ON Semiconductor Corporation
Q1 2010 Earnings Call Transcript

Published: 6 May 2010

[Operator:]

Good afternoon. My name is Julienne, and I will be your conference operator today. At this time, I would like to welcome everyone to the ON Semiconductor First Quarter Earnings Conference Call. [Operator Instructions] I would now like to turn the conference over to Mr. Ken Rizvi. Please go ahead, sir.

[Ken Rizvi:]

Thank you. Good afternoon, and thank you for joining ON Semiconductor's First Quarter 2010 Conference Call. I'm joined today by Keith Jackson, our President and CEO; and Donald Colvin, our CFO. This call is being webcast on the Investor Relations section of our website at onsemi.com and will be available for approximately 30 days following this conference call, along with our earnings release for the first quarter of 2010. The script for today's call is posted on our website and will be furnished via Form 8-K filing. Our earnings release in this presentation include certain non-GAAP financial measures. Reconciliations of these non-GAAP financial measures to the most directly comparable measures under GAAP are in our earnings release and posted separately on our website in the Investor Relations section. In the upcoming quarter, we will be hosting our annual stockholders meeting on May 18. During the course of this conference call, we will make projections or other forward-looking statements regarding future events or the future financial performance of the company. The words believe, estimate, anticipate, intend, expect, plan or similar expressions are intended to identify forward-looking statements. We wish to caution that such statements are subject to risks and uncertainties that could cause actual events or results 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, Form 10-Qs and other filings with the SEC. The company assumes no obligation to update forward-looking statements to reflect actual results, changed assumptions or other factors. Now let's hear from Donald Colvin, who will provide an overview of the first quarter results. Donald?

[Donald Colvin:]

Thank you, Ken, and thanks to everyone joining us today. ON Semiconductor Corp. today announced that total revenues in the first quarter of 2010 were $550.2 million, an increase of approximately 11% from the fourth quarter of 2009. During the first quarter of 2010, the company reported GAAP net income of $63 million or approximately $0.14 per diluted share. The first quarter 2010 GAAP net income included net charges of $22.3 million or $0.05 per fully diluted share from special items, which are detailed in schedules to our earnings release. First quarter 2010 non-GAAP net income was $85.3 million or $0.19 per share on a fully-diluted basis and includes stock-based compensation expense. As anticipated, in the first quarter of 2010, we did not see the approximately $0.03 per fully diluted share benefit from the receipt of research and development grants and an actuarial gain on our overseas pension plans that we benefited from in the fourth quarter of 2009. In the first quarter, we closed the acquisition of California Micro Devices for approximately $113 million. As of the transaction close, CMD had approximately $43 million of cash and cash equivalents on its balance sheet. Due to the transaction closing within the quarter and acquisition-related accounting, we recognized approximately $6 to $7 million in revenue from CMD. On a GAAP basis, net income was negatively impacted in the first quarter by approximately $9 million or $0.02 per fully diluted share due to acquisition-related costs such as restructuring, transaction-related legal and investment banking costs, expensing of appraised inventory fair market value step-up and amortization of intangibles. On a non-GAAP basis, net income was negatively impacted by approximately $3 million or approximately $0.01 per fully diluted share primarily related to deal-related expenses such as legal and banking fees, which negatively impacted operating expenses during the quarter. We exited the first quarter of 2010 with cash and cash equivalents of approximately $560 million. This was down slightly from the fourth quarter of 2009 due to the cash purchase of CMD. Our Board of Directors approved a prepayment of approximately $170 million of our senior secured credit facility, which will occur in the second quarter of 2010. This is a significant milestone for the company as this facility, through various amendments, has remained with the company since the original LBO (leveraged buyout) more than a decade ago. Based on current LIBOR rates, this prepayment will save the company approximately $3.4 million per year in cash interest expense. At the end of the first quarter, total days sales outstanding increased from the fourth quarter by approximately two days to approximately 50 days. ON Semiconductor's internal inventory increased slightly from fourth quarter levels on a days basis to approximately 84 days. Included in our total inventory, our internal inventory, is approximately $2 million of inventory written-up to fair value related to our acquisitions and approximately $5 million of inventory from our acquisition of CMD and $21 million of bridge inventory related to our announced closure of front-end manufacturing lines. Net of the bridge inventory, CMD and written-up to fair value inventory, days would have been approximately 76 days at the end of the quarter. Distribution inventories were at the lowest level in the company's history, exiting the first quarter on a weeks basis at less than eight weeks. Cash capital expenditures during the quarter were $41 million. We currently anticipate spending approximately $130 million to $160 million in cash capital expenditures related to equipment for 2010. This is an increase from prior estimates based on our customers' strong demand expectations for the second half of 2010. In addition, we plan on spending approximately $30 million of capital for buildings to enable office consolidations in the Bay Area and assembly and test consolidation from two locations to one in the Philippines. Now, I would like to turn it over to Keith Jackson for additional comments on the business environment.

[Keith Jackson:]

Thanks, Don. Now for an overview of our end markets. During the first quarter of 2010, our end market splits were as follows

[Donald Colvin:]

Thank you, Keith. Based upon current product booking trends, backlog levels and estimated turns levels, we anticipate that total revenues will be approximately $565 million to $580 million in the second quarter of 2010. I also remind the listeners that ON Semiconductor recognizes revenue on a sell-through basis, not on a sell-in basis. Backlog levels at the beginning of the second quarter of 2010 went up from backlog levels at the beginning of the first quarter of 2010 and represent over 90% of our anticipated second quarter revenues. We expect the average selling prices for the second quarter will be down approximately 1% sequentially. We expect cash capital expenditures of approximately $45 million to $55 million. For the second quarter, we expect GAAP gross margin of approximately 41.5% to 42.5%. Our GAAP gross margin in the second quarter will be negatively impacted among other things, from expensing of appraised inventory fair market value step-up associated with our acquisitions of approximately $3 million. We expect non-GAAP gross margin of approximately 42% to 43%. We also expect total GAAP operating expenses of approximately $138 million to $142 million. Our GAAP operating expenses include the amortization of intangibles, restructuring, asset impairments and other charges which totaled together approximate $10 million. We also expect total non-GAAP operating expenses of approximately $128 million to $132 million. We anticipate GAAP net interest expense and other expenses will be approximately $17 million for the second quarter, which includes non-cash interest expense of approximately $7 million. We anticipate our non-GAAP net interest expense and other expenses will be approximately $10 million. GAAP taxes are expected to be approximately $4 million, and cash taxes, $3 million. We also expect stock-based compensation of approximately $13 million to $14 million, of which approximately $3 million to $4 million is expected to be in cost of goods sold and the remaining in operating expenses. This expense is included in our non-GAAP financial measures. Our current fully diluted share count is approximately 445 million shares based upon the current stock price. Further details of our share count and EPS calculations are provided regularly in our quarterly and annual report on Form 10-Q and Form 10-K. With that, I would like to start the Q&A session.

[Operator:]

[Operator Instructions] Your first question is from the line of Tristan Gerra with Robert W. Baird.

[Tristan Gerra:]

I think you previously said you have over $600 million in front-end capacity. As your revenue guidance gets you closer to that run rate, what are your plans with your capacity versus just efficiencies? And also, do you have any plans to move to 0.23-micron at Gresham any time soon?

[Keith Jackson:]

Okay, Tristan. On the capacity front, we certainly have that. Actually, it exceeds that number if you fully load Gresham and you use our external network. So that number we've given you is really an internal number. We've been investing capital in all of our front-ends this year, with the exception of one. And that capacity has been coming on a little bit each quarter, and it will continue to expand through the third quarter of this year. So that capacity is expanding as we go forward. Relative to the line widths in Gresham, we do have a process, actually its a 110-nanometer process that is now being made for our ASIC products. But the bulk of that material running in the factory today is at 0.35-micron or at 0.25-micron.

[Tristan Gerra:]

And could you remind us what the utilization rates are at the front end for the overall company and also for Gresham marketing?

[Keith Jackson:]

So overall, utilization for the company is about mid-90s for first quarter. And again, I expect it will remain in that range. As the capacity is coming in and the revenue is ramping up, it should be fairly close in nature.

[Operator:]

Your next question is from the line of Parag Agarwal with UBS.

[Parag Agarwal:]

First question is about your lead time. Can you give some more color as to where do your lead time stand and what are the constraints in capacity or any back-end capacity you're seeing right now?

[Keith Jackson:]

Our lead times have extended from the fourth quarter of 2009 as the order patterns continue to strengthen and be quite strong. The lead times that we normally quote are now out close to 18 weeks, but I would remind those that are following us that most of our customer base, something like 80% of our customer base, has a special logistical and supply chain programs, which is not subject to those lead times. So really those are for those that do not have specific logistics programs set up for them.

[Parag Agarwal:]

And secondly, you alluded with strong second half. Could you comment on the seasonality of second half as we could expect this year versus the previous years?

[Keith Jackson:]

So our backlog, as we look good at this time with the quarter end of Q3, continues to show positive progression. At this stage, certainly, it's too early for me to call it a half, but the third quarter, at this stage at least, is showing the normal patterns of being up from the second quarter on a backlog basis. So again, we're not going to give forecast for the second half, but we have no indication that this year will be much different than other years.

[Parag Agarwal:]

What could be the potential impact of expensing dollar on your business?

[Keith Jackson:]

So we're already seeing some of the impact in our ASP numbers that we report as the euro weakens. It does look like there's a little bit of ASP weakening that happens with our business there in Europe. But at the same time, our expenses in Europe should be coming down as well. So at the bottom line, we don't really expect a significant impact, but within the various lines, ASP would show an impact with a strengthening dollar on the ASPs and then the expenses, hopefully -- which should be offset by expenses coming down.

[Donald Colvin:]

And we have two major manufacturing sites in Europe plus some design centers, and as Keith mentioned, the European sales are, I think, 17% or something of our total revenue, of which less than half of that is invoiced in euros. So on actual fight [ph] , net-net is probably slightly positive, more savings and expense are offsetting a slight reduction in revenue.

[Operator:]

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

[John Pitzer:]

You said in your prepared comments that distribution inventory is at all-time lows. I'm just kind of curious as given how tight things are and how strong demand appears to be, why aren't the distribution companies trying to build more inventory? What's your expectation for that channel as we move into the June quarter?

[Keith Jackson:]

Okay, I believe they would like to build more inventory. I've had dialogues with each of them. They would love to see more inventory. They are not able to fully support the demand that they see at the levels of inventory that the industry is supporting. But frankly, their capacity is just not there to build inventories with the in-demands being as strong as they are. So there was a very slight distribution gain for us in total dollars in Q2, but for many weeks, it went down. So the demand is ramping faster than we can ramp is the simple answer to the question.

[John Pitzer:]

And then, Keith, as a follow-on, how comfortable are you when you move one space ahead of the distribution channel that there is not a brewing inventory issue? And then on similar vein, you talked a little about pricing on the last question and pricing on the mixed-adjusted basis was down a little bit in March. You expect it to be down in June. I guess my question to you is with utilization rates in the mid-90s, why not be a little bit more aggressive trying to price higher as a way, one to get more value but two, also, maybe shake out some double ordering and/or potential inventory building?

[Keith Jackson:]

We are taking up prices on anything that is not under contract. The prices have been going up. And that's built-in to the forecast. We do have annual contracts with many of the large customers and quarterly with others. What you're seeing there in our forecast does have a lot of assumption on currency changes. We are seeing the dollar strengthening. So that's built-in to the forecast. But also, just a matter of, again, how many contracts can you move, how quickly. So we are definitely seeing a strengthening environment. We are definitely taking our prices up, specifically through distribution, those prices have been going up steadily every few months.

[John Pitzer:]

Donald, I missed your dollar amount for CMD in the quarter, and I guess as we think about June, how much revenue contribution will you get from that acquisition?

[Donald Colvin:]

I think we mentioned about $7 million, $6 million, $7 million in the quarter from CMD. And in June quarter, we're expecting about $13 million, $14 million, and the contribution from that will be minimal simply because it's going to take us time to integrate it into our system. And just a quick follow-on to Keith's comment on the ASP, I mean historically, it's like a supertanker, it takes time for that to turn around. You've got this [ph] inventory, you've got these contracts. So basically, once you start the actions, it's usually the third quarter out six months away before you see the full benefits. So what I would remind you is that the rate of decline has come down this quarter. I personally think it will be under 1%. So really, we should start to see the benefits of what Keith mentioned and you asked starting in the third quarter.

[Operator:]

Your next question is from the line of James Schneider with Goldman Sachs.

[James Schneider:]

I guess, maybe, to return to the topic of lead times for a second. Obviously, they are extended out a little further. When do you expect you'll be able to start bringing those back in? Do you think it will be this quarter or do you think it may be out further in the back half of the year?

[Keith Jackson:]

Unfortunately, that requires me to guess at what the order rates will be in the back half of the year. But if we see the current levels of demand as we're seeing today in the second half, I would expect to start bringing them in slightly before the end of the year.

[James Schneider:]

And then on it's follow-up, we believe the end market exposure, auto and industrial have been clearly very strong over the past couple of quarters. Do you expect that as we get into what's typically seasonally softer back half of the year that we could see some softening just seasonally there? Or has that continued to be strong for you in the back half?

[Keith Jackson:]

It continues to be strong. What we're seeing there in both of those markets are new designs focused at energy efficiency, displacing older designs. Those have more semiconductor content and specifically, more content from ON. And so everything we're hearing from our customers in both of those segments indicates that they should remain strong even in the second half, where those sectors typically weaken a bit.

[Operator:]

Your next question is from the line of John Barton with Cowen.

[John Barton:]

Keith and Donald, I heard both of your comments about ASP trends and going up going forward, the lag time, et cetera. Could you quantify what type of appreciation you think we could see in ASPs, and the real root of the question is we did not see a collapse in the downturn of ASPs. So my assumption would be it would not bounce back with the same magnitude or appreciate that same magnitude as previous cycles and be interested on your thoughts on that?

[Keith Jackson:]

Yes, I think that's a fair statement. To move something of a magnitude that we've got with 16,000 products and 9 billion units a quarter, those just don't jump a lot. But what we've experienced in the past, probably the peak quarter-on-quarter changes were about 2% to 3% in either direction, sequentially. But specifically, I don't think we've ever turned in more than 3% up in a quarter.

[John Barton:]

And you commented on the lead time extending to 18 weeks for customers that weren't on logistics programs, I assume you mean consignment hubbing et cetera. For those customers that are in those programs, how quickly can you respond or have you been responding to upticks? I mean, what is their lead time? And then the second part of the question is some of your competitors have left the quarter with delinquent backlogs. Have you been able to take advantage of that as far as gaining share of customers?

[Keith Jackson:]

Yes. Unfortunately, our capacities are finite and we are not able to pick up as much as we'd like on that, John. What I would say is that for the folks, even the folks that are on the special programs, you still have the factory cycles. And so really our lead times to them would look just like our factory cycles. And depending on product, that's anywhere from eight to 15 weeks.

[Operator:]

Your next question is from the line of Craig Berger with FBR Capital Markets.

[Craig Berger:]

I guess, first, can you just remind us where you are in integrating CMD in terms of operating expenses? What kind of savings do we expect from here? And also, can you just remind us why OpEx jumped up so much in the first quarter? And then I have a follow-up.

[Donald Colvin:]

Let me handle the last one first, Craig. OpEx in the first quarter, we had the benefit of over $0.03 in the fourth quarter. As we told you on the script from a pension and R&D grants, which we didn't recur in the first quarter. Then we restored salaries, and didn't force any vacation, because we are running at full speed in the first quarter. So that was a pretty big step function. And then in addition to that, we had another $5 million, $6 million of expense related to the CMD acquisition, legal fees, OpEx, et cetera. I'll remind the listeners that we are now applying the new accounting rules where you do not capitalize, for instance, the deal cost that used to happen in prior year, so we expensed them in the first quarter. So if you put all that out, we actually did perform reasonably okay in line with our expectations and above guidance. And also, if you look at trend into this quarter, you see that we get very little growth in expenses, and we have a lot of fall through from the delta revenue to the bottom line. So that was just basically a one-off transition quarter. As far as the operating expense from California Micro Devices, I would expect that we will benefit from savings there starting in the second half and mainly in the fourth quarter. Because it does take time, especially when you're running the other activities at full steam to do that integration. There will be a nominal contribution, and it will be accretive fairly marginally so in the bottom line in the second quarter but the real benefits will be in the later part of this year.

[Craig Berger:]

So flattish to slightly up OpEx in the back half, just to clarify?

[Donald Colvin:]

I would think in the back half of the year or on an apples-for-apples basis, you'll see very minor increase in our OpEx. I think they're seeing the big step function increase, and I would think very, very minor, $1 million, $2 million increase sequentially, no more than that. $1 million increase when you look to the second half sequentially over the first half.

[Craig Berger:]

Just a follow-up, could you just remind us where you are on your fab consolidation plan? I think you still had one closure left to go, perhaps you're rethinking that. If not, what's the timing magnitude of any factory rework savings out there?

[Keith Jackson:]

So yes, we still have the factory in Phoenix that we're planning to close. Due to the strong demand, we delayed that, but we're not rethinking the plan to close it. We should have that closed before the end of the year. We're targeting some time in early fourth quarter, but certainly before the end of the year. And I'll just remind you that, that should be worth approximately $8 million a quarter in cost reductions.

[Craig Berger:]

Cash or depreciation?

[Keith Jackson:]

Total cash. Mainly cash.

[Donald Colvin:]

That's an old factory, just mix and no depreciation. So essentially, all cash.

[Operator:]

Your next question is from the line of John Vinh with Collins Stewart.

[John Vinh:]

Just a follow-up to that, obviously, at this point, you guys are spitting distance to your new target models at a 45% gross margins. Do you need to close the Phoenix fab closures to get to 45% gross margins at this point?

[Donald Colvin:]

Yes, we do. We are within spitting distance, especially if you consider sale and revenue even this quarter. But the sequential growth, as you say, we're spitting distance of that objective. But structurally, we're still running the Phoenix factory which will make up, as Keith said, $8 million of cash savings, which is approximately 1 1/2% of gross margin. That is how you should model it. The 45% model works with the closure of ZR, it's 43.5% if ZR is still turning.

[John Vinh:]

And then also, given the tightness that you guys are still seeing, can you talk about what sort of visibility you have into Q3? And if you look into your Q3 backlog at this point, what are some of the markets that are represented in that mix at this point?

[Keith Jackson:]

Unfortunately, or fortunately, however you want to look at it, all of the markets continue very strong into Q3. We don't see anything that is lightening up, and then the traditional consumer push is there as well. So on a sequential change, consumer clearly will be up the most in Q3. But all of them, every market we have, is showing more backlog at this stage for Q3 than we had going in the Q2.

[Operator:]

Your next question is from the line of Chris Danely with JPMorgan.

[Christopher Danely:]

Sounds like the lead times are continuing to stretch out. Some of your competitors have posited that because their lead times are shorter, they might be able to gain share. So is there any, I guess, thoughts as to maybe ramping capacity a little bit more aggressively to try and bring down those lead times, i.e., are they starting to develop into a negative?

[Keith Jackson:]

I don't believe they are. We look at results and I think we have been outgrowing the competition, including the previous quarter. And on a sell-through basis, we believe we can continue that pace. Lead times are very misleading indicator. They just indicate how long you think it's going to take you to deliver the next one, including all the assumptions you've made and what you're going to be starting for the next multiple numbers of weeks. So to the extent, we continue to expand capacity on par or ahead of our competition. The lead times are irrelevant data. Really, it just means that we're keeping basically demand ahead of the capacity expansions.

[Christopher Danely:]

And when was the last time they were this far out?

[Keith Jackson:]

2006, probably, was the last time we saw this.

[Christopher Danely:]

And as my follow-up, it sounds like your auto and industrial revenue is getting back or should be above the previous peak this quarter. However, if we look at the end markets there, they're pretty far away from being back to their previous peak, so how do you explain that discrepancy?

[Keith Jackson:]

Yes, again, I mentioned it earlier that we're seeing big model changes with focus on energy efficiency that use more semiconductors. And specifically, we've got some very, very strong design positions with proprietary products in both of those areas for more efficient products. So I think we're seeing a benefit of some acceleration in model changes which, quite frankly, replaces older discrete and passive implementations.

[Operator:]

Your next question is from the line of Terence Whalen with Citi.

[Terence Whalen:]

This one is on CapEx. I think, looking at your expectation for a $15 million CapEx next quarter, then if I were to think forward the next couple of quarters and look at your $130 million to $160 million CapEx range, that implies a meaningful decline in CapEx sequentially in the third and fourth quarter. Can you help me understand, with the targeted 130 to 160 , how much capacity is being brought online? And also, how are lead times of tools affecting the conversion from cash to capacity?

[Donald Colvin:]

Donald here. The 130 to 160 was for equipment. In addition to that, there's additional 25 million or so, 30 million of buildings. And basically a building in San Jose to consolidate what's a leased property and a building extension in the Philippines to consolidate to test facilities. So you've got to add that on, you got that on, you come to 180 or 190. But we'd like to split the buildings out, so that you can see what we're really spending on specific capacity to increase our production capacity. As far as the impact on that, I'll let Keith addressed what he believes the impact of that will be on our lead times.

[Keith Jackson:]

From a impact to the company, again, sequentially, you should be able to -- with the investments we're making, increased capacity at more than 5% per quarter. And this is not always an even investment. All the money is not equal, so I'm not going to be able to give you exact break out right now, but it should be more than 5% per quarter at those investment rates or more from a capacity perspective.

[Terence Whalen:]

And then as a follow-up, I guess, one big competitor said actually they recently got their lead times in, in the first quarter, it seems like from pretty lofty levels. To what degree is there sort of a race to contract lead times to remain competitive based on some lead times actually coming in while others are going out?

[Keith Jackson:]

I don't have an answer to that. We don't run the business based on lead times. We base it on our customers' demands, and we continue to take orders when they request them from us. So it's not really an index that we chase competitively.

[Operator:]

Your next question is from the line of Steve Smigie with Raymond James.

[Jonathan Smigie:]

And also congratulations on the debt paydown that you talked about, the term debt paydown here. If I were just to look at that, excluding other events in the quarter, does that mean that debt dropped to something like 765 in cash or dropped to 390, something like that?

[Donald Colvin:]

That's a good approximation. I think that's a fair approximation, yes.

[Jonathan Smigie:]

And then just thoughts on continue use of the cash flow there, continue to work that debt down a little bit, maybe leave $600 million debt on the books going forward, if you can get it down that low. Is that sort of the way to think about it, the rest goes to acquisitions or buyback?

[Donald Colvin:]

Well, we're not planning to spend all the cash on acquisitions, so I think we've made that clear. We're not acquisition junkies. What we're trying to do is to increase the shareholder value added. So I think we do want to get off debt particularly things identifying a debt when the bank facility has a lot of nasty performance requirements, compliance requirements, so it makes it a lot easier to get rid of that. So basically, as we explain at the Analyst Day, we continue to be opportunistic. If we see good things that we can talk in, we will look at it but we're not obliged to do it. And we want to operate the company on a shareholder friendly way. And if we can get shareholders happier with the dividend or going forward or with the buyback, we will consider that. Right now, I think our choice has been pay down the bank facility and invest a little bit more in equipment to get our lead times in and our capacity out and our revenue up. These priorities change in this industry quite rapidly, so that's the game plan.

[Jonathan Smigie:]

Could you talk a little bit about -- based on your R&D investment, what you would think the future would look like in terms of growth for your various product segments? I guess part of what I'm getting at is, would you drive standard products as much as others, or would you expect that to decline and just hit the ASP one more time? If standard product shrinks to the percentage of revenue, does that drive up ASP or will that be part of what helps maybe ASP going forward?

[Keith Jackson:]

So I'll address that a bit. The investments we're making clearly will favor the analog and mixed signal products, as opposed to standard products. That's true relative to R&D, and it's also true relative to our capacity expansions. So like the last several years, I do expect to see continued growth in standard products. However, I expect to see much more growth on a percentage basis coming from the analog and mixed signal products. That is positive for ASPs. That is -- we don't need much more of a shift. If I could only -- any more of a shift, as we talked about earlier, to hit our model. We really just need to get the Phoenix fab closed. So we'll have to update the model with higher numbers looking at that shift in the out years.

[Donald Colvin:]

Remind you, Steve, we did hit our record gross margin this quarter. And if you take the midpoint of guidance, that will be a new record next quarter. So step-by-step, we are on the way.

[Operator:]

[Operator Instructions] Your next question is from the line of Ramesh Misra with Brigantine Advisors.

[Ramesh Misra:]

In regards to your formerly acquired businesses from ADI and AMI, there are revenues relative to their prior historical peaks?

[Keith Jackson:]

So in the ADI case, we are exceeding those prior cases. That is difficult for us to break out, because now the teams have been together and working on joint projects for two years. But overall, the net effect of that is well ahead of what we purchased. On the AMI side, we should be approaching those peaks coming up here in the next quarter.

[Ramesh Misra:]

In regards to the basic tightness of availability, do you have any estimate on how much business your leaving on the table at this point?

[Keith Jackson:]

That's really hard to estimate. A lot of the demand we see that is in excess of supply is into the distribution channel. And there's really no way for us to know how much of that would sell-through in the quarter or how much of that would be inventory-build. So I guess the simple answer is, we have no way of knowing.

[Ramesh Misra:]

In regards to your foundry suppliers that you plan on bringing on, I presume that's both for the front-end and back-end. How much of your production, either in wafer starts or some other metric is being done outside? And how much do you expect that to ramp up over the next few quarters?

[Keith Jackson:]

At this stage in Q1, that was approximately 28% of sales, which is actually a high point for us in recent history. I don't expect that it will grow dramatically more, but it could reach something like 30% of sales if we can get as much as we'd like.

[Ramesh Misra:]

In regards to your Computing business, obviously, it is unseasonably strong in Q1. Any key drivers for that? And do you expect consequently, I mean, the second half ramp in the Computing business to be somewhat more muted due to the strong strength?

[Keith Jackson:]

I've heard the theories, and we're actually not expecting more muted second half. We do think there will be more enterprise upgrades in the second half than you saw on the first half, so we're really not looking for a more muted response at this stage. And we are preparing ourselves for a more normal scenario.

[Operator:]

Your next question is from the line of Gus Richard with Piper Jaffray.

[Auguste Richard:]

It looks like you had a pretty good strong uptick in infrastructure-related things, and in talking to companies, I gather a lot of demand is pent up in the industrial sector and there's an upgrade cycle driven by energy efficiency. Are you guys seeing that? Do you believe it? And how long historically have these industrial cycles gone and do you think will this be in line with them?

[Keith Jackson:]

So we have seen it. We do believe it. We're experiencing it as we speak. And again, as I mentioned, I think the biggest driver for us specifically is the shift to more semiconductor-control and power-delivery types of products, which gives us an unfair growth advantage within that sector. So we do believe it. We think it's going to stay strong. As far as how long it goes, we're in no position to answer that. It certainly looks strong through all the backlog we have right now going forward into the next quarters.

[Auguste Richard:]

Do you think this drives in your business because you're so broad-based, sort of a mix shift to a more industrial-comment structure could lower revenue per customer, higher margin? Is that something that could impact margins going forward here?

[Keith Jackson:]

Typically speaking, industrial does strengthen our margins, as does communications infrastructure. And both of those are quite strong right now. We're seeing a lot of 3G build out around the globe and a lot of pent-up demand for products in that area. So those typically are more positive things from a mix perspective.

[Auguste Richard:]

And just last quick one, as we get into the summer, would you expect the normal seasonal pause in the infrastructure, or you're just not seeing it? You think you're going to blow through it this year?

[Keith Jackson:]

Again, really no way for us to tell at this point.

[Operator:]

Your next question is from the line of Patrick Wang with Wedbush Securities.

[Patrick Wang:]

First question, I guess, Keith, you talked about some anticipated strength in the Automotive end market. And I guess, you also even offer to comment that you expect to pass the historical peak from before. Can you just give us a little bit more detail about kind of what you're seeing, what gives you that confidence in that growth?

[Keith Jackson:]

Well, we're seeing several things. One, clearly, the North American market has been more robust than was expected. We see China continuing to ramp. And Europe was not expected to do much but frankly, they're holding up quite well. Part of that, of course, is that they sell into the China market with European automobiles. So frankly, the end-demand piece still looks strong. Further strengthening out specifically, however, is we saw a lot of shifts in the sub-assemblies that we plan using our newest proprietary products, adding new features to the cars, which gives us a more electronic content per vehicle boost. And so that combination for us looks like a very, very strong year.

[Patrick Wang:]

Your exposure to China, the growth in the China market there, is that one of your primary drivers there?

[Keith Jackson:]

Directly and indirectly, it's the fastest-growing segment. And the indirectly comment is that there's still a lot of components coming from Europe and North America, American customers that are being used by the China automakers. And so we see the orders coming from, not just China, but from our Western world customers that are supplying to China.

[Patrick Wang:]

And then for my follow-up, I guess, Don, if you could help just maybe summarize the moving parts on gross margin, just once and for all. I guess, one of the things that a lot of us are wondering about is some of the drivers to get margins even higher above your record margins that you just reported and guided to, so any help there would be great.

[Donald Colvin:]

We would like to do that, too. And I think, as Keith mentioned, we get 1 1/2 points if we close ZR, which we are currently not planning for at a near term, later, at the end of the year, beginning next year, before we get the benefit of that. If you look at what we announced at the Analyst Day, it was 45%, take that down 43.5%. So as someone mentioned within spitting distance. But I think it's fair to say that if we can get prices moving, that will be a positive. We already stated that's more of a second half story than our next quarter story. And then also right now, we've got certain inefficiencies, we're running the supply-chain hot, certain expedite, certain extra freight costs, the cost associated with the volcano in Iceland and the expedites in trade with that. All these costs are running hotter and that should come down over time. So there is hope that we can get above the 45% gross margin, but I think that the process is going to be a slow rather than instant gratification. One point I just would like to emphasize is the midpoint of our operating expense is also falling this quarter. Because we have a non-recurring expenses, like deal cost and all the rest that are not going to happen again in Q2. So the net-net is we see ourselves generating a significant consequential improvement in earnings, so we're just steady as she goes. But it's fair to say that we do have certain inefficiencies because of the hot way we're running our factories. And as we add more capacity, that should help the margin in the second half.

[Operator:]

And there are no further questions at this time. We would like to thank you all for joining today's ON Semiconductor First Quarter Earnings Conference Call. Please disconnect your lines at this time, and have a great evening.