Ladies and gentlemen, thank you for standing by and welcome to the ON Semiconductor First Quarter 2021 Earnings Conference Call. I would now like to turn the call over to Parag Agarwal, Vice President of Investor Relations and Corporate Development. Thank you. Please go ahead.

Thank you, Denise. Good morning and thank you for joining ON Semiconductor Corporation’s first quarter 2021 quarterly results conference call. I am joined today by Hassane El-Khoury, our President and CEO and Thad Trent, 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 2021 first quarter earnings release will be available on our website at approximately 1 hour following this conference call and a recorded webcast will be available for approximately 30 days following this conference call. Additional information related to our end markets, business segments, geographies, channels, share count and 2021 fiscal calendar are also posted on our website. Our earnings release and this presentation includes certain non-GAAP financial measures. Reconciliation of these non-GAAP financial measures with the most directly comparable measures under GAAP are included in our earnings release, which is posted separately on our website in the Investor Relations section. During the course of this conference call, we will make projections or other forward-looking statements regarding future events or future financial performance of the company. The words believe, estimate, project, anticipate, intend, may, expect, will, large, should 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 from projections. Important factors which can affect 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 Securities and Exchange Commission. Additional factors are described in our earnings release for the first quarter of 2021. Our Analyst Day is scheduled for August 5. We plan to host an event in New York City and we look forward to seeing you all in person in the summer. We will send out further details regarding the event in a few weeks. Now, let me turn it over to Hassane. Hassane?

Thank you, Parag and thank you everyone for joining us today. For the first quarter of 2021, we posted strong results driven by solid execution and broad-based strength across our strategic end markets. We reported revenue of $1.48 billion, up 16% year-over-year. More importantly, our focus on gross margin expansion is beginning to show results, with first quarter gross margin increasing by 370 basis points year-over-year and by 80 basis points quarter-over-quarter. We have taken steps to optimize our product portfolio and channel strategy to ensure that we capture the right value for our products and these steps will continue to drive favorable and sustainable results. At the same time, we continue to drive cost improvements throughout our supply chain, improving efficiency of our operations and shifting our product mix towards higher margins.

Thanks, Hassane. Let me start by saying that I am energized to join ON Semiconductor at a very exciting time for our company. We have tremendous opportunities to create value for our shareholders, customers and employees as we execute our strategic transformation. We have the building blocks of a robust product portfolio, excellent teams and operational scale to drive sustainable financial results during this transition. Now, let me comment on the current business environment. During the first quarter of 2021, we saw continuing recovery in business conditions, driven by further acceleration in global economic activity. We are seeing broad-based strength across most end-markets as semiconductor content continues to increase in the products we encounter in our daily lives. As Hassane mentioned, we continue to benefit from the secular megatrends in automotive and industrial end market, which now account for 60% of our total revenue. Although the industry is faced with severe supply constraints globally, we have supported our customers through proactive inventory management by taking channel inventory down, while holding more on our balance sheet. We believe supply and demand will start to balance later in the year. Now, let me turn to results for the quarter. Revenue for the first quarter of 2021 was $1.48 billion, an increase of 16% over the first quarter of 2020 and 2.4% quarter-over-quarter versus normal seasonality of a sequential decline of 2% to 3%. The year-over-year increase in revenue was driven by broad-based strength with automotive and industrial growing by 16% and 17% respectively. Gross margin for the first quarter of 2021 was 35.2%, a 370 basis point improvement year-over-year and an 80 basis point improvement sequentially. The gross margin improvements are being driven by improved mix to higher margin products, improved utilization and our laser focus on cost structures across the company. Our factory utilization was 84% as we ramp production to align with the strong demand. As we move forward, our fab lighter strategy will allow us to continue to reduce our manufacturing footprint and optimize the mix of products within our fabs to reduce our overall cost structure. GAAP earnings per share for the first quarter was $0.20 per diluted share as compared to a net loss of $0.03 per share in the first quarter of 2020. Non-GAAP net income for the first quarter of 2021 was $0.35 per diluted share as compared to $0.10 per share in the first quarter of 2020.

Thank you. Your first question comes from Ross Seymore with Deutsche Bank. Your line is open.

Hi, guys. Thanks for letting me ask the question. Congrats on the strong results and guidance. I guess the first question I had is on the supply side. Obviously, demand is strong across the board. But on the supply side, Hassane, I wondered if there are any impacts limiting your revenues from supply limitations either internally or elsewhere in the supply chain and probably more importantly, any impact of your product rationalization efforts on your total revenues and then just how that process is going currently?

Yes. Thanks, Ross. So look, the obvious answer is yes. It’s impacting our ability to ship to the demand that we have. So, revenue could have been higher if we did not have any constraints in a perfect world. However, we are where we are as an industry, but that’s not really impacting what we are doing moving forward on the portfolio rationalization to answer your second question, because it’s actually helping us. We kind of know already based on the strategic reviews that we have done, where we are going to be landing and we are putting priority on these products, especially when it comes to internal utilization. Like Thad mentioned, we have good utilization this quarter. Now, it’s really maintaining the optimization and running the growth and the high margin products within our fabs and that fits very well with the rationalization, creating more capacity for the products that we want to maintain.

That’s a perfect segue to my follow-up question, Hassane or Thad, either one of you guys. The utilization, I think, Thad, you said is at 85% already. It’s good to see that back to normal levels. Can you talk about some of the drivers of gross margin going forward? The product optimization you just mentioned, Hassane, is an obvious one, but I assume that’s going to take a little bit of time to bear fruit. So, the second quarter gross margin is showing a nice pop; is that simply the utilization rising again and kind of what are the steps to get that gross margin from the 36.5% to 37% up to your target range?

Yes. Look, we have launched a gross margin initiative corporate wide. So, there is not a single pop that caused the margin in Q2 that we guided to. It’s really across the board. Of course, some of it is utilization, but we have a laser focus on cost optimization within the supply chain. We have been talking strategically with our customers about some of the cost increases that we have seen and how we pass some of those on. There are operational efficiencies that we have been doing. We have seen some of that start in the first quarter. And that’s why I called it the favorable and sustainable moving forward that’s kind of where you are going to see us clicking up. Utilization will get better over time, but more importantly, where the lift for gross margin is going to be is what I mentioned in the prior answer is as we start shifting more of our internal capacity to higher gross margin products and offloading the, call it, the legacy or the harvest product line, that’s going to create a mix shift to the higher gross margin that will come of course with better utilization.

Great. Thanks, guys.

Your next question comes from Chris Danley with Citi. Your line is open.

Hey, thanks guys and I will add my congrats on the strong quarter and outlook. So, would you say that the shortages are getting better in Q2 or getting a little worse? And then how do you expect this easing of demand you talked about in the second half of the year? Could we have like a sub-seasonal quarter or do you expect to go from above seasonal back to normal seasonal?

Yes. So look, the expectation is really what we are talking with our customers and how I would call it the velocity of how fast the demand is coming. I talked last call that the problem has not been really on the capacity per se, it has been on how quickly that demand came and layered on a very strong quarter. So, that’s the velocity. So, when I talk about demand and supply and demand subsiding in the second half of the year or towards the end of the year, I am not talking about really demand going weaker or backwards. I am talking about the momentum, but it will remain at a very healthy and not – and better than seasonal outlook. So, that’s where we see the demand. But the balancing of us being able to catch up to the demand is going to happen, I would say, towards the second half of the year.

Yes. And Chris, this is Thad. I would just add, if you take the midpoint of our guidance for Q2, that’s our record for the company, right. It’s up 9% sequentially. As you look into Q3, I think coming off that high mark, we will be sub-seasonal in Q3 and then probably return to seasonal in Q4.

Okay. Thanks, guys. That’s helpful. And then for my follow-up, I guess between your own input costs and raw material going up and then any chance for, I guess, firmer pricing on your products, how do you expect the total impact of that to be towards margins? Do you think it kind of negates everything out or do you think that, that could be a little bit of lift to the margins as far as like your own pricing goes versus the input costs?

It’s – pricing is a small portion of our gross margin trajectory, because obviously right now we are in a favorable environment, but what we are looking for is those sustainable pricing structures and sustainable cost structures that will remain favorable and the up or down. And that’s you always hear me talk about structural gross margin improvement. That’s how we are going to get there. So to answer your question more directly, there is not a one size fits all. It’s not a one to one. It’s really talking to our strategic customers in order to reset, one, is the cost basis. But more importantly, in some cases, there is a value to price discrepancy and we are even covering that with some strategic customers and commitment to a longer term supply, because today, that’s really the most important thing is how do we prevent this, where we are today from happening to our customers over the next 3 to 5 years. That’s really where the focus is, is getting those agreements, getting those long-term views for us and the customers both on supply and on pricing.

Okay, great. Thanks, guys.

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

Thanks for taking my question. Hassane, you mentioned – Thad mentioned Q2 up 9% sequentially, I was hoping you could give us some color on which end markets could be above or below that number? But then also importantly, you are guiding to record sales in Q2, but gross margins will still be 200 basis points below right prior peaks and I am curious what’s causing that delta?

So, the demand is pretty broad. So, there is not a single end market that is driving the majority of it. Obviously, all our focus and our strategic end markets are going to see strength, and that really is mirrored across the industry when you talk about auto and industrial and so on.

Yes. On the gross margin compared to the historical, if you go back to 2018, which was the peak, I believe, was Q3 of ‘18, our – the midpoint of our guidance for Q2 would be about 5% higher than that peak. But you are right, the margins are lower, and that’s primarily because of the investments the company has been making in the capital, so our depreciation has been going up as we have been ramping up the balance in East Fishkill. Obviously, as we go forward, and we rationalize that footprint because that will give us some opportunities to improve those margins as we talked about as well. But that’s the primary driver and the difference between the two.

Got it. Thank you. And for my follow-up, I am curious, Hassane, how does – what we have seen in the last few months is companies that had better internal capacity are able to withstand this chip shortage issue better than their competitors. So, as you think about ON for the next few years, how does kind of reducing lead time and being responsive to customers align with the goal of having a lighter fab footprint over time? Do you think you can achieve both, be very responsive to customers, but still have a lighter fab footprint? Thank you.

Yes, absolutely. I am highly confident that we are able to do both. And from – obviously, we have been working on the rationalization of our portfolio and the manufacturing footprint since I joined the company. And I see a path for achieving both. And that’s going to be really with the rationalization. When you have a pretty broad footprint, it could be as easy as streamlining technologies within a fab, you will get better utilization, you will get better cost while still running a very different set of products. It doesn’t change really the overall products you run. It will change the volumes at which you can run per fab by just streamlining on a technology basis or even in the back end on a package basis. By removing all these inefficiencies, we are able to even get more out of our existing fab footprint or back-end footprint. And then as we restructure and consolidate, you are going to get that volume upside to maintain our growth. So we are going to be able to get both confidently.

Yes. And Vivek, just to clarify, right, as we talk about being fab lighter, it’s not necessarily going outside. We will still run the same volume in our fab. It will be just as long as a higher throughput in those fabs and then also looking at subscale fabs and doing something with those to reduce that footprint. But it isn’t necessarily shifting from inside to the outside.

Got it. Thank you.

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

Yes. Thank you and congrats on the good momentum. Thad, just a question on the decision to kind of build inventory on the balance sheet, while simultaneously reducing inventory in the distribution channel. Maybe you could walk us through kind of the rationale of that decision? And when you are talking about kind of demand-supply rebalancing later this year, can you give us some thoughts in terms of kind of where we are right now and what are the steps that you are taking in order to kind of get the supply in balance relative to demand? Is it more demand is just decelerating? And then or is the combination where demand is decelerating and supply is starting to increase to meet that level of demand? Thank you.

Sure. I think I lost track of the first question.

The first question is on the balance – sorry on the balance sheet.

Yes. Yes. Okay, so let me address that, sorry. So, we made the decision, obviously, we were running at about 11 weeks of inventory last quarter. Our target range is 11 weeks to 13 weeks of inventory in the channel. We dropped it to 8.4 weeks. The logic there is it doesn’t make sense to have inventories sitting on the shelves of the distributors versus supporting customers. So, by holding on our balance sheet, we can support the customers either through the channel or directly, but it allows us to ensure that we are allocating the products to the right customers at the right time versus just having it sit in the channel for extended weeks. So, it was a proactive decision basically for customer support.

No, I mean, I was going to tackle your second question about demand. So from the demand perspective, it’s really there are a few things going on. One is a lot of the work that we have done that I mentioned earlier about changing the mix and streamlining our footprint, we have more supply coming online. Not through capital expenditure, but literally through streamlining our operations, part of the initiatives that we have for our strategy. So, that’s going to help increase our supply, but also the velocity that the demand came in will start to subside, which means that we are able to get more visibility on what the steady-state demand is in order for us to build for that. What’s been happening is we get the demand signal, we start the wafers, then the demand gets stronger, we start wafers. But those wafers have a latency before they get out, and that’s why we are in the supply constraint. But as we are getting more stable, outlook of demand which remains by the way at a very healthy level, I am not talking about demand going backwards, I am talking about the velocity, the demand kind of stabilizing. We are able to start material for that demand, and that will get us towards the end of the year on a balanced supply and demand picture.

And for my follow-up, in terms of the automotive market, you had record automotive revenue, as you stated. Can you talk about kind of what you are seeing in that industry as we progress throughout the year in terms of SAR production, are we done with the kind of the component shortages impacting production? Do we still have more way to go? And so how do we think about the overall industry? And then how do we think about kind of your momentum in silicon carbide and electric vehicles?

Yes. I think as an industry, automotive is going to remain strong. There is low inventory across the board. I don’t know when anybody tried to buy a car lately, but there is no inventory anywhere, whether it’s rental cars or new cars or used cars. So, that’s going to fuel the strength that we are seeing. And obviously, we do have pockets where some of the OEMs have reduced production because of the supply. And we do have some ad hoc issues in the industry. Like unfortunately, the renaissance fire that happened in the fab, that also has an impact on where the demand is going to be. But that doesn’t change the overall picture for automotive being one of the strongest years I have seen. Our momentum remains very strong. Obviously, we keep talking about a content story. So, as those vehicles are back online, we are going to see our content grow with that, and that’s part of our growth trajectory, not just for this year, but moving forward. And that includes our silicon carbide. I am very close to our silicon carbide initiatives here in the company. And more importantly, I am watching very closely and personally engaged with customers on platform design wins that are going to fuel our growth from the revenue and the margin. But what I like about our silicon carbide story is we are not just on the electrification of the vehicle itself, although that’s a great area, we are also engaged on the infrastructure, whether it’s onboard charging or infrastructure charging. That’s going to also fuel because as we get more and more EVs on the road, we need to have an infrastructure to charge them, and we are engaged with that. And that’s also going to be part of the industrial strategy for us.

I appreciate it. Thank you.

Your next question comes from Toshiya Hari with Goldman Sachs. Your line is open.

Hassane, I wanted to come back to your comment about Q3 revenue potentially being sub-seasonal. You talked about very strong demand across your key markets. Inventory up and down the supply chain seems pretty low, including your distribution channel, and you have got idiosyncratic drivers of growth in power and image sensors and so on and so forth. So I am just trying to better understand why Q3 would be sub-seasonal given the backdrop? And then I have got a quick follow-up.

Yes. I mean, if you talk about sub-seasonal, Q3 is usually up 3% to 4%. But you have to remember, we are coming off of a 9% up quarter in Q2, which is typically 3% to 4% down. So, when we talk about seasonality, for this year, you can throw that a little bit out the window. What we are looking is just maximizing our supply in order to meet the maximum demand we can. So, demand remains strong. So, even if we talk about sub-seasonal Q3, that’s still a very healthy Q3 coming off of a second quarter with a 9% sequential growth.

Okay. So, from your standpoint, is supply a bigger issue in Q3 than it is in Q2? Is that a fair statement or no?

No. I wouldn’t say it’s bigger. I think we are still going to be navigating the same supply constraints that we see.

Okay. Got it. And then as a quick follow-up, I was hoping you could give us an update on Belgium and Niigata. I know you are in conversations with potential counterparties, but any update there? And I think on prior calls, you have mentioned each fab potential sale would give you tens, 20s of millions of dollars in cost savings? Does that continue to be the case? Thank you.

Yes. I mean, we have nothing new to report. Obviously, as soon as we conclude anything, we will make sure that becomes public. But where the status you stated is exactly where we are.

Thank you.

Your next question comes from Vijay Rakesh with Mizuho. Your line is open.

Hi, guys. Great quarter and guide out of the box. Just a question on the automotive side. You mentioned silicon carbide. Obviously, on the EV side, that continues to grow. Any thoughts on how you see that percentage? And how you see that growing in ‘21, ‘22? And what is it as a percent of your auto revenues there? Thanks.

I think it’s going to stay. We don’t break it up specifically. We look at our electrification, both silicon carbide and IGBT that’s been growing. It’s going to continue to grow. And as more silicon carbide sees its way on the penetration as far as technology from the IGBT as customers crossover over next, call it, 2 years to 3 years, we are just going to be growing our content with that. But right now, our focus is layering in all the design wins in order for us to be able to do that. And we are on track.

Got it. And on the 300-millimeter side, can you give us some idea of how you are ramping that, where do you expect utilizations as you look out this year, next year as you move some products into 300-millimeter as well? Thanks.

Yes. I mean we are on track to move in this, but just to remind everybody we don’t take ownership of the fab until 2023. So, until then it remains an outside fab, but our focus is to make sure all of our products that we want to be running there is in there, not just qualified internally but qualified with our customers, so when we take ownership of that fab, we are able to ramp it as planned.

Got it. Thanks.

Your next question comes from Craig Ellis with B. Riley Securities. Your line is open.

Yes. Thanks for taking the question guys. Congratulations on the strategic progress so far. I wanted to start with a longer-term question, Hassane, you mentioned that you are working on some long-term agreements with some of your customers. The question is what percent of sales could those be in 2021? And as we look out over the next 3 years to 4 years, how much larger could those long-term agreements be as you have a couple of years to work on it. And to use auto as one example, would that mean, for example, that in auto, you could actually accelerate the premium industry growth that I think the company has talked about 10 percentage points or would those long-term agreements really leave relative growth unchanged versus what the company has been looking for?

Yes. I wouldn’t say it will change our growth target because our growth targets are pretty aggressive when you compare them to the SAR numbers over the next few years. So, I am very comfortable with those. Now of course, from the prior question, if silicon carbide accelerates faster than what we think, then that’s going to be higher growth for us than we expected. So, there are some puts and takes on the growth trajectory. And that’s why what the growth we have provided is a pretty well balanced growth. As far as the long-term agreements, I look at them as more outlook confidence. If you look out over the next few years, we want to be able to spare capacity. We want to be able to potentially build or shift capacity into the strategic products we want. And we are engaged with customers to make sure that their demands over the next few years are met. And that comes with a 2-way where we make sure the investments are made in the areas where we see the growth. And from the customers side, the investment is made in order to give us the visibility and the long-term agreement for us to make sure that we are building for the right domain. So, it’s a win-win for our strategic customers. We have been working with a lot of them in order to make sure that what we experienced in 2021 does not occur again. And that only comes with a steady and outward-looking demand signal that they will commit to.

That makes a lot of sense. And then the follow-up is for you that. So, a number of times in the commentary prepared and Q&A, the company mentioned strategic mix out. The question is, are we starting to see that in the business, for example, I noted communications was down 10% year-on-year in the first quarter, when will we see that impact peak in the business? Is that later in 2021 or would that be sometime more distant in 2022? Thank you.

Yes. As we go through our strategic review process, it’s too early to really see those results coming through our financials at this point. I think you will see that shifting much further out in 2022, probably hitting the revenue numbers. So, I wouldn’t look at this quarter as being indicative of the strategic markets that we are focused on. Obviously, auto and industrial will be strategic to us, but I wouldn’t read more into that on a short-term basis.

Thank you. Good luck.

Your next question comes from Christopher Rolland with Susquehanna. Your line is open.

Hi, guys. Thanks for the question. There have been some rumors about some CMOS image sensor tightness out there. Can you guys talk about that market specifically? And are there any supply constraints there that you guys are seeing, whether you specifically or anywhere in the supply chain for those modules? Thanks.

The short answer is yes. We see it – most of it is – well, all of it is foundry for us, and we all know the foundry situation. Part of our allocation strategy that I have been discussing or hinting at during the call applies to image sensing. But for sure, there is tightness in the market.

Great. And then perhaps tying into that as well, just a discussion about East Fishkill. So 2023, that’s when you guys get the fabs. But are you able to ramp meaningfully before that? Is there some additional capacity that you can kind of touch there? And then this supply chain tightness that we have seen out there, has that accelerated qualifications or re-qualifications from other fabs to this fab? You have talked about $2 billion-plus of revenue. So I guess, putting all the pieces together, where are you guys going to be in 2023 when you get this fab in terms of utilizations, in terms of ramping to that $2 billion plus revenue? Has this put you guys in a better position? And where do you see that position? Thanks.

Yes. Look, we still have a few years on. We have looked at the products that we are moving. We have reprioritized in order to make sure the products we are moving with higher priority are the strategic products, the growth products that I have been talking about, part of the portfolio rationalization. So those, of course, we are going to try to accelerate. But as you know, with a lot of product qualifications, it is not how hard or how fast you work, it takes time to qualify. There are X number of hours you have to test and those hours have to pass. We can do parallel qualifications we can do customer qualifications, and we are doing all of the above to make sure that when we take ownership of the fab in 2023, it has the maximum utilization we can get to at that time given all of the demand that we have. As far as the short-term, of course, we maintain a close relationship with global foundries that operates the fab, and we navigate the supply constraints, just like we do with any outside foundry.

Thanks, Hassane.

Your next question comes from Chris Caso with Raymond James. Your line is open.

Thank you. Good morning. The first question is about the production plan as we go through the year. And it sounds like you would be ramping production pretty significantly now to catch up on supply, and that’s obviously having a margin benefit now. What does that look like as we go into the second half with revenue potentially flattening out as you go to Q3? Does that mean utilization comes down a bit or – and I guess, what does that imply for gross margins as we go into the second half of the year?

Yes. As I mentioned, utilization is currently at 84%. It was mid-70s last quarter. As we look through the remainder of the year, we think it’s going to stay right in that level based on the projections we are seeing in the backlog. So, when we talk about the second half coming back into balance, it’s balanced really at this level, right. So, we don’t expect the utilizations to drop much through the remainder of the year.

Alright. So just as a follow-on to that, given what some of your peers have said about expecting tight supply through the year. Do you expect you will still have the opportunity to improve the mix as you go through the year, prioritize some of the higher-margin products and therefore, still get a mixed benefit as you go through the second half?

Yes, absolutely. I mean that’s – we have already started doing that. And we hope to get more favorable mix and optimize those fabs as we go through the rest of the year, and that will give us some tailwind on the gross margin, additional tailwind. So, that’s what we talked about, right, is that the next phase of the gross margin isn’t all about utilization, it’s really about optimizing the footprint and optimizing what’s going through those fabs to increase the throughput.

Yes. Very helpful. Thank you.

And your next question comes from Matt Ramsay with Cowen. Your line is open.

Good morning. Thank you. Hassane, as you think back to when you were thinking about joining the company and when you came into the company, it seems to me like the – as you think about modernizing or rationalizing the footprint of manufacturing, I don’t know if you guys would have thought about the extreme 6-inch and 8-inch tightness across the industry when you started putting the plan together. So, I wonder if you might reflect on that a little bit. Are there any new variables or has the aperture sort of broadened for strategic options as you think about it, given the tightness and the likelihood of 6-inch and 8-inch tightness persisting across the industry for a longer period of time? Thanks.

No, from where we look at it obviously, we had to re-look and revisit our baseline assumptions. And I will tell you it hasn’t changed, because the fact of the matter is not the 6-inch or 8-inch tightness that is driving, it is how effective can we run those fabs at the scale that they are in versus consolidating or moving from, for example, 6-inch to 8-inch, as an example. So, it doesn’t change what we need to do, which is we need to streamline our manufacturing footprint, we need to consolidate, and we need to have all our fabs be at a scale that we can drive lower cost and as we keep those fabs fully utilized, that cost will basically spread across all products that we run in. So, it doesn’t change the valuation of these fabs as far as the market is concerned. But when we decide to potentially divest any of those assets, they will just bring in more than they did when I first started.

Fair enough. That makes sense. As my follow-up, you guys mentioned in the prepared script, strength from computing and also strength from GPUs. Maybe you could talk about how big are those markets for you guys specifically that you called out driving some upside? And are those particular products at the richer end of the mix? And are you, I guess, planning on those sustaining through the balance of the year? It seems like those would be fairly high-margin products into those markets. Thanks.

Yes. Our product focus on – in these segments. First of all, those segments are not a big percent of our revenue. However, they are very, I would call them, adjacent to our power product offering that we have in the auto and industrial where we bring a lot of value in these GPU cars and so on, which have seen some growth. So, we are able to support that growth, but I will just reiterate, we are able to support that growth once we have fully supported our automotive and industrial customers, which are part of our strategic markets.

And your next question comes from Kevin Cassidy with Rosenblatt Securities. Your line is open.

Thank you and congratulations on the great results. Your CapEx spending at $77 million came in lower than, I guess, guidance, guidance was $90 million to $100 million. Was that just due to timing of the equipment delivery or is there some other change that’s happening?

No, that’s just the timing of the cash payments, right. So, you can think about it still being in that 7% range long-term. This quarter it just happened to be lower on a cash basis, but no change in strategy at this point.

Okay. And can you say what percentage of that goes towards the 300-millimeter and how much maybe for 8-inch?

I don’t have the breakout, but I would say the majority of that is going towards the 300-millimeter today.

Okay. And so is there – I guess, what is the lead times for 8-inch equipment? Or can you still find used equipment?

Yes. Well, yes, because our investment or CapEx in the 8-inch is really maintenance or upgrade investment, back to what I mentioned, streamlining, removing some bottlenecks in the fab. So we’re not looking at purchasing heavy equipment. And as you streamline and consolidate some of the lines within a physical location, we have the flexibility to move some equipment from our own from one spot to the own from one spot to the next in order to remove any bottlenecks that are specific to a fab. So we haven’t hit any roadblocks in what we aim to achieve in the 6 or 8-inch fab trajectory we have.

Okay, great. Thanks for clarifying.

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

Yes. Again, thanks for letting me ask the questions. Congratulations on strong results. Hassane, I’m a little curious on this inventory strategy. To what extent is taking on more inventory tactical to try to kind of make sure your customers aren’t building much inventory? And if you can comment on what you think end customer inventory that would be great? And to what extent might this be a little bit more structural? And as we think about use of cash, how should we think about the use of cash relative to your inventory strategy?

Yes. I would say, John, it’s tactical. When we have strong demand and strong signals from our customers coming to us directly, regardless of how we fulfill either direct or through distribution, the customer engagement is direct with us. And being able to have those conversations and move inventory where we need to move it in order to support our strategic direction and back to our portfolio rationalization, it is better for us to hold that inventory than put it at the distributor and have them ship at their discretion, I would say, based on their backlog or their order. So from that perspective, it is purely a tactical approach to how we believe we are able to support it. And that worked very well for us. We had a great quarter that we just talked about. We have a great outlook. That’s all part of it. That is a tactic. Now as far as longer term, obviously, we’re going to be talking about rationalizing our inventory management, both in the channel and internally, because that has to match the velocity at which we are able to get our products from start to finished goods. How do you stage products in die bank and how do you stage products and finished goods is going to depend on the rationalization and really the efficiency of our manufacturing footprint, and that’s going to drive a change in our capital allocation for inventory management. And again, it’s either internal or external. For me, it’s the same. It is inventory that needs to be monetized by getting on a customer board.

And John, on the cash, I wouldn’t expect the inventory to increase the balance sheet inventory to increase. I think over the longer term, it will come back into balance, but we’re not looking to increase it further. We think this is about the right level for this tactical, as you call it, tactical move in managing the inventory on a short-term basis.

That’s helpful. And then for my follow-up, Hassane, I was a little bit surprised about two things. One, that pricing is not a big part of what’s going on right now. And two, neither is portfolio rationalization? And the reason why is, if I go back and think about what you historically did in the NOR market, if memory serves me correct, you used periods of strength to kind of price customers out of the market and move that portfolio more aggressively. I guess, why aren’t you doing that now? Are these just different markets in the sense that they’re more socked and it’s hard to do that without kind of not supporting your customers? Or why isn’t the portfolio rationalization happening more quickly?

Well, let me put it this way. We are doing that. It is happening quickly, but there’s a lot of pieces to it. If you think about it, it’s not going to have an impact in Q1. It’s starting to have an impact in Q2, and it’ll have more impact, talk about Q3 and Q4 because there is backlog that we have accepted before that we’re going to support. There is pricing actions that we are doing, like you said, to price some opportunities out of the market because we’re not going to be supporting them. But that all is going to help towards the end of the year as we get through the portfolio rationalization. But as far as happening quickly, we are. Because one thing you have to also remember, the difference with it is when you have the tightness in supply, if I’m not shipping and the customer because of strategic reasons on the portfolio and the customer can’t get that product from somewhere else they’re not going to build that boat that I’m also on with products that I do want. So we have to make sure there’s some production that’s still going, and that’s the trade-off we’re able to make.

Thanks helpful. Thank you.

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

Hey guys. First of all, congratulations on a very strong guide. I had two questions. Hassane, first one for you, I know silicon carbide and power for cars in automotive is a focus area. If I had to ask you, what is your view of ON’s position in that market today with your products? I know if I asked you where you want to be, you would say, number one, but I’m curious where you are today? And I’m curious what you think needs to be done to get to that top-tier slot?

Sure. We are in a very good place, and it’s only getting better. It’s – today, it’s better than it was when I first started. So that’s kind of the focus that we have. How is it going to get better, to use your term for us to become number one, which, of course, we play to win and we don’t dabble. That’s going to be with a focus and an investment strategy, and that’s the work that we have been looking at. But that’s the work we’re looking at for silicon carbide and a lot of our other segments that – and the technology in order to make sure that when we pick a vector, be it silicon carbide or anything else that we’re able to sustain it over the next 4, 5 years and investments in products in order to get to that leadership position.

Great, so. And for the next one, I just wanted to ask you and Thad, about the cost side. So as you look at some of the cost initiatives that you guys have started on, would you say that you could have done are sort of underway and close to getting done and the hard work has started? Or where would you sort of characterize where you are in the process of cutting costs?

Yes. It’s not the hard and easy way, it’s how long it takes to implement and get the benefit of. We can implement, if I use the two categories, we can implement two things. One is easy, one is hard. The easy one is implemented, but it’s not going to see results for another quarter or so. We’re doing all of these in parallel. Obviously, anything that is, what I call, low-hanging fruit has already been launched and initiated. The question is, have we seen all of the benefit of it? The answer is no. So it’s not really – I look at it as the timing to get or reap the benefits of hard or easy implementation. What we have done is we’ve launched a lot of them in Q1. You’re starting to see that benefit in Q2. And back to my prepared remarks, those benefits are obviously favorable, but more importantly, to me, they are sustainable. So it’s a cumulative effect as these things kind of start showing the benefit, they’re cumulative on what we’ve already established as a baseline. And that’s the gross margin trajectory that we are – we set ourselves up for.

Thank you.

Your next question comes from Harlan Sur with JPMorgan. Your line is open.

Good morning. Great job on the quarterly execution. The ISG business was down about 2% sequentially, it was up 9% year-over-year. I believe auto and industrial make up a majority of ISG revenues. And these two end markets combined are up 5% sequentially and 17% year-over-year. So the largest delta does appear to reflect the capacity constraints on foundry that you guys talked about. Similar to your overall business, do you guys expect that ISG foundry capacity to be more in line with your demand by the fourth quarter of this year?

So ISG specifically, obviously, the revenue is 100% constrained by supply. So that is a one-to-one supply constraint. And that will remain through probably the first half of 2022. That’s the one business that will remain a little bit out of balance between the supply and demand, given the growth in that market with ADAS and everything. We’re working very closely with our foundry partners to get more capacity, obviously, because we have a lot of common customers with the microcontrollers or the advanced nodes that they ship. And that’s how we’re going to be able to get a little bit more capacity. We do have a path to more capacity for the second half of the year. That’s capacity that we’ve negotiated in the first quarter. So of course, that’s going to alleviate some of that gap, but it was not – it’s not going to resolve it, but it will get us closer to it.

No, I appreciate the insights there. And then despite the potential for Q3 revenues to be, maybe a bit sub-seasonal, I would assume that the team would expect gross margins to continue to move higher. I mean you already seem to be executing to a focus on a higher mix of gross margin products. So while Q3 revenues might be seasonal, should we expect gross margins to continue to move higher as we move through the second half of the year?

Yes, Harlan, this is Thad. We expect gross margins to continue to expand through the remainder of the year. This is from a lot of the things we’ve talked about, whether it’s the cost initiatives, also the mix. The benefit of the utilization and the cost structure in the fabs, but yes, we do expect even as revenue is coming back into balance, we expect gross margins to continue to accelerate.

Yes. Great job. Thank you.

Your next question comes from Mark Lipacis with Jefferies. Your line is open.

Hi, thanks for taking my question. Hassane, a lot of time, what happens at this part of the cycle is you get OEMs and contract manufacturers order more components than they need. Some people call that double ordering, some call it, building inventory, safety stock. And then what happens to industry adds capacity, lead time shrink and then the requirement for that safety stock declines and semiconductor companies see the quarter cancellations. So the questions here are is this cycle – can this cycle be different than all the other ones? And as I listen to how you’re planning to retool ON’s manufacturing operations, I’m trying to figure out if you’re insulated from this dynamic in some way for your future portfolio? And I had a follow-up. Thanks.

Yes. So if you think about a lot of the commentary that we’ve talked about, all of that is to – in order to set us up to be more distance from any cycle that that as you say is expecting. It’s the same thing that happened in ‘18 or coming out of ‘18 into ‘19. So what does that about holding the inventory on our balance sheet versus putting it in the channel because that gives us a more clearer and quick response to the true demand signals. It’s much harder to put double orders on our direct book rather than through the distributors. So that gives us much better visibility, the engagement, not just with the Tier 1, but with the OEMs directly. When you have an OEM that is going lines down in a few days because they’re not getting parts, I guarantee you, there’s no double ordering in that. Nobody has got those products on the shelf and causing an OEM lines down. So that’s another signal that we look at. Again, more responsive when we hold the inventory than what it is – when it is in the channel. As far as the portfolio rationale or the manufacturing footprint, specifically, that’s why I said, we’re very cautious about investing to add more capacity versus removing some bottlenecks as we change the product mix in our manufacturing, just changing that bottleneck so we’re not adding CapEx that will end up loading us with depreciation. It is adding very light investment in whether it’s a tester or one machine in order to get that throughput out, in order to support the high demand but not really impact our long-term utilization outlook that we want to maintain in that 85 plus. So all of these, whether they shield us, I can’t comment on that because who knows what the cycle would look like. But what I will tell you is it will make us much more immune than just letting it ride.

Very helpful. Thanks. And then I have a follow-up. The OEMs that seem to be doing better right now are those that abandon these just-in-time inventory processes and built inventories on their own volition last year. And I’m wondering if you’re hearing from your customers the desire to take that approach even as you and other semiconductor companies plan to increase your own days of inventory on your own balance sheet?

Yes. It’s not – I wouldn’t say it’s common across the board. There are still some customers. Unfortunately, they are in denial. And we’re working with them, but everybody has a decision to make. We can make the decision for us, and they have to make their own decision about how they want to manage inventory. But I will tell you, the just-in-time error is not going to be sustainable. And customers who are going to keep pushing for it after this is done, will just find themselves in it in the next demand turn or the demand strength or even slight upside. For me, the focus is a productive engagement with the customer, where they are confident in their demand signal, and I’m confident in my investment in order to meet that. The short-term cancellation, all of that, I think, is going to be a thing of the past. And that’s going to be the difference between a strategic customer and a non-strategic customer it’s the ones that we are able to run a healthy and profitable, but more importantly, a predictable business with. That’s where our focus has been. And part of it is part of those long-term agreements. Now when I look at the inventory for customers who have done it, I’ve done it in my past lives, where some customers will work with us on what we call a BCP, business continuity plan, which includes some inventory with us, but more inventory with them that we have visibility to, where they will hold it, they will order it, they have 2 months or so of it. And we just have to make sure it’s replenished. We’ve done that, a lot of it with our Japanese strategic customers. And I’m hoping that we’ll start expanding for European and North American customers as well.

That makes lot of sense. Thanks, Hassane. Very helpful.

This concludes the Q&A session for today’s call. I’d now like to turn the call back over to Hassane El-Khoury, President and CEO.

Thank you all for joining us today. I’d like to thank our worldwide teams for stepping up to help drive our transformation, which has already started delivering favorable results. We remain focused on our execution as we navigate the current market conditions, and I look forward to seeing you all at our Analyst Day on August 5. Thank you.

This concludes today’s conference call. You may now disconnect.