked a little bit about Southeast Asia and your operations there being a little bit disrupted in the quarter. Can you speak to any impact on revenue and gross margins in the quarter and where your operations are today? Then I've got a quick follow-up.

Yeah, hi, this is Thad. So, you know, we talked about our utilization came down slightly to 80%. We think that to return back into normal levels of low 80%. We think it had minimal impact on this quarter, primarily because we were able to allocate those resources and that capacity into other sites and recover from it. The sites are stabilizing now. They're not back up to full speed yet, but we think they'll be there very quickly, and that's why we think the utilization comes back up into normal run rate levels here pretty quickly.

Got it. That's helpful. And then as my follow-up, I wanted to ask about Q1 of next year. I think historically pre-COVID, you know, seasonality would drive business down a little bit. I think... some of the adjustments that you would make historically would hit Q1 disproportionately. I'm curious how we should be thinking about Q1 into next year, just given how strong the environment is. You talked about all the design wins and the visibility you have into the quarter. So should Q1 of 22 be above seasonality? And, again, how should we think about pricing and gross margins into the March quarter as well? Thank you.

Well, you know, we're not going to give you guidance for Q1, right? We only guide one quarter at a time. But normal seasonality for Q1 is down 2% to 3%. Based on what we see today, we're going to perform better than that. What we can see in terms of backlog and supply coming online, we're probably looking at flat to what our Q4 number is going to be. But we're not going to provide more guidance than that.

Thank you very much.

Your next question comes from the line of Harsh Kumar with Piper Sandler. Your line is open.

Yeah. Hey, guys. First of all, strong congratulations. Tremendous execution effort here. Hasan, I wanted to ask a broader question just above the minutiae and the data. Maybe you could help us. I know that EVs are near and dear to your heart, and you're making a pretty big bet on EVs. on that front, two things. How much revenue do you think you get from EVs today? And then once you start to get to your, I think you said $1 billion in 2023, let's say I'm sitting 2023, how much of your business will be EVs at that point in time? Throwing in ADAS and all that other stuff you guys do.

Look, we're not breaking down the EV revenue today. I gave the outlook just to highlight the growth that we're seeing, but more importantly, to highlight the penetration of silicon carbide getting to the run rate of a billion dollars. You know, we've always said over the next few years, you know, we're going to see a coexistence of IGBT and silicon carbide, but silicon carbide is starting to accelerate as customers see the efficiency of it coupled with our technology on packaging. So that is going to accelerate our ramp in silicon carbide to get to that run rate above a billion by 2023, which is very meaningful from where we are today. And that revenue trajectory getting to the billion is basically doubling for us every year. I'll be providing more of that color as we start ramping. But at this point, that's kind of the level I'm going to be talking about. But I'm very comfortable with the EV ramp. You know, it's A lot of people, we've been talking about EV ramps and content for a few years now. Now we have it. It's starting. Customers have the LTSAs to guarantee for their supply, and we're going to be supporting their growth along with ours.

Very well. Thanks, Hassan. And then for my second question, you've got a, I think Vivek mentioned, you've got a long-term target of 45%. You're guiding to 43%. I guess I wanted to just Make sure that there's no near-term sort of things that are helping you here, that it's all structural. Could you maybe just give us some color on how much the strong ASPs helped you versus legacy business reduction, which I think we can calculate also. Also, you're supposed to sell fabs, and we haven't seen much of a progress on that front. But I'm looking at it and saying you're already at low 80s utilization. Why would you even need to sell fabs going forward as you grow?

Yeah, look, a lot of it, most of it is self-help. You know, we talked, Thad talked about the increase in units sold. Those unit increases are based on favorable margin mix. So you're already starting to see that mix shift. We've already talked about walking away from 100 million at 15%. You know, I've always said, even in this pricing environment, low margin is low margin. And we will actively walk away from that business and move it to you know, the auto and industrial that for us are driving higher margins. All of these things are self-help and, of course, sustainable. The other thing, you know, over the last year, the other thing that worked in our favor is the utilization. And that's sustainable, as you mentioned, as we wind down some of our fabs and we restructure and do the fab manufacturing optimization. that utilization is going to be and remain at that higher level, even with that 10% to 15% reduction in the non-core business. So all of these, I would say, are self-help. As far as the current pricing environment, there are two things that I would talk about in pricing. One is passing on the price increases to our customers. That's gross margin neutral to us because we're passing on cost increases that we have incurred to our customers. So that's You can think of it as the margin neutral for us. The other one is the price-to-value discrepancy, where we have products of high value that historically, for whatever reason, were shipping below market, and those adjustments are sustainable because that's the value of the product that many other customers buy. So all of these are structural, and we just have to stay ahead of the manufacturing utilization as we wind down that 10% to 15% remaining of the low-margin business And we're going to get there, as we talked about in our analyst day. So all of these are going to yield to a structurally sustainable financial model. And when we get there, we'll talk about how to go to the next level.

Yeah, and hey, Harsh, I would add on the manufacturing sites, we're still planning on exiting the manufacturing sites. We've got the 300-millimeter fab coming online later next year. It's in 23 that we take ownership. So we've got to fill that FAB. That gives us a better cost advantage as well. And you saw that we were building inventory on the balance sheet to support those FAB transitions. So we've always said it's not about handing the keys to somebody. It's about the exit and the qualification process and the exit over time. So even though we haven't announced a divestiture of those FABs, we're making progress in qualifying those products in other locations that are more efficient, and we're building the inventory for that transition. So the progress is underway.

Understood. Thanks, guys. Great stuff.

Your next question comes from the line of Raji Gill with Needham & Company. Your line is open.

Yeah, thank you, and I want to echo my congrats on the excellent results. Hasan, I want to delve a little bit deeper in the long-term agreements that you're seeing in your business. You talked about $2.5 billion of committed contracts. business, particularly $2 billion in SIC for EVs, and two-thirds was related to the traction inverters. Could you maybe describe what you're seeing in that market? It seems like you have the products, the right products, to align for the future growth. Can you talk a little bit about, you know, the qualification process, the, you know, the engagements with your customers on that massive kind of committed capital, committed to business? And then just, you know, more broadly, are you seeing in the industry a shift, a transition to more longer-term commitments, better visibility from your customers in response to the component shortages that we've seen this year? Are you seeing a change in behavior from your customers to enter into longer-term supply agreements to get access to that supply.

Thank you. Yeah. So, absolutely right. Let me talk about the first one. So, the first one is, I would say, a very different engagement model for the design and capability. You know, when you're talking about a product that is fit for purpose for a customer inverter, traction inverter. Every car is different, whether it's performance or range or heavy duty and so on. All of these variables are what our team and the customer's team take into account in order to get a design in. I highlight that to give you the visibility that it's not a dual source concept. It is a design-in concept that leads to design-win, and that's why customers, once they have that problem solved on their side, the long-term supply agreement is the next natural step because if and when we give them a traction inverter that provides much better efficiency than any of our competitors, they will either co-invest or give us the LTSA or end, give us the LTSA over a longer period of time. at least through the run rate of that product, and then some. So that's the stickiness of the revenue that I talk about, that I refer to. Stickiness from a design win perspective. It's not something that is swappable, but also stickiness from the commitment that the customers are providing to us. Which leads to the second level, and the answer is yes, the engagement model is different. It's not equal to everything. There are products where you know, they're not strategic potentially for our customers. However, they are important. We're not going to lock up capacity with a long-term agreement. But when we talk about strategic components like silicon carbide, like IGBT, like the 48-volt rail, like the strategic T-mix that I talked about that go along with our ADAS for cameras, or the image sensors, all of these are key products that enable differentiated technologies to our customers, whether it's traction or vision with ADAS. Those customers do want the stability, and they do want the supply resiliency that we are able to provide to them through the long-term agreements. And that's the model that we're moving to with a lot of customers. Again, it's not 100%, but it is strategic and surgical, like I've always talked about when it comes to LTSAs.

And for my follow-up question, Go ahead. No, go ahead. No, I would just say for my follow-up, and thanks for the insight, Hasan, on that, it does relate to the pricing question, but it's more of a, again, it's a structural on a positive side. You obviously are seeing some price increases, but would you say that, you know, the days of kind of heavily deflationary pricing for semis are starting to come to an end, or at the very least, the price declines will start to abate going forward because of the strategic importance of these components for ADAS EVs, for industrial automation. Do you think this is more structural in nature where the pricing environment, maybe not be as high as it is now, but could continue to be favorable over the coming years? Or do you view this as more temporary?

No, I think it is also sustainable. I don't think the pricing benefit that we historically give our customers year over year is going to disappear, but it definitely will be very muted for these new ramps. Given the capital intensity that is required to ramp those products and get them up, they're not going to be under your traditional, hey, every year give me X percent or else. Those days are over for these strategic ones, so that's what gives me comfort. in investing in the capex in order to increase that uh to match that demand uh you know we work with our customers on uh on efficiencies that we are able to get or efficiencies they're able to get because look if our products allow our customers to shave off one or two dollars in metal because of heating given the efficiency of our products uh it's still money i don't have to give that savings but if i enable it that's still savings on an end unit price which is the car That's what makes our solution attractive is because the efficiency drives a lot more cost reduction outside of the semiconductor than it is in the semiconductor. And that's very attractive to our customers.

Great. Thank you.

Thank you.

Your next question comes from the line of Chris Casso from Raymond James. Your line is open.

Yes, thank you. Good morning. Just a follow-up question on the LTSAs. And if you could clarify, what are the obligations from both you and the customers over those agreements? What are they promising you? What are you promising them? And, you know, within those agreements, you know, one of the investor concerns right now is one day, you know, demand will probably slow from these levels. So, you know, what are the provisions in there that protect you and protect them in the event that the demand winds up being different than what's envisaged over those agreements?

Look, when we talk about LTSAs, we are focusing on the strategic intent. Let me talk about silicon carbide or EVs, IGBT and silicon carbide as an example. So to me, that demand and that ramp is happening. EVs are happening. EVs are driven by companies and driven by customers themselves. So if the ramp is shifting one quarter or two quarters or whatever, you know what, we'll work with customers. What they get and what customers are getting is the supply assurance that when they do ramp, we will be able to support their ramp. Now, what gives me the confidence in the ramps that we are signing up for with our customers is when a customer co-invests with you. in order to support the ramp, that's a pretty high confidence and high credibility of the ramp because everybody is easy to say they're going to be the kings of the world when it comes to EV. But when a company says and puts money down on it as a co-investment in order to get their ramp and their supply assurance, that tells me that they're going to be winners in that market because they're putting their money where their mouth is. And we will be doing the same through our CapEx intensity that Seth talked about. We're increasing it in order to support those ramps. So we get the long-term visibility. We get the sustainability of the revenue and the margin associated with it. We have confidence in investing our CapEx to expand for that capacity. And the customers get the confidence that they're going to get it when they are ready for ramp and that the customer will ramp. on time when the time comes, given the timeline of the LTSAs. So all of these give me that confidence. Again, I'm not going after LTSAs for all of our products. I am very, very selective and being very strategic about what to get the LTSAs in order not to have that issue that you talked about.

Right. That's very helpful. Thank you. As a follow-up, I guess maybe you can give us some sense of you know, how much of the business now is, you know, kind of within that strategic framework that you speak of. And I suppose some of it's within the LTSAs, you know, some of it's not. But, you know, I guess the question is, over time, you know, we've seen, you know, pricing for semi, you know, typical years kind of down 5% a year. And that's made up with cost reductions. It sounds like for a large part of your business, You're working with a different framework. What about for the rest of the business? Are there structural things happening both within ON and the industry which will prevent that price decline and make things more sticky even in the event of an industry downturn?

Look, we're not the ON semiconductor that you're used to. We're the new ON Semi, and our focus is on strategic products and sustainable financial models. part of that business that we are walking away from, you know, the $100 million at 15% margin that I was talking about, that's the behavior that you are describing. Where an up is good and down, you have to give a lot of pricing to maintain share. I don't care about that business. I only care about the proprietary business that adds value to the customer. When you have proprietary business, even silicon carbide as an example, those are sustainable from both pricing and the margin perspective. We are no longer chasing fab fillers in a downturn, which is what historically the company has done. We are moving the mix that goes into our fabs to proprietary and high-value products, and those are not going to be fluctuating based on what the end market does. That's the new company we are. That's the new company we are delivering results against that you see today.

And that gives me the confidence of the sustainability of our model moving forward, regardless of what the market does. Got it. Well done. Thank you.

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

Hey, good morning, guys. Thanks for letting me ask the question. So I'm just quickly going back to the auto sector. If you read some third-party reports, the industry might miss out on as much as $220 billion in of revenue this year because they don't have chip inventory. I'm just kind of curious as you talk to the auto supply chain, whether or not you think they're going to structurally change the way they think about their inventory and their partners going forward. And the LTSAs are great. I'm kind of curious if you've explored the idea of actually taking some customer capital, especially as you work to build out your silicon carbide capacity.

Yeah, so let me just touch on the last one. We have taken customer capital through the form of co-investments in our capacity expansion. So that model is new, and we've opened it up to customers, and some customers have taken us up on it. The model is changing. Let me put it this way. You talked about the $200 billion in revenue. Nobody wants to be in that spot anymore. So there are customers that unfortunately are still in denial and that's not okay for them, that's okay for me. We're doubling down with customers who get it, who do understand the importance of semiconductor, the importance of the power and sensing in the future of mobility. Those are the customers that have jumped on the opportunity to secure supply. now i'll mention one thing there is a shift for customers to go with credible suppliers suppliers credible suppliers of scale that is very important because supply resilience is a hot button for all customers all the way to the oem my personal engagements with oem are about supply resilience not just supply assurance and our ability to be able to have a product running in two geographically independent locations, in a lot of cases, give that supply resilience to our customers where it may not be COVID, but we always have disruption. We've had disruptions for the last four to five years. So having that supply resilience and proving it to the customer supports their business continuity because they don't have to build inventory and hoard inventory. They can depend on us. That matters in the selection process today. It's not only about the products. Of course, you have to have products that are proprietary and high efficiency to win. But to get selected longer term as a strategic supplier with the co-investment, we're talking about much more than that.

And then, Hasan, as my follow-up, I kind of want to go back to the idea of what if this is cyclical versus structural. And I guess in your auto and your industrial business, You've done a great job sort of laying out, you know, the structural thesis, which is fairly easy to underwrite. I kind of want to think about the other bucket a little bit. If I add back the $60 billion of divestitures, I'm assuming most of that's coming in other. That other bucket's up over 30% year over year, and it's up almost, I believe, about eight high single digits sequentially, so even outgrowing your auto business. You know, when you think about that other bucket, was there sort of value discrepancy that the old on wasn't pricing right? Or is that somewhere where we might have to be a little bit worried about the cyclical pricing leverage today that might go away tomorrow?

Yeah, no, look, you don't have to worry about that. What we talked about other, that doesn't equate it to non-core or declining or commodity either. What we put in other, for example, we have a lot of our industrial that is not necessarily power that goes into there. That's actually very accretive margin already. So what you're seeing a lot of it is the benefit of that high margin in the other bucket that is not getting diluted by that $100 million or 60% of it this quarter at the 15% margin. So there are highly proprietary products, even in the other. They just don't fall under the power and sensing, and that's part of describing our company. So I don't want to equate others to not important to the company. That's why you see the growth being across the board, but the drag from the $100 million is most of it is in that other bucket.

Thank you.

Your next question comes from the line of Harlan Sir with J.P. Morgan. Your line is open.

Good morning. Congratulations on the solid results in execution. The intelligent sensing business, if I look at it, first nine months of this year has undergrown both your auto and industrial. However, on a year-over-year and quarter-over-quarter, the trends actually have been improving every single quarter this year. I know that it's been heavily supply constrained because most of this business is outsourced, so it looks like your Foundry partners are increasing their supply, but do you guys expect this segment to also be constrained through most of 2022? And then Hassan, can you just give us an update on your efforts to bring in some of the image sensor manufacturing in-house?

Yeah, so Harlan, you said it right. That business is primarily, well, all of it is external manufacturing, and that has been constrained throughout 2021. We're starting to see a little bit more capacity being directed to us because of the growth that we're seeing and really because of the impact that it has on automotives. So we're getting more secure supply, and you're gonna see that increasing through next year. So having said that, we do have an effort for new products, of course, to bring in-house. You're not gonna see us do a very big shift of existing products, just moving them in, but we do have a healthy funnel of new product development And, you know, we already have products taped out in East Fishkill, imaging products. Our new imaging products are taped out in East Fishkill. So we're going to have a FAB, call it the Flex FAB strategy for imaging, where we'll maintain externally, but we're also going to double down on the internal in order to expand our supply over the next few years.

And I appreciate the insights there. And then maybe as a follow-up to that, so on East Fishkill and the transition to 300 millimeter, the handoff doesn't occur till I guess end of next year, but you are in the midst of qualifying numerous products. You guys will be benefiting from the better economics of 300 millimeter manufacturing, but driving strong yields will be critical to achieving those lower costs and increased capacity. I know it's early, but how are yields trending on the processes that are being qualified? at East Fishkill?

Look, yields are, you know, of course, I compare yields to production yields in every fab that we have for the specific technology, and the yields are exactly where they need to be to run full production in a 300-millimeter environment. You know, a lot of our power devices are already or have been shipping for a few quarters now out of East Fishkill at production yields. So I'm not concerned about the yield. Of course, when you move new technology that is very complex, like image sensing, you have to work on yield. But I will tell you today, we do have a yielding product that is imaging on our boards. So again, we're out of the research side of it. We're actually in the development and production side of it across a lot of our products, and we'll keep doing that through 2022.

Yeah, good to see the execution. Thank you. Thanks, Paul.

Your next question comes from the line of Tori Zandberg with Stiefel. Your line is open.

Yes, and congratulations on the record results. Hassan, the first question is on this transition from ICE to EV. I mean, it seems like the pandemic has really accelerated that transition. I don't know if there's anything that you could share with us from your end, you know, any numbers, any data points, because, you know, clearly that transition is accelerating materially.

Can you just tell me what transition? I missed the first part. Did you say IGBTV? No, from ICE to EV. ICE to EV. Look, I don't think it's the pandemic that accelerated it. I think there are a few things. One is the heightened focus on environmental responsibility that corporations have, driven by corporations and boards, driven by investors, and driven by employees. All of these factors, and really governmental mandates in a lot of cases, whether in the U.S. it's state mandates or in Europe or in Asia it's government mandates. All of these factors are driving an accelerated adoption, an accelerated investment and launch of car models from ICE to EVs. That is happening. You know, you hear a lot in the targets of by 2025, X percent of cars will be EVs. By 2030, X percent of cars will be EVs. Those are hard milestones defined either by the company themselves for their own targets or by government where you can't buy a new car unless it's EV by those times. That's what's accelerating it. Coming out of the pandemic and needing the demand in automotive, there's a lot more push on EV because if somebody's buying a car now, They would want a car to be an EV, otherwise they don't want to change it in the next five to ten years. That's a very positive impact on our push to EVs and what's sustaining our growth. You know, a lot of the numbers I gave as far as the LTSAs for silicon carbide or IGBT or power inverters, just to highlight to everybody, all those are incremental to our baseline business today. That's pure growth, net of, of course, that 10% to 15% we're going to be walking away from. But that's sustainable growth over a 5 to 10-year period of time. And that's what makes it exciting for us. We're in the right spot.

That's very helpful. And as my follow-up for Thad, the CapEx $130 million or $140 million next quarter, is that kind of the run rate we should use for next year? Or will there be another step up potentially the following quarter?

No, we've said starting next year, the capital intensity will go up to roughly 12% for the next couple of years. And then after that, it'll moderate down to about 9%. But we will be investing. We've got more investments to make in East Biscayle. And then obviously to support the silicon carbide, we've got investments there to make. And then with the GTAT acquisition as well. So 12% for the next couple of years.

That's very helpful. Thank you. And congrats again.

Thank you.

Your next question comes from the line of Pradeep Ramani with UBS. Your line is open.

Hi. Thanks for taking my question. I guess I had a couple. So, you know, there's a lot of concern around pricing in your product portfolio. But, I mean, can you give us some color around, one, How much of your pricing actually is on a like-for-like basis? How much of it is actually like-for-like versus how much of it is benefiting from a mixed shift to your products, which I would assume is a little bit more structural and longer-lived? And then I have a follow-up.

Look, I mentioned earlier on the call, most of our actions are structural because they're driven by a mixed shift. You know, we talked about walking away from the $100 million at average of 15% gross margin. Those products or that capacity just shifted to a much higher gross margin mix of products. So we replaced that $100 million with a much more structurally favorable mix as far as the margin. For cost, you know, I mentioned earlier, The price increases because the costs are neutral to the margin because we're passing it on to customers. We're passing it directly to customers, and therefore that's sustainable as well. You're not going to see the benefit for it. Everything else that we talked about earlier from a market condition, we're walking away from that business. That $100 million is a dent in the 10% to 15%. It's about 1% to 2%. We talked about 10% to 15%. So there's still the upside on the margin expansion just from the mix moving forward. So I'm not worried about the sustainability of it. The benefit is sustainable, and the benefit is driven by value of the products that we are shipping today. And we're shipping 3% more units in Q3 than we did before. Those 3% more units are on favorable margin. That's true demand. And that is sustainable.

Got it. Thanks. And on GTAP, I guess when I look at GTAP in context of your overall EV revenue, is there sort of a contribution you can speak to in terms of GTAP potentially supplying other customers versus how much of your EV revenue is actually coming from your products versus GTAP, basically?

Today, a small portion is coming from GTAT. We just closed the acquisition. I mentioned that we are already and will be shipping more revenue based on GTAT substrates in Q4. Moving forward, we're going to start seeing more of a mix going from outside substrates that we have historically done more into GTAT-based substrate, which will be internal. Obviously, it will be on semi-substrate moving forward. As that mix shifts to our internal created or internal grown substrate, our margin will also benefit from that because, of course, the cost structure of having an insourced, a vertically integrated substrate is better than externally sourced. So we haven't seen the benefit of that margin. That will come as we progress. transition more into GTAT substrates, and that's over that ramp that I talked about in my prepared remarks.

Yeah, and I would just add, in the Q4 guidance, there is $3 to $4 million of GTAT revenue, and that's with third parties, with other customers that are outside of OnSemi. So you can think about that as being the run rate going forward, so it's not a material amount to the company.

Got it. Thank you.

Your next question comes from William Stein with Truist Securities. Your line is open.

Great. Thanks for taking my questions. First, I just was hoping you might linger on the co-investing theme for a moment. Is this customers investing in their own capacity that aligns with that of On Semi, or is it more like non-recurring engineering, or are they actually investing to sort of own or perhaps guarantee capacity

in uh in your fab and then i do have a follow-up yeah so the investment obviously is uh yeah of course they are investing on their side but the investments i'm referring to is they're investing on our side uh primarily obviously for supply assurance uh and for late stage uh development for products that will go for their uh applications uh and that you know i talked about that's what gives me the the confidence and the sustainability and the stickiness of that revenue is the late-stage R&D that customers are investing in in order to get that product and the supply assurance that they will depend on us when they need to ramp. So both of these are what the investment is from their side. Of course, in parallel to that, they're building up their capacity to ramp their own vehicles, but that's not what I'm referring to.

Great. That's helpful. And then the follow-up is about the tone of buyers or buyer behavior, if you will. If we think about their behavior a quarter ago relative to where it is today, when we think about their propensity to chase shortages and try to reel in as much upside as they can and that sort of thing versus maybe cooling off, or narrowing the scope or expanding the scope of expedites. Can you comment on that trend, please?

Look, I think everybody is in blocking and tackling mode as far as making sure they get just enough supply to keep the line running. You know, I can't tell you how many lines are running and what their capacity, but a lot of the lines are now running at 100%, but keeping the line running is more important than keeping it at 100% versus shutting down the line. That's what the focus has been from our side and our customer's side. There's not enough to go around to give everybody 100%, but we work constructively with our customers to make sure that they get the minimum quantities across all of our products to maintain the running line and achieve their financial targets of unit sales. That's the engagement we have directly with the OEMs. It's no longer between us, Tier 1, and then they deal with the OEM. It's either a two-party, us and the OEM, where we understand what they need directly, or it's a three-way meeting with the Tier 1 and the OEM in order to make sure everybody triangulates and nobody's hiding anything in their pockets. It's full transparency, blocking and tackling. We all have one purpose in mind, which is keep the lines running, because that's when demand is real versus, you know, sitting somewhere in the supply chain. That's the level of engagement we have, and that gives me the comfort and the transparency of our engagement, and that's what we're basing a lot of our forward-looking comments on.

Thank you, and congrats.

Thank you.

I would now like to turn the call back over to Mr. Hassan El-Khoury, President and CEO.

Thank you all for joining us today. I once again thank our worldwide teams for their hard work in driving our transformation solid and sustainable results. We have established a strong foundation of revenue, LTSAs, and funnel growth over the last few quarters to deliver a leadership position in the vehicle electrification ramps driven by our silicon carbide products, along with a broad offering of power semiconductor solutions to enable the rest of the vehicle. Along with our leadership in automotive safety with our sensing products, we have become the supplier of choice for all marquee names worldwide. We are very excited about the opportunity in front of us, and we remain focused on execution to make sustained progress towards our target financial model.

Thank you.

Ladies and gentlemen, this concludes today's conference call. You may now disconnect.