ON Semiconductor Corporation
Q4 2007 Earnings Call Transcript

Published: 3 Feb 2008

[Operator:]

Good day ladies and gentlemen and welcome to ON Semiconductor fourth quarter Earnings Call. (Operator Instructions). I would now like to introduce your host for today's release call Mr. Ken Rizvi. Sir, you may begin.

[Ken Rizvi:]

Thank you Matt. Good afternoon and thank you for joining ON Semiconductor's fourth quarter 2007 conference call. I am joined today by Keith Jackson, our CEO, and Donald Colvin, our CFO. This call is being webcast on the Investor Relations section of our website at www.onsemi.com and will be available for approximately 30 days along with our earnings release for the fourth quarter of 2007. Our earnings release and this presentation include certain non-GAAP financial measures. Reconciliations of these non-GAAP financial measures to the most direct comparable measures under GAAP are in our earnings release and posted on our website in the Investor Relations section. In the upcoming quarter we will present at the Morgan Stanley Technology Conference on March 4th, and the Citigroup Small and Mid Cap Conference on March 18th. During the course of this conference call we will make projections or other forward-looking statements regarding future events or the future financial performance of the company. The words estimate, intend, expect, plan or similar expressions are intended to identify forward-looking statements. We wish to caution that such statements are subject risks and uncertainties that could cause actual results or event to differ materially. Important factors relating to our business including factors that could cause actual results to differ from our forward-looking statements are described in our Form 10-K and other filings with the SEC. The company assumes no obligation to update forward-looking statements to reflect actual results, change in assumptions or other factors. Now let's hear from Donald Colvin our CFO, who will provide the overview of the fourth quarter of 2007 results. Donald?

[Donald Colvin:]

Thank you, Ken and thanks to everyone who is joining us today. ON Semiconductor Corporation today announced that total revenues in the fourth quarter of 2007 were $407.9 million. As anticipated, an increase of approximately 1% from the third quarter of 2007. Total revenues during the quarter included approximately $385.1 million of product revenues and approximately $22.8 million of manufacturing services revenue. During the fourth quarter of 2007, the company reported net income of $61.1 million or $0.20 per share on a fully diluted basis. Fourth quarter 2007 non-GAAP net income was $68.7 million or $0.23 per share on a fully diluted basis. On a mix-adjusted basis average selling prices in the fourth quarter of 2007 was down approximately 1% from the third quarter of 2007 The company's total gross margin in the fourth quarter was 37.3%, a decrease of approximately 130 basis points compared to the third quarter. Gross margins for product revenues were 39.4% during the fourth quarter of 2007 compared to 40.7% during the third quarter. The majority of this decrease was due to product mix and increases in manufacturing costs. EBITDA for the fourth quarter of 2007 was $95.5 million compared to EBITDA for the third quarter of $95.5 million. During the fourth quarter of 2007 the company used approximately $184 million of cash on hand to purchase the CPU Voltage and PC Thermal Products Group from Analog Devices. This includes amounts payable under a one-year manufacturing agreement. Even with this purchase, the company exited the fourth quarter with cash and cash equivalents of $274.6 million. At the end of the fourth quarter day sales outstanding were reduced to approximately 39 days. Internal inventories decreased slightly on a day's basis to approximately 79 days. Internal inventories in the fourth quarter include approximately $7 million of inventories acquired at part of the ADI acquisition. Distribution inventories were down slightly to just under 11 weeks. Cash capital expenditures during the fourth quarter were approximately $50 million. Now, I would like to turn it over to Keith Jackson for additional comment on the business environment.

[Keith Jackson:]

Thanks John. Now for an overview of our end markets, during the fourth quarter of 2007, we saw strong growth in our computing end markets, which grew by approximately 10% sequentially and represented approximately 27% of our product sales. Our second largest end market was the consumer end market, which remained relatively flat at approximately 24% of fourth quarter 2007 product sales. The wireless end market represented approximately 17% of fourth quarter product sales and was relatively flat on a dollar basis sequentially. The automotive end market was down slightly as anticipated and represented approximately 15% of fourth quarter product sales. The industrial and net working end markets were down slightly on a dollar basis in the fourth quarter and represented approximately 11% and 6% of product sales respectively. During the fourth quarter on a direct billing basis no product OEM customer was more than 5% of product sales and our top five product OEM customers were Continental, Delta, Motorola, Sony Ericson and Samsung. Our top manufacturing services customer was LSI as anticipated. On a geographic basis our contribution in this quarter from product sales in Asia excluding Japan were up 100 basis points and represented approximately 65% of product sales. Our product sales in the Americas decreased by approximately 200 basis points and represented approximately 17% of product sales. Sales in Europe stayed relatively flat and represented approximately 15% of product sales during the quarter and sales in Japan were up 100 basis points to 3% of product sales. Looking across the channels sales to the distribution channel were up by 200 basis points to approximately 50% of product sales. Direct sales to OEMs decreased by approximately 100 points to approximately 40% of product sales and the EMS channel decreased by approximately 100 basis points to 10% of product sales. During the fourth quarter product revenues broken out by our divisions were as follows

[Donald Colvin:]

Thank you Keith. Well we remain optimistic about our growth prospects for 2008. The market environment has become more challenging over the last few weeks. Historically any significant downturn in semiconductor has been prefaced by high levels of distribution inventory, stretch lead times, significant pricing pressure, and customer cancellations. To-date our distribution inventories have remained within our model at approximately 11 week for several quarters. Week times throughout 2007 remained roughly in the 8 to 10 week range. We expect less sequential pricing pressure in the first quarter of 2008 versus the first quarter of 2007, and first quarter 2008 revenues are expected to be higher than the first quarter of 2007. For the last few years, ON Semiconductor has generated strong earnings and cash flow from operations for our shareholders, significantly reduced our interest expense burden and improve the overall operations of the company. We understand there is much uncertainly from our investor base on the outlook for the US and the global economy for 2008, and the potential impact to semiconductor companies such as ON. To help ensure that we continue to generate strong cash flows and earnings for our shareholders, we intend to accelerate our standalone cost reduction program including a continued focus on the consolidation of our manufacturing operations. Over the course of the next 12 to 18 months, we've identified a total of over $40 million of additional annualized savings primarily in manufacturing cost, through actions that have been taken, and actions we expect to take. The rate of these savings is expected to increase over that period to generate greater than $10 million of savings per quarter. We also continue to be excited about our announced all stock acquisition of AMI. We believe our customers and shareholders will benefit from this transaction and continue to proceed with integration planning meetings to assess the timing of synergy and revenue opportunities post the transaction close. From our integration planning meetings, we have identified a significant amount of synergies and believe both sets of shareholders will benefit from the overall scale and improved cash flow generation capabilities of the combined company. So first quarter 2008 outlook. Over the last few weeks we have seen considerable uncertainty in global markets. We have no way of exactly determining the impact of these uncertainties on our business. We believe our business will be negatively impacted. We have updated our guidance to accommodate our best view today of the reduced outlook. Based upon product booking trends, backlog levels, anticipated manufacturing services revenue and estimated turns revenues, we anticipate the total revenues will be down approximately 3% to 7% sequentially in the first quarter of 2008. Backlog levels at the beginning of the first quarter of 2008 were down from backlog levels at the beginning of the fourth quarter of 2007 and represent over 90% of our anticipated first quarter 2008 revenues. We expect that average selling prices for the first quarter of 2008 will be down approximately 1% sequentially. We expect our total gross margin in the first quarter of 2008 to be approximately 3.5.5% to 36.6% and our product gross margins to be approximately 37.5% to 38.5%. We expect the purchase accounting rules associated with the recent acquisition of the CPU Voltage and PC Thermal Products group from Analog Devices will negatively impact total gross margins by approximately 50 basis points in the first quarter of 2008. This negative impact is already included in the gross margin guidance I just gave you. We expect cash capital expenditures of approximately $30 million in the first quarter and 2008 total cash capital expenditures of approximately $100 million to $110 million. For the first quarter we also expect total GAAP operating expenses of approximately $90 million 23% of revenue with SG&A expenses at approximately 12% to 13% of sales and the R&D expenses at approximately 10% of sales. The $90 million of GAAP operating expenses includes approximately $5 million associated with non-cash stock based compensation expense as well as approximately $5 million of incremental operating expenses plus $2.5 million from the amortization of intangibles associated with the acquisition of CPU Voltage and Thermal Products Group. We anticipate that net interest expense will be approximately $7.5 million for the first quarter of 2008 and taxes to be approximately $2.5 million. We currently expect total stock based compensation expense on a pre and post tax basis to be approximately $7 million in the first quarter of 2008 and this expense is included in our guidance. Our current fully diluted share current is approximately 301 million shares based on recent share price, which includes approximately 292 million of common stock and 9 million shares related to options convertibles and restricted stock. Further details of our share count and EPS calculations are provided regularly in our 10-Q's and K's. With that I would like start the Q&A session.

[Operator:]

(Operator Instructions). Our first question comes from Romit Shah of Lehmon Brothers. Your question please.

[Romit Shah:]

Yeah, thanks for taking my question. Just on the product mix, what surprised you last quarter and how does the mix impact gross margins in Q1?

[Keith Jackson:]

So in Q4 we saw sequentially weaker sales in the tester market, which impacts us specifically in our high frequency business, which has the company's highest margins. So we definitely saw a bit softening in that area. But frankly from a mix perspective that was probably the most significant impact. Gross margins overall were definitely impacted significantly by currency moves, where our manufacturing base is large and our sales in the same currencies are not as large. We saw some very dramatic devaluation of the dollar in those countries and it had a bigger impact than mix.

[Romit Shah:]

Okay, and then just on the manufacturing costs, they were little higher than you thought in Q4. Are they are up again in Q1 as well?

[Keith Jackson:]

The exchange rates will continue to work against us in Q1 we do have some pretty aggressive programs for cost reductions received, we can offset that. But certainly the combination of the exchange rates and some slightly lower volumes led to our guidance on gross margin in Q1.

[Operator:]

Our next question is from Craig Ellis of Citigroup. Your question please

[Craig Ellis:]

Thanks Don, to start off with, you mentioned $40 million of annual manufacturing cost savings. When would you expect to start to get the benefit of that and when will you be at full $10 million a quarter run rate.

[Donald Colvin:]

Yes, I think we said 12 to 18 months. So, I think we start to get a benefit at the end of this year and get a full benefit by the second half of next year. That was the best estimation.

[Craig Ellis:]

Okay and then you mentioned how pricing was looking versus going into the first quarter of '07. As you look at the backlog, are you seeing that same 1% quarter-on-quarter price decline is holding up or are you starting to see greater pricing aggressiveness forming in the backlog.

[Donald Colvin:]

As of today when we made the call we see the pricing guidance holding up. We don't see any negative trend there.

[Operator:]

Our next question is from John Barton of Cowen. Your question please,

[John Barton:]

Yes, thank you. Could you talk about the revenue expectation in your guidance that is being contributed from the acquisition from ADI product lines, please?

[Keith Jackson:]

Right now we're looking for something in low teens that is still not a certain number for us. There is a certain portion of the business that ADI does on the sell through basis and distribution. And so we need to get more specific numbers on what that impact is, but certainly we're seeing kind of normal desktop PC erosion in Q1, plus the impact of the sell through portion that we'll not get advantage of in Q1. So, kind of low teens for the first quarter.

[Donald Colvin:]

Now, looking Donald here John. looking at the business now we've had it for a month, we're pretty happy with what we got. The team is a great team and we think the products from this business can generate in the second half of the year higher gross margins than the corporate average. But before we've said that the first quarter will be a tough one because we have to transform from their model to our model and build up some inventory in distribution, because we go through more distribution than needed, so what makes it a bit more complicated to tie on the right number and we are not at the cruising altitude of profit in the first quarter, but this should be a business that can generate over $20 million of revenue per quarter at a gross margin enhancement to our normal business.

[John Barton:]

And those adjustments that you talked about Donald done by the end of the March quarter?

[Donald Colvin:]

This should – 80%, 90% done. There will still be because you have got to flow the inventory through distribution, there may be some residual carry forward in to the second quarter this should all be done by the middle of the year.

[Operator:]

Our next question's from Chris Danely of JP Morgan. Your question please.

[Chris Danely of JP Morgan:]

Hey thanks. Hey Donald and Keith can you just be a little more specific on what exactly has changed in last three weeks. Have you just seen customers getting more cautious they're trying to burn down inventory, are you seeing any push outs just a little more color on what's happened?

[Keith Jackson:]

I think there's two things have been going on Chris, one we have not seen the pull rates from our service programs out of the automotive sector. Normally Q1 is up for automotive and so we anticipated that that pattern would follow through, but quite frankly they are not pulling at the rates we anticipated. And then secondly the new bookings the turns bookings have definitely slowed here in the back half of January and so I think when you couple that with the overall macro environment we are just discounting as much turns as we would have anticipated earlier. So it's really caution on our part, because we are not seeing the economy support robust turns right now.

[Chris Danely of JP Morgan:]

So do you think it's more of the demand than an inventory problem?

[Keith Jackson:]

I definitely do. The only places we have seen any market inventories have been in the China local brands in handsets to any extent and while that is a significant business for us . It's not that significant in our overall inventory picture.

[Operator:]

Your next question is from Craig Berger of FBR. Your question please.

[Craig Berger:]

Good afternoon. Thanks for taking my questions. On the 50 bits of ADI impact, is that a first quarter only thing do we get those 50 bits back in second quarter or what happened there?

[Keith Jackson:]

Yes. The ADI should be more or less neutral to gross margin in the second quarter and from then onwards it will be enhancing to gross margin.

[Craig Berger:]

What do you view as the product margin associated with those products?

[Keith Jackson:]

I think we have said that that should be, the ADI business should be of 40% and closer to the mid-forties and that's definitely the kind of margin that we see in our book.

[Craig Berger:]

What should the share count be once you close this AMIS deal?

[Keith Jackson:]

Just over 400 million approximately between 405 million and 410 million shares is our best estimate.

[Operator:]

Our next question is from Tristan Gerra of Robert Baird. Your question please.

[Tristan Gerra:]

Hi guys. What percentage of your production was outsourced currently and what do you expect this percentage to be by year end assuming you stop migrating progression this second half?

[Keith Jackson:]

Yeah, so in the last quarter that number was approximately 21% and I will hope to exit this year at a rate that is kind of 3 to 4 points lower than that.

[Tristan Gerra:]

Okay, and given the outlook so far this year just for Q1 any change in terms of your utilization rates target for Gresham by the end of this year and also how much, any type of guidance in terms of Foundry revenues for this year?

[Keith Jackson:]

Yes so on the utilization for Gresham that outlook still remains very solid as you may remember most of that increase is coming from business we're transferring in from boundaries those programs are still on the same schedule as we discussed in our last few conferences we've attended and we have got qualification of our first product and our shipping that in our analog products out of Gresham now. So that looks pretty much on track what we've guided in the past and I believe our manufacturing service guidance for the year is approximately $60 million to $65 million.

[Operator:]

Our next question is from Kevin Cassidy of Thomas Weisel. Your question please.

[Kevin Cassidy:]

Thank you. Can you say on the CapEx expectation for 2008 does that include the acquisition of AMI?

[Donald Colvin:]

No, we gave guidance for standalone business. We do expect a small amount of capital expenditure from a, sorry I thought you meant AMI. The ADI includes, the guidance includes any capital for ADI. I stand corrected the 100 to 110 includes an allocation for minimal capital, mainly for testers and a little bit of office improvements from ADI. Yes.

[Kevin Cassidy:]

Okay, well I did ask about AMI.

[Donald Colvin:]

I am sorry. Okay AMI, No. These vehicles are always so close, so AMI no, but we can post acquisition at $20 million to $30 million, and a reasonable amount of capital in addition to the 100 to 110 that I guided.

[Kevin Cassidy:]

Okay, speaking of ADI. Do you know what the revenue was in the fourth quarter for that product that you acquired?

[Donald Colvin:]

We believe it was north of $20 million.

[Kevin Cassidy:]

Our next question is from Ramesh Misra of Collins Stewart. Your question please?

[Ramesh Misra:]

Good afternoon gentleman, first question was in regards to the ADI acquisition. Prior to the acquisition, you had expected that it would be accretive to gross margins. Now you are expecting it to be down 50 bps and contributing to 50 bps decline in Q1. Can you tell us if something changed or is this as a seasonality or is there some other factor specific to that ADI business you are acquiring?

[Keith Jackson:]

No, the deal hopefully, may be I wasn't clear enough. The deal will be accretive to gross margins and our outlook is that this business will run close to mid 40s and gross margins, were superior to 40% gross margin in the second half. But what happens because of the accounting rules you have to value the finished goods at market price and sell them at very, very low margins. As you, because we purchased finished goods, so, the first quarter is, if you like a bit, falsified from a margin standpoint and penalized from a overall gross margin standpoint, as we transit out their finished goods inventory at low margin. There will be a little bit of residual impact of that in the second quarter and once we get in to the third quarter it's on a good basis. And so the hypothesis that we discussed together in the past still stands and as I said we are happy as the financial justification for the transaction is intact.

[Ramesh Misra:]

So I guess it sounds like gross margin should be going up nicely in Q2 also can you talk about what's the transition plan of the ADI products in to the Gresham flab when do you anticipate 100% of the ADI products to move over to the Gresham and by when?

[Keith Jackson:]

So we have pre-purchased 2008 materials for that business from ADI. So for the remainder of the year we will be shipping materials out of analog devices wafer fabrication facilities going in to 2009 we would then be operating out of our foundries plus some residuals at an external foundry that they use for their thermal business today. So really it's a beginning it's Q1 of 2009.

[Operator:]

Your next question is from Steve Smigie of Raymond James, your question please.

[Steve Smigie:]

Great thank you. Just looking at some of your 10-Q's it sort of looks like your digital consumer product is one of your higher margin business. I am just curious you could talk a little bit of how that looks over '08. You take the products that ship in to that business and try to ship them into other end markets or you just try to grow the consumer business or am I thinking about that wrong?

[Keith Jackson:]

No you're thinking about that well. That business there largely today is wireless handset based and so what you have is products that are aimed at portable applications and so we are actually expanding that and see some good growth into the more portable entertainment areas as well as handsets and we continue to expand our product offerings there, which now are fairly complete in Audio and LED'S as well as the traditional protection and voltage management products.

[Steve Smigie:]

Okay, if I could take a swat at a couple of more or two more questions consumer questions. One would be what the mix within the consumer group is now, it seems like you are doing well in TV's and gaming systems and all that is it in one sort of end or one product category within consumer that's particular strong for you or is it all pretty evenly distributed?

[Keith Jackson:]

Actually it is fairly well distributed Steve, however we're seeing the strongest growth on a sequential basis now in the TV's. At least in the first half I would expect that to be mostly in the TV's and then secondarily in the portable entertainment arena.

[Steve Smigie:]

Then the last question is just, I think one of your competitors is picking up some share and power management on gaming systems. You guys have usually been strong in the gaming system. Are you seeing any new threat's there or are you actually seeing new opportunities?

[Keith Jackson:]

We are seeing new opportunities in gaming systems where we have traditionally not been strong and actually except to gain some share there this year and do not except substantially share losses in our existing platforms.

[Steve Smigie:]

Okay, thank you.

[Operator:]

Your next question is comes from Steven Park of Wedbush, your question please.

[Steven Park:]

Just had a quick question regarding the gross margins in the second half. So as the famous inventory issues goes away is that still -- can we still look at the 200 basis point kind of jump from kind of a Q2 to Q3 or is that going to be less than that you think?

[Donald Colvin:]

We'd like to avoid that kind of details like Q2 over Q3, but I think its fair to say that we do see throughout the year a 200 bps progression in our product gross margin 200 bps progression of product gross margin as we grow our top line and we benefit from the full margin of the ADI business.

[Steven Park:]

Just set of to another quick question. So are you seeing any excess inventory, you've got any of the product lines that you guys have, maybe more than other or do you have visibility into that right now?

[Donald Colvin:]

Well I think, I noted that is a concern for investors and I was trying to spell that out in my comments on the guidance and we really believe that our inventories are under control. In the second half of last year we never had any straight lead times. Lead times were constant, there was no froth in the market and there was no incentive for customers to build inventory. So both from an OEM standpoint from an internal standpoint and from a distribution standpoint we do not see any inventory overhang issue and our business has been a little bit weaker over the last few weeks. But we believe this has been as much a self fulfilling micro concern than anything else. Keith mentioned specifically certain areas like North American auto build that are much weaker than the normally seasonally but at start out we related to a slower consumption. And we are adjusting our costs associated with that, but we still believe the outlook is relatively flat, there is no big cancellations and no big question from others the backlog has filled in a kind of stable way for the second quarter and no big alarms there and hopefully the economic headache will be over by mid-year and we'll see a normal seasonal strength in the second half.

[Operator:]

Your next question is from Craig Berger of FBR. Your question?

[Craig Berger:]

I just said a follow-up on the $40 million of savings that you announced. Is that related to the ANS acquisition and did you guys save $50 on that before?

[Donald Colvin:]

Yeah, so the answer of that is independent of AMI acquisition, and so the comments we've made on AMI in the past are independent to that and it will add to that number.

[Craig Berger:]

So, should your organic OpEx go down through the year? We think about OpEx for '08.

[Donald Colvin:]

I think we gave a specific guidance to the first quarter. I think what you should see is that the OpEx as a percent of revenue will decline as we go through the year. The major delta of our operating expenses, Q1 over Q4 is related to the ADI acquisition and the associated amortization of intangibles. So, that is a step function delta in Q1. But as a percent of revenue our OpEx will fall throughout the year.

[Keith Jackson:]

And, Craig also those savings were not just OpEx. That's total savings including manufacturing cost.

[Craig Berger:]

What's the split between gross margins versus OpEx and also do you want the analyst to put the $2.5 million of amortization of intangibles above the line or below the line or below the line. Is it a pro forma number, how do you want us to treat that?

[Donald Colvin:]

Well, what we have always done and we've always reconciled as GAAP numbers to non-GAAP and we'll continue to do that. So in your GAAP numbers you should include it in your non-GAAP numbers you should exclude it when we did the serving of other companies and sister companies in the industry, I think 90% plus of sister companies excluded from the non-GAAP numbers.

[Craig Berger:]

And gross margin versus OpEx on the $40 million of savings?

[Donald Colvin:]

The $40 million of savings will probably be 75% gross margin COGS and 25% OpEx.

[Craig Berger:]

Thank you.

[Operator:]

Ladies and gentlemen this concludes our question and answer session for today. Thank you for participating in today's conference. This concludes the program and you may now disconnect. Good day.