ON Semiconductor Corporation

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Welcome to the On Semi second quarter 2022 earnings conference call. At this time, all participants are in a listen-only mode. After the speaker's presentation, there will be a question and answer session. To ask a question during the session, you'll need to press star 1 1 on your telephone. Please be advised that today's conference is being recorded. I would now like to hand the conference over to your speaker today, Parag Agarwal. Vice President of Investor Relations and Corporate Development. Please go ahead.

Thank you, Liz. Good morning, and thank you for joining OnSemi's second quarter of 2022 quarterly results conference call. I'm joined today by Hassan El Khoury, our President and CEO, and Ted Trant, our CFO. This call is being webcast on the Investor Relations section of our website at www.onsemi.com. A replay of this webcast, along with our 2022 second 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 is posted on the investor relations section of our website. Our earnings release and this presentation include certain non-GAAP financial measures. Reconciliation of these non-GAAP financial measures to the most directly comparable GAAP measures and the GAAP financial measures 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 or other forward-looking statements regarding the future events or the future financial performance of the company. We wish to caution that such statements are subject to risk and uncertainties that could cause actual results or events to differ materially from projections. Important factors that can affect our business, including factors that could cause actual results to differ from forward-looking statements, are described in our most recent Form 10-K and Form 10-Qs in other filings with the Securities and Exchange Commission and in our earnings release for the second quarter of 2022. 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 evils that may occur except as required by law. Now, let me turn it over to Hassan. Hassan?

Thank you, Farag, and thank you, everyone, for joining the call. Nearly a year ago to the day, we unveiled our strategy to deliver intelligent power and sensing technologies for the sustainable ecosystem fueled by high-growth megatrends in automotive, industrial, and cloud power. This meant that we would not only provide differentiated solutions for our customers, but that we would execute on our commitments to our shareholders. Today, we announced another quarter of record revenue, gross margin, and EPS, and I could not be prouder of the progress we have made. We achieved our first ever $2 billion revenue quarter with record revenue in the automotive and industrial end markets. As compared to last year's second quarter, our total revenue increased 25%, our non-GAAP gross margin expanded by 1,130 basis points, and our earnings per share more than doubled to $1.34 per share. In the face of challenging business conditions, our employees have maintained steadfast in their dedication to our customers, and I want to thank them all for their continued hard work and tenacity. Despite ongoing geopolitical and macroeconomic uncertainty, demand for products in our focus areas remain strong. Our automotive and industrial revenue now accounts for 66% of our overall business and combined grew 9% quarter over quarter and 38% year over year. This performance was driven by increasing adoption of our market leading intelligent power and sensing solutions in the fastest growing applications. We have seen a slowing demand in our non-core end markets, but demand from automotive and industrial continues to outpace supply. The volatility in energy markets and supply chain disruptions across the globe are driving an accelerated adoption of electric vehicles, alternative energy, and industrial automation. Our market-leading portfolio, coupled with the differentiated performance of our products and end-to-end capabilities, has distinguished OnSemi as a premier source for intelligent power and sensing solutions. and our customers are increasingly relying on us to enable their roadmap in a rapidly evolving market. While we are optimistic about our outlook, we remain sensitive to dynamic market conditions. The structural changes we implemented over the past 18 months to rationalize our product portfolio and optimize our cost structure have reduced the volatility in our financials, and we have positioned the company to be more resilient in all business environments. The nature of our customer engagements has evolved into strategic partnerships to support our customers' long-term technology roadmaps, advanced capacity planning, and supply assurance. Customers continue to expand the scope of their LTSAs to include OnSemi's entire portfolio of intelligent power and sensing solutions, which accounted for 66% of our total revenue in the second quarter, up from 62% a year ago. We have signed LTSAs, covering up to 200 parts across our entire portfolio, and for existing LTSAs, customers are still requesting additional near-term volumes and extending the duration of our agreements, in some cases through 2029. For their longer-term demand, they are co-investing with Onsemi in capacity expansion to secure their supply, which in turn improves our demand planning. We continue to make progress in our transformation journey to structurally improve the gross margin of the company. We have redeployed capital to high-margin, high-growth areas such as silicon carbide, and over the last 12 months, we have exited approximately $210 million in revenue at an average gross margin of 24%, of which $36 million occurred in the second quarter at an average gross margin of 34%. Despite a deliberate loss of non-core revenue, we have been able to grow at an impressive pace and offset these losses with new product revenue, which increased 35% year-over-year at favorable gross margins. Our intelligent power revenue grew by 31% year-over-year and 10% quarter-over-quarter, driven by the market-leading efficiency of our solution. The superior performance of our silicon carbide and IGBTs has enabled us to engage directly and sign LTSAs with leading automotive OEMs and EV disruptors across the globe. They rely on non-semi-silicon carbide expertise and end-to-end capabilities to help them achieve their electrification goal. Although internal combustion engine vehicle sales were nearly flat in 2021, EVs grew by 94% and are expected to grow at a CAGR of 22% to 45% of total light vehicle units in the next five years. Electric vehicles require up to $700 of incremental on-semi content for drivetrain and onboard charging as compared to an internal combustion engine car. As the transition continues to accelerate from ICE vehicles to electric, we expect to see steep growth in our intelligent power revenue for automotive. Our progress to our silicon carbide leadership is one that I'm especially proud of. We are seeing a steep acceleration in our silicon carbide ramp and have doubled our silicon carbide revenue quarter over quarter in the second quarter. We had forecasted to double last year's silicon carbide revenue in 22, and thanks to our global team's impressive acceleration of our capacity expansion plan and our latest customer engagement, we are confidently raising our annual projection to triple last year's silicon carbide revenue in 2022 and exceed $1 billion in revenue in 2023. Towards that end, we have also secured more than $4 billion of committed silicon carbide revenue through long-term supply agreements for the next three years as compared to the $2.6 billion we had previously disclosed. To support the steep acceleration in our silicon carbide revenue, we are rapidly expanding capacity across our sites. By the end of this year, we plan to quadruple our substrate output on a year-over-year basis, and we are adding capacity for wafering, epi, and modules at our various sites around the globe. Furthermore, we are adding 200-millimeter silicon carbide capacity at our existing fabs and we are on track to double our front-end wafer capacity by the end of 2023 as compared to that at the end of 22 and further double that capacity by the end of 24. Our energy infrastructure business is also growing at a rapid pace. With a year-over-year revenue increase of 61% due to we are on track to exceed our 2022 target of 50% growth year-over-year. As I indicated earlier, volatility in the global energy supply is driving rapid adoption of alternative energy, and with our broad portfolio of high-efficiency silicon carbide and IGBT modules, we are the key enabler in this market. We expect the alternative energy market to be a long-term driver for our business as utility-scale power plant installations grow rapidly worldwide, reducing both fossil fuel dependence and associated climate impacts. The top 10 solar inverter suppliers have more than 80% of the global market share, and OnSemi has signed long-term supply agreements with seven of them, totaling more than $1 billion in revenue. Beyond the LTSAs, we continue to expand our footprint in the alternative energy market, and in the second quarter, we secured a design win for our silicon carbide module for solar inverters with a leading global industrial OEM. While silicon carbide is the fastest growing part of our power business, our silicon power products remain integral to our intelligent power portfolio, with year over year growth of approximately 30% in our IGBT and MOSFET revenue. This growth was primarily driven by automotive and industrial, where higher efficiency of our products is a key differentiator. Our intelligent sensing revenue grew by 39% year over year, and by 10% quarter over quarter. The growth in our intelligent sensing was driven by both automotive and industrial end markets, which grew by approximately 60% and 30% respectively year over year. The steep growth in our automotive image sensors is driven by an increasing number of cameras per car, a mixed shift towards higher resolution and higher ASP sensors, and accelerating penetration of ADAS. One of the primary drivers of increasing number of cameras per car has been the efforts by traditional OEMs to match the ADAS and related safety features offered by disruptors and the new EV models. We are seeing increasing use of our image sensors to enable safety through the replacement of traditional mirrors by camera-enabled digital mirrors. We secured a design win for a digital mirror that incorporates four cameras for the rear and outside views. This mirror overcomes obstructions caused by passengers, headrests, and other objects and provides integrated rear view and side view for blind spot monitoring. We signed another LTSA to supply image sensors for a vision system to replace mirrors with cameras in commercial trucks. This system provides the driver with a more complete view of operating conditions over traditional mirrors and delivers improved driver vision and flight spot illumination. We entered into an LTSA with a leading manufacturer of agriculture equipment to supply our new super exposure flicker-free high dynamic range image sensor for targeted spray systems in weed elimination. A vision system comprising more than 30 on semi-image sensors identifies weeds and signals the nozzle control system to precisely spray herbicide in just the right quantity. This application sustainably eliminates the indiscriminate use of agricultural chemicals, enables savings of more than 75% of herbicide, and helps protect the environment. In the industrial and market, our growth is driven by industrial and warehouse automation applications. Our scanning business grew by 70% year-over-year, driven by strong traction of our image sensors in industrial and warehouse applications. This growth is driven by expansion and increased automation of warehouse by global e-commerce leaders. Our proprietary global shutter technology, which enables high-speed capture of images and low-light performance, coupled with strong technical support, are the key drivers of our leadership in this market. Our transformation journey is well underway, and we are aggressively hiring worldwide to keep up with our growth. Ansemi is driving disruptive innovation and energy in the semiconductor space. and the work we do matters for our customers, to our employees, and for the environment. We play a critical role in the most exciting megatrends that will define our future, such as electric vehicles, autonomous driving, robotics and automation, and alternative energy. There is no better time to be part of a growth story like ours, and I invite anyone interested in joining our talented team to apply online. Now, I will turn the call over to Thad to provide additional details on our financials and guidance.

Thanks, Hassan. Another quarter of record results clearly demonstrates our accelerating momentum in the fastest-growing semiconductor market and the progress we have made in our transformation. We are a stronger company today after having focused our strategy, redirected our investments, and doubled down on intelligent power and sensing solutions for the automotive, industrial, and cloud power markets. We rationalized our product portfolio by exiting price-sensitive products in favor of highly differentiated intelligent power and sensing solutions. Our worldwide teams are focused on operational efficiencies to reduce cost while we continue to make progress towards our fab lighter manufacturing strategy with the announced divestitures of two subscale fabs. The structural changes we have implemented over the last 18 months have significantly improved the predictability of our financial results and have positioned the company to consistently execute in dynamic market conditions. Our disciplined execution resulted in record financial performance for the last five consecutive quarters, and we are thrilled that the results of our transformation are being recognized by the financial and business communities. In a noteworthy milestone, Bond Semi has been included in the S&P 500 Index and recognized as a Fortune 500 company. We could not have achieved these results without the dedication of our worldwide team, and I continue to be impressed with their operational excellence quarter after quarter. To our employees around the world, thank you for your unwavering commitment to ensuring the success of our customers. We are seeing unprecedented demand for our products driven by accelerating megatrends of vehicle electrification, ADAS, factory automation, and energy infrastructure. In silicon carbide alone, we have LTSAs of more than $4 billion for the next three years. Our customers value the market-leading performance of our solutions, the breadth of our intelligent power and sensing portfolio, and our end-to-end manufacturing capabilities, and choose OnSemi as a strategic partner to enable their long-term technology roadmaps. Our focus markets of automotive and industrial grew by 41% and 34% respectively year-over-year to account for 66% of revenue as compared to 59% a year ago. We expect continued strength in the automotive and industrial end markets amid slowing demand for our non-core businesses, parts of which we are exiting to further achieve our transformation goals. We're also making progress on our sustainability initiatives. Last quarter, we published our sustainability report in which we reiterated our commitment to achieving net zero by 2040. We recognize the importance in doing our part for the environment as we deliver cutting edge technologies that enable our customers to create a sustainable future. In 2021, approximately 75% of our revenue was sustainable product revenue. We significantly reduced our water consumption compared to the previous year, and we are already making progress in reducing our greenhouse gas emissions. Our intelligent power solutions for electric vehicles, EV charging, and energy infrastructure are helping to slow the pace of climate change, and our intelligent sensing solutions enable automation and efficiencies, which in turn reduce energy consumption. Turning to results for the second quarter, As I mentioned, Q2 was another quarter of record results. Total revenue was $2.085 billion, an increase of 25% over the second quarter of 2021 and 7% quarter over quarter. This increase was driven by strength in our automotive and industrial businesses, which grew 38% year over year and 9% quarter over quarter. Our Q2 revenue was above the high end of our guidance range as we navigated the China lockdowns and recovered the impacted revenue late in the second quarter. Revenue from both Intelligent Power and Intelligent Sensing was at record levels. Intelligent Power grew by 31% year over year to 48% of revenue, and Intelligent Sensing grew by 39% year over year to 18% of revenue. All three business units reported record revenue in the second quarter, Revenue for the Power Solutions Group, or PSG, was $1.06 billion, an increase of 25% year-over-year, and achieving its first billion-dollar quarter. Revenue for the Advanced Solutions Group, or ASG, was $716.7 million, an increase of 18% year-over-year. Revenue for the Intelligent Sensing Group, or ISG, for the quarter was $311.3 million, an increase of 44% year-over-year. Gap and non-gap gross margin for the second quarter was 49.7%. Our non-gap gross margin improved 30 basis points quarter over quarter, primarily driven by a favorable mix of automotive and industrial markets, and despite a proactive slowdown in our wafer starts, which reduced our utilization from 81% in Q1 to 77% in the second quarter. Six quarters into our transformation, better control of our operational levers to optimize efficiencies, maximize output, and deliver for our customers and our shareholders. GAAP operating margin for the quarter was 28% and non-GAAP operating margin was a record of 34.5%. GAAP earnings per diluted share for the second quarter was $1.02 as compared to 42 cents in a quarter a year ago. Non-GAAP earnings per diluted share was $1.34 as compared to $0.63 in the second quarter of 2021. We relaunched our share buyback program and for the first time in over two years, repurchased 1.5 million shares for $89.7 million at an average price of $59.76 per share. This represents 44% of our free cash flows for the second quarter and there is $1.2 billion remaining on our authorized repurchase program. Now let me give you some additional numbers for your models. GAAP operating expenses for the second quarter were $453.1 million as compared to $357.9 million in the second quarter of 2021. Non-GAAP operating expenses were $317.7 million as compared to $314.2 million in the quarter a year ago. Non-GAAP operating expenses increased by $14.9 million sequentially, driven by hiring to support our growth. As I indicated in previous calls, OpEx will continue to trend higher as we bring in additional talent to support our growth. As we guided in the past, our non-GAAP tax rate will increase in 2022 as we have substantially utilized our NOL attributes. For the second quarter, our non-GAAP tax rate increased to 16.3% from 4.6% in the fourth quarter of 2021. This change accounted for 18 cents of VPS dilution in the second quarter and 34 cents year to date. Our GAAP diluted share count was 447 million shares and our non-GAAP diluted share count was 441.6 million shares. Please note that we have an updated reference table on the investor relations section of our website to assist you with calculating our diluted share count at various share prices. Turning to the Q2 balance sheet, cash and cash equivalents was $1.79 billion and we had $1.5 billion under on our revolver. Cash from operations was $420.8 million and free cash flow was $202.7 million and free cash flow on an LTM basis was 17% of revenue. Capital expenditures during the second quarter were $218 million, which equates to a capital intensity of 10.5%. As we indicated previously, we were directing a significant portion of our capital expenditures towards the capacity expansion of silicon carbide and enabling our 300-millimeter capabilities at the East Fishkill SAB. We expect to see a higher level of capital intensity in the second half of the year as we continue to invest in equipment and capacity expansion to support our growth. Accounts receivable was $1.1 billion resulting in DSO of 50 days. The sequential increase in AR was due to non-linear shipments as we recovered revenue late in the quarter from the China lockdowns. Inventory increased $67 million sequentially to $1.56 billion and days of inventory decreased by three days to 136 days. We continue to build inventory to support our fab transition in ramping silicon carbide. Distribution inventory decreased approximately $12 million quarter over quarter and remains consistent with Q1 at 7.1 weeks. We continue to maintain distribution inventory at historically low levels to hold more inventory on our balance sheet for our customers' needs rather than building inventory in the supply chain. Total debt was $3.2 billion, and our net leverage remains well under one. Turning to guidance for the third quarter, demand continues to outpace supply in our targeted automotive and industrial end markets, while there are pockets of softness in our non-core markets. Given the uncertainty in the macro environment, we are taking a conservative stance in judging down demand in our guidance for the third quarter. A table detailing our GAAP and non-GAAP guidance is provided in the press release related to our second quarter results. Let me now provide you key elements of our non-GAAP guidance for the third quarter. We anticipate revenue will be in the range of $2.07 billion to $2.17 billion. We expect non-GAAP gross margin to remain between 48% to 50%. This includes share-based compensation of $3 million. Although we continue to focus on long-term gross margin expansion and sustainability, our rapidly accelerating silicon carbide ramp will be diluted to gross margins by 100 to 200 basis points over the next several quarters due to the incremental startup cost as we scale the operation. We expect non-GAAP operating expenses of $319 million to $334 million to include share-based compensation of $21 million. We anticipate our non-GAAP OIE will be $24 to $28 million. For the remainder of 2022, we expect our non-GAAP tax rates to be in the range of 15.5 to 60.5%. and non-GAAP diluted share count for the third quarter is expected to be approximately 440 million shares. This results in non-GAAP earnings per share to be in the range of $1.25 to $1.37. We expect capital expenditures of $265 to $295 million in the second quarter as we ramp up our silicon carbide production and invest in 300 millimeter capabilities. In summary, The transformation of the company has enabled us to deliver outstanding financial results and at the same time reduce the volatility in our financials. With leadership and intelligent power and sensing solutions for the fastest growing applications in automotive and industrial, we are well positioned to deliver sustained long-term financial performance for our shareholders. With that, I'd like to turn it back over to Liz to open up for Q&A.

As a reminder, to ask a question, you'll need to press star 1 1 on your telephone. Please stand by while we compile the Q&A roster.

Our first question comes from Ross Seymour with Deutsche Bank.

Your line is now open.

Hi, guys. Thanks for letting me ask a question. I guess my first question is on the general macro trends and how you're reacting to them. You talked about a little bit of weakness in your non-core businesses, Hasan, and then Thad just talked about the utilization actually coming down sequentially. So how do I, in general, reconcile demand being greater than supply in your core businesses, weakness in your non-core, and kind of what does it mean to the ability to backfill on that given your utilization is dropping?

Yeah, look, not all capacity is fungible, obviously. So what we're doing is we're being very cautious in our inventory management. You know, you've seen our inventory go down in days. We're focusing our inventory on the strategic inventory in our core business and silicon carbide and the FAP transition. So that will remain. That side of the utilization is full. But as we see the softening in the economic and, you know, that said, our cautious outlook on the macro, which is built into our guide, we're taking measures as part of our resilience of our model that we've been talking about in good and bad times. And these are kind of the things we're focusing on to get through this and come out stronger.

Great. Thanks for that, Kala. Hasan, I guess, Thad, one for you on a little more specifically on the gross margin side of things. You talked about a bunch of different moving parts in your third quarter guide and then even over the next few quarters with silicon carbide being a point or two headwind to gross margin. Can you just walk us through the puts and takes? And I believe at one point you thought you could keep the gross margin relatively flat at this kind of 49-ish level for the next few quarters, even into the first half of next year. Is that still true?

Yeah, look, we're in our targeted range of 48% to 50% in our guidance. I noted that they got a headwind of 100 to 200 basis points resulting from silicon carbide. As Hassan mentioned, the silicon carbide is ramping faster than we anticipated even 90 days ago, and that's causing a dilutive impact. Silicon carbide products at scale are at or above the corporate average, so to achieve our goals there is primarily just the lumpiness of bringing capacity on and supporting that growth that gives us the headwind here. But we are still very happy that we can maintain margins at this level within our target range as we ramp silicon carbide. And by the way, bringing utilization down slightly to offset some of the inventory that Vaughn talked about as well. So I think, again, that shows the resilience in the model.

Thank you.

Our next question comes from Chris Dainley with Citi.

Your line is now open.

Hey, thanks, guys. Just to follow on Ross's question, so, you know, theoretically, when would gross margins bottom for both the silicon carbide and for the overall company?

Well, look, you know, we think we're, again, we're in our range, right? We think we're there. You know, there'll be some puts and takes over the next few quarters. We think we'll be able to maintain that range, you know, plus or minus. But, you know, I would call this kind of the rate at which you should be modeling.

Okay. And then as a follow-up, you talked about some, you know, macro issues in the non-auto and industrial business. Can you just expand on that? And are you guys, I guess, predicting that they will get any worse? Or have we seen the worst there? And does this have any impact on overall pricing for the company?

Yeah, this is a sign. Look, I don't know about getting better or worse. They're non-core. We've always said a lot of that business are the areas we want to exit. So we're taking utilization down as part of that strategy. It's not going to have an impact on margin from a dilutive side because I've always said, and I've been very firm even on these calls prior, we're not going to chase that pricing down. We are planning on exiting that business Therefore, you shouldn't expect any dilution on the margin because of it.

Great. Thanks, guys.

Thank you. Our next question comes from Vivek Arya with Bank of America. Your line is now open.

Thanks for taking my question. I wanted to dig in into your very strong disclosure on the silicon carbide side. If I got it right, I think, Hasan, you mentioned a billion dollars for next year. I think in the past you said a billion dollar exiting 23, and then probably more than 2 billion in perhaps 24, and then 4 billion in terms of run rate or pipeline. I forget the exact word you used, and I think that number used to be 2.6 billion. So I'm curious, what has driven the upside to your silicon carbide numbers to this extent? How much of this is autos? How much of this is expanding relationship with existing customers versus new customers? And then I had a follow-up.

Sure. Look, I've always said the strength of our silicon carbide starts with technology. And when I talk about technology, it's devices and packages. We have differentiated solutions that matter at the end system, meaning it translates into longer battery, longer range, whatever tuning the OEM would like for that specific platform. So that's consistent. That's now proven in the results that we've seen already beyond what we projected, but also in the outlook that we said. And you're right, the first disclosure that I put is I've always said we're going to double our silicon carbide in 22. I changed that to triple in 22 based on the strength that we're seeing already, even in the second quarter. So we're going to exit 2022 at a higher run rate than we expected. And then we're going to continue that growth in 23, which leads to the updated number that I've given on the billion dollar in 23. Now on the $4 billion, that's a mix of existing customer that started ramping, came back and deployed additional platforms on their LTSAs and some of them extended the LTSA But also within the quarter, we have extended the LTSAs with new customers and new platforms. So it is broad, it's geographically, and it's customer diverse. And some of it includes OEMs directly, and that's the level of strategic partnerships we have had. About 90% of it is automotive. And then you saw me talk about the solar side of it, or the renewable energy side, where we've also had LTSAs with the top seven. That's a slower ramp, obviously, than automotive. But nevertheless, that keeps pushing. So 90% of automotive strength and stickiness because of our technology across the board. And of course, we can't underestimate the end-to-end capability we have for the supply assurance.

And for my follow-up, how should we think about the percentage of insourcing versus outsourcing of substrates that it will take to achieve your $4 billion target over time? Maybe if you could give us a sense for how much of the substrate requirements are being met internally, and then how do you see that ratio go through time, and what that implies for your capital intensity over time? Thank you.

Yeah, so look, our capital intensity already has a lot of the expansion that we talked about. I've always said we're going to exit this year with a quadrupling of our substrate capacity after the GTAP acquisition. We're on track of doing that. That's going to fuel the growth in the subsequent years. And, of course, as we put that capacity online, the percent of internal is going to keep increasing into what we want, which is the majority internal. we're always going to have an external component of it because, you know, we don't build capacity for a max peak of a ramp. We build capacity for a steady state, so we're going to use external substrate if we need to to flex during a ramp. But other than that, I would expect the majority will be from our internal, and that's already counted in our CAPEX numbers. Thank you.

Thank you. Our next question comes from Toshi Ahari with Goldman Sachs. Your line is now open.

Hi, good morning. Thank you so much for taking the question. I've got two as well. First on gross margins, I guess a multi-part question. Thad, you mentioned that the gross margin headwind from the SIC ramp over the next several quarters to be one to two percentage points. I'm curious how the progression of that will look like, meaning should we expect 25 to 50 basis points of headwind every quarter, or is it more back-cap loaded? Any sort of shape of that headwind would be helpful. And then how should we think about ESK from an accounting perspective? How much depreciation would hit your P&L, and what are the implications for gross margins in first half of 2013?

Yeah, so this is that. Let me take those in reverse order. So EFK comes online in 2023, so you're not going to see an impact in Q3 and Q4, obviously. As we bring on the FAB, we'll be providing foundry services to global foundries for the next three years, which will wind down, as we've said. There is revenue associated with that boundary agreement, which is low margin. You can think about it as being boundary margins in the mid to high single-digit range. You can think about for 2023 as that being a headwind of somewhere around 40 to 70 basis points on a quarterly basis. And that's the impact of that. The rest of it we feel like we can offset, and obviously we get the efficiency of a better cost structure as we move more and more product into that fab over time as well. On the silicon carbide, as I said, 100 to 200 basis points of headwind. It is a little lumpy depending on the revenue and the timing of the equipment. We do believe we can keep the margins in this range of 48 to 50%. wind. You may see it move around a little bit, you know, plus or minus 50 basis points here and there, but we think we can be in that tight range even offsetting those margins. But it isn't necessarily linear from this point to 200 basis points. It's a little more fluctuation, and like I said, you know, you'll see a little bit of fluctuation on the gross margin line, but we don't think it's material, and we think we can offset it with other efficiencies.

A quick follow-up, Thad. The 40 to 70 basis point headwind from EFK, you know, should we expect you to hold the current range on gross margins even with that headwind, or could that drive another leg down in 2030?

No, no. Yeah, no, we believe we can offset it with other gross margin expansion initiatives and our FabLighter strategy. So, you know, even though it's a headwind, we feel like we can still maintain our margins in this range.

Okay, great. And then as my follow up, just on capital allocation, it was interesting to see you buy back stock in the quarter, just given sort of the CapEx ramp you spoke to in your in your SIC business going forward. Can you remind us how we should be thinking about the balance between investing in your business versus, you know, returning returning cash to shareholders and remind us how much cash you'd like to have on your balance sheet steady state? Thank you.

Yeah, look, you know, I don't think anything really changes with our capital allocation, right? We'll continue to invest back into our businesses, R&D, CapEx, you know, and obviously investing for our long-term growth. So that's our number one priority. You know, we've always said we want financial flexibility for M&A if there's some opportunity out there for us on that that fits our model. And then we would return cash to shareholders through the buyback. You know, we will obviously... pace each of those depending on the requirements. We've got a lot of CapEx requirements over the next several quarters. So we will be very disciplined when it comes to the capital allocation.

Thank you. Thank you.

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

Great, thanks for taking my questions. I think you said that your CapEx plans include some funding from customers. Can you perhaps detail how much of your CapEx plan includes such advances and how that influences your thinking about spending?

Yeah, so our CapEx doesn't change, right? We said we'd run around 12% for the next few years, and I think we'll still maintain that Funding from the customer offset that, but you don't see that through the CapEx. Our CapEx intensity doesn't necessarily change because we still report it that way. We do have customers that are co-investing with us for capital, in some cases some NREs, things like that, to invest in silicon carbide and other capacity that we're bringing online. That makes those customers much more sticky, and it's a good – just improve that relationship with that customer on a strategic basis.

And my follow-up, if I can, relates to the business that you intend to exit. Can you remind us how much of that is left after the current quarter? What's left to exit and maybe the pacing and margin of that, please?

Yeah, good question. So we've got, you know, roughly... around roughly $600 million left to exit. We've always said that would be market driven. We're pricing that at a position that as capacity comes back on and it's the price sensitive part of our portfolio that we would likely exit it. We haven't been exiting as fast as what we anticipated. Originally, we thought we'd exit about another $300 million in the latter half of this year. We think we're probably going to exit about half of that, so roughly about $150 million between Q3 and Q4, and then that obviously leaves a big slug for us next year as well in 2023. If the market gets softer faster, we could exit that faster. We've always said faster is better for us. We'll right-size our manufacturing and reallocate that capacity into automotive industrial. You can expect roughly, you know, kind of even, I think, you know, $75 million a quarter between Q3 and Q4.

And the margin on that, can you remind us?

Yeah, that margin is, you know, what we exited last quarter, I think it was about 34% margin. You can think about most of that today as kind of being in the low 40% range.

Thank you.

But that is the stuff that is highly price sensitive.

Great. Thank you.

Thank you. Our next question comes from Rajivindra Gill with Dietemann Company. Your line is now open.

Yeah, thanks for taking my questions, and congrats on navigating through this uncertain environment with really good results. Just another follow-up on the gross margins. If I add up the ESK headwinds of negative 40 to negative 70 basis points a quarter, you know, plus the Silicon Carbide startup cost, of negative 100 to 200, you're talking about anywhere between negative 140 to negative 210 basis points through headwinds to gross margins over the next several quarters. Stripping that out would put your gross margins above 50% on a more normalized basis. So my question number one is, that's still a significant headwind, if you combine the two, and yet you're kind of still talking about a 48% to 50% range. So specifically, you know, what are the drivers to offset that headwind, especially the fact if utilization rates are going to be dropping for some of the non-core business? I'm curious how you're able to offset those kind of several headwinds over the next several quarters.

Yeah, look, this is a sign. In the short term, obviously, those are the headwinds that we're offsetting through efficiencies that we have internally. I talked about new products ramping. So new products ramping outside of silicon carbide are accreted to gross margin. So we have a lot of these, you know, I always said thousands of line items that we keep working on in order to offset that. And over a longer time, that's going to take itself out with silicon carbide ramping, the dilution effect will get less and less as we ramp into that capacity and the same thing with efk where our foundry business to global foundry will be reduced year over year at quarter after quarter which will reduce that headwind so in the short term it's operational efficiencies that we are driving and longer term is structural as we grow into it and while we do that we're navigating the market like you've seen us do using utilization very carefully to balance between utilization and inventory building.

And thank you for that, Hasan. And just for my follow up, if you look at your auto business, it was $784 million in Q2 versus $556 million in June of last year. Taking out 2021 and 2020, which was during the COVID years, almost 80% above where it was at pre-COVID levels. So 440 million in June of 2019. Now you're doing 784 million, if you look at it from that perspective. So obviously the units have been kind of declining since 2019. I know the content is very strong, but just wondering how you're able to get this kind of outsized growth, even from kind of pre-COVID levels, what's happening with respect to pricing and how much of that pricing scenario is going to be sustainable as we go into next year? Thank you.

Yeah, that's a very good question because that's something I look at internally. So from the units perspective, you can't really linearize the units because A lot of the things we have been exiting also, when we talk about not just the non-core market, but also non-differentiated products, a lot of it is that very, very high volume, very, very low ASP business that we have been exiting, which some of it is going into automotive. So from a unit decline, I review that. The only thing I look at that is how to balance the manufacturing into our fab lighter strategy. So that's one thing here. But a lot of the new products that we are shipping are higher ASP but not as much volume. Think about IGBT modules, think about silicon carbide module, much higher ASP and much lower volume. The second part of the growth is if you compare the EVs built back into – if I go back to 18, if you want to do that as the baseline, EV units are much, much higher percent of total units built than they were three years ago, even when they were last year. So a lot of that is the content. Then, of course, you have the pricing stuff, which I've always said is some of it is we're pricing ourselves out of the market, and that's the stuff we're not going to chase down, and that's sustainable as far as margin, not sustainable from a price perspective, and that's expected. But the price-to-value discrepancies that we have been doing is sustainable, And the way I monitor that is, one, the LTSAs that customers are signing, which include volume and price over the length of the LTSA. And even in my prepared remarks, I talk about customers coming in and wanting to extend those LTSAs beyond the original timeline that they had. And the LTSA is not about image sensor or silicon carbide or highly constrained. It's You know, some of them have 200 parts from on semi. So customers are valuing the whole portfolio. They're valuing where we are economically, even with the price-to-value discrepancies, because we started way below market. And that is sustainable, one, from the LTSA side, and two, I know kind of a feel of where we are versus the market, and we're not an outlier.

Thank you.

Thank you. Thank you. Our next question comes from Gary Mobley with Wells Fargo.

Hi. I believe that was me, Gary Mobley, Wells Fargo Securities. I apologize if otherwise. But I had a multi-part question on silicon carbide. And so I'm wondering what your view is on silicon carbide's contribution to gross margin over the long term. Will it be at corporate gross margin when that business is billion dollars plus next year and with respect to silicon carbide materials capacity or supply I believe there's a there's a constraint situation in that market today and and so I'm wondering if that's contemplated as well into your fiscal year 23 outlook yeah the the silicon carbide as we said is at or above the corporate average gross margin at scale

we believe for the next several quarters we're going to have the headwinds of 100 to 200 basis points. But I think, you know, if you think about late next year, that headwind should be behind us, and we will be achieving those gross margin targets at that time.

Yeah, look, from a supply-demand perspective, it's hard to make silicon carbide, and it sure is a heck harder to scale it at the pace we are scaling it. Based on the acceleration of the EV penetration into total vehicles made, we do see, and I think that comment is supported by some of the industry analysts out there, silicon carbide is going to remain constrained in the foreseeable future, and that's why our focus is on investing heavily into that capacity, ramping that capacity as hard as we can, and supporting our LTSA customers And that's the reason you've seen an increase in LTSA customers that are signing up with committed revenue because they want to get that capacity. They want to have us invest in that capacity so we are there when they need to ramp versus them having to scramble. The last thing they want is announced EV aspirations and not have the main event that drives the car. So we're working with our customers to support their EV ramps. And we do that through LTSAs, and we do that through heavy investments in order to increase the pace. That's what we need.

Appreciate that, guys. As my follow-up, I wanted to ask about what's embedded in your third-core guidance with respect to some of the end markets that may be showing some softness. In particular, I'm curious to know what your exposure is currently between consumer PCs and smartphones. Can you remind us of that?

Yeah, look, when we think about the guidance going forward, we believe that auto and industrial continue to be supply constraints. So we believe that auto is up more than our guidance. We think that industrial is flat to up, and we think the other markets are potentially down, and that's the conservative in our guide there. We don't break out between those various markets. They're not strategic to us, and part of where we're seeing the softness is the non-core business that we're hoping to exit. So if that does get softer faster, that could allow us to exit even quicker.

Thank you. Thank you.

Our next question comes from Joseph Moore with Morgan Stanley. Your line is now open.

great thank you um staying with the silicon carbide topic you know if i add up kind of the numbers you're talking about and i look at the numbers that your top four or five competitors are talking about we're getting to numbers that are much larger than kind of the third party estimates for silicon carbide so i assume that's that the market is growing faster than the third parties success but i would have thought we were constrained by battery capacity and just kind of the general ev and battery power capability of your customer so You know, do you think the market is expanding that much more rapidly versus on success within the market? And do you think some people might be overly optimistic about how big this could be?

Yeah, look, one thing history has taught me is external reports are accurate backwards looking, not so much forward looking. The numbers I'm putting together, and I'm sure some of my peers do that, are bottom, for us, I can speak specifically, they're bottoms up number. They are numbers that are uh under long-term supply agreements and remember we always talk about those are committed revenue it's not i don't talk about funnel i don't talk about you know projections of what conversion is going to be these are long-term supply agreement contractual documents between us and the customer stating by year and some of them by quarter about what the rank profile and we have identified vehicle platforms that we're working on with the customer where that silicon carbide is going to go into So from the on-semi side, I can speak very comfortably about the ramp that we are seeing because that's what we're working on. Now, from what de-risks the ramp and the market in general is the geographical and the customer slash platform diversity that we have engaged in, where if there's one model that doesn't ramp the way they expect, there will be another model that will ramp faster than they expect. Because for us, the LTSA, especially the ones with an OEM, are at an OEM level, not necessarily at a model level. So that's how we balance the risk. A lot of the strategics that we are working with, you know, we always look at overall capacity from a battery perspective because that will be kind of the secondary bottleneck. A lot of these OEMs have committed battery capacity, and, you know, they've made their own disclosures, so I won't comment on that. So from a ramp perspective, it is ahead of where we even thought. There is an acceleration in silicon carbide that we have seen in our current revenue and have seen outlined in our projection with the long-term supply agreement. But we're ready for it, and our customers have everything else they need to ramp up that volume.

Great. Thank you very much. And just a quick follow-up, kind of more of a housekeeping thing. Is the treatment of the startup expense in silicon carbide sort of similar gap versus non-gap, or are there any big differences we should be aware of?

All of our startup costs are in our non-gap results, so we don't exclude anything. That's the headwind.

Great.

Great. Thank you very much. Thank you.

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

Yeah. Hey guys, I had a quick one. When I talk to investors that are negative or bearish on the stocks, they often bring up the fact that you guys might have been involved in raising prices a lot more aggressively than some of your other competitors. I was curious, Hasan, if you could walk me through how things work in real life in a business. Is that even possible that you are super aggressive in raising prices and maintain, you know, maintain business with our customers? or do you risk losing business? I was just curious if you can give me puts and takes on that angle, and then I've got a quick follow-up.

Yeah, look, I'll give you, I've been very straightforward about this. There's two components of this. I'll talk with the easiest one first. We've always been very straightforward and direct about the fact that in non-core business that we plan to exit, we price ourselves out of the market. That's one way to exit that business is by pricing yourself out of the market. So that, I would say, If that's where you're hearing it from, that would be true. And it's not a risk of losing business. It's the intent of losing the business. And we've had that intent, and we even disclose it in our prepared remarks of how much we lost and how much we intend on losing. So that's one side of it. The other side, which is more on the value strategic, as I talk about the price-to-value discrepancy, I don't think there's a risk of losing that business, especially with the fact that a lot of these products, the value products that we supply to our customers, after the price actions that we've taken, we still remain committed to them and we have them under LTSAs with our customers. That tells you that our pricing is not out of line. Otherwise, why would the customer want to sign up for it, one? And two, why would they want to come back and extend that? Now, relative, and it's all relative, you know, maybe the percent that you hear that we've raised higher may be higher than as a percent than some of our peers have done. I don't know what they've done. I don't know what talk is in the market. But you also have to remember where we started from. In a lot of areas, and I have that data that we're acting on, we have been pricing way below market. So getting it back to market may be a bigger percent, but it doesn't mean that you're above market. And the data and the commitments from our customers prove that from an external view.

Hey, thank you very much, Ishan. That was very helpful. And then as a follow-up real quickly, there's a lot of chatter, a lot of talk, not from you guys, but from everywhere else about a Tesla contract possibly. Are you willing to talk about that at all? And is that a part of the billion dollar 2023 goal? That's another question we get from investors a lot.

Look, I will maintain my policy of not commenting on specific customer engagement or customer ramps. So I'll leave it at that.

Fair enough. Thank you, Hassan. Congrats, guys. Thanks.

Thank you. Thank you.

Thank you. Our next question comes from Matt Ramsey. Rick Cowan, your line is now open.

Thank you very much for squeezing me in, guys. Good morning. I wanted to ask on the silicon carbide business, as you get to sort of this billion dollars in scale and continue to scale beyond that, Hasan, you mentioned that this is going to be sort of a historically quick volume ramp of a new technology that's no doubt complicated to get to yield and to scale. So what I would like to understand a little bit more about how your agreements with your customers, obviously, if there's upside to your ability to scale yields and volumes, then great, you'll be able to fulfill all that. But is there any sort of, I don't know what the right term would be, risk sharing in some of these agreements in case the yields maybe don't come through as you guys planned? It's great that you're winning all this business. I'm just trying to figure out how you might risk mitigate some of the volume ramps and the yield ramps as this technology scales. Thanks.

Let me put it this way. We have enough data, and we've been in this business for long enough to have a very solid baseline and a very solid learning, call it, slope. Whether it's yield, whether it's bull growth, whether it's ramp, et cetera, I'm very, very comfortable with our commitments to our customers. I would say the way we look at it is equal upside-downside. I'm not concerned about it. We look at it as equal upside-downside. I'm not concerned about that. My main focus is not on the technology and what the technology is outputting. Right now, it is putting the equipment in place, ramping that equipment, and we've done a great job at that so far and we're going to continue to do that. But the biggest thing for us is ramping the baseline that we've already established. We have a great product and very good yield that has been and already is in production.

Thanks for that. It's great to hear. I think that from my conversations anyway, I think that's sort of the last hurdle to get investors across is just the confidence in those metrics.

Yeah, I'm not worried about the metrics. I personally review those metrics. I'm a technology person other than a CEO, and we have a solid outlook with the solid financials

Thanks very much. A quick follow-up for Thad. I got a couple of questions this morning on the receivables and DSO lines jumping up a bit in the quarter. If you had any context there, I'd appreciate it. Thank you.

Yeah, absolutely. As I mentioned in the prepared remarks, we recovered from the China lockdown. So if you look at our revenue for the quarter, it wasn't linear. because of that. So it was very back-end loaded, which caused AR to go up and DSO to go up. But it's temporary, just as it takes time to collect that cash. But natural in terms of, if you look at the slope of linearity throughout the quarter being back-end loaded. Don't expect that to continue now that we've fully recovered that revenue from the China lockdowns, and we're not seeing any impact going forward, knock on wood here. But that's the reason. It's purely temporary.

Thanks, guys. Congrats on all the progress.

Thank you.

That concludes today's question and answer session. I'd like to turn the call back to Hassan Elkhoury, President and CEO, for closing remarks.

Thank you all for joining us today. We delivered outstanding results in the second quarter, and I again want to thank our worldwide teams for their commitment to excellence as we execute our strategy. While we have exceeded our expectations, we are nowhere near the full potential of OnSemi. With accelerating growth in our silicon cards and the fastest-growing megatrends, we are on a path to deliver sustained, above-market revenue and earnings growth. We look forward to seeing you at various investor events during the quarter. Thank you.

This concludes today's conference call. Thank you for participating. Now disconnect.

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