NXP Semiconductors N.V. (NXPI) Earnings Call Transcript & Summary

Good afternoon, everybody. Why don't we get started with the next presentation? I'm Ross Seymore on the semiconductor research side of things. We're very happy to have NXP Semiconductors management team up here with us. We have CFO, Bill Betz; and VP of Investor Relations, Jeff Palmer. So guys, thanks for joining us in Las Vegas.

Why don't we just start with some big-picture macro questions? Thus far, we've seen weakness earlier in the year with some of the consumer applications. You guys don't have a lot of exposure to that, but it seems to be spreading into areas like data center now. How are you guys seeing the demand environment? And then, we'll get into the supply side of the equation, which has been a bigger issue after that.

Yes. So why don't I take that one, Ross? I think my microphone is on, yes. So not to be contrary or disappoint you, folks, but we're actually seeing demand in auto and industrial continue to be stronger than our ability to supply. If you remember back a couple of weeks ago, on our earnings call, we talked about derisking our backlog. And to be real clear, derisking our backlog is more art than science. And what we did is we looked at the optimism some of our customers have versus what we think the reality is to build product, kind of set that delta aside. We believe that in tight supply environments, people double orders. It's a natural human behavior. We basically -- there's some good ways you can tell whether someone is double ordering or not, set that aside. And then we looked at orders that might be just stale, sitting on the backlog for a period of time. We put those things together, kind of turned the crank. And basically, we ended up with a risk-adjusted backlog. And what we did is we looked at that versus our supply commitments from our partners. And we can only supply about 80% of that derisked backlog. So we continue to see things are fairly tight in our environment. Primarily, as you all know, automotive and industrial is 72% of our revenue.

Yes. And that's the side that I think is still holding up pretty uniformly. One of the bigger analog companies gave people a little bit of worry a couple of weeks ago, but generally speaking, that's -- those are the markets that are holding in the best thus far. The supply side of the equation, talk a little bit about what you're doing to expand that internally and externally? Because you guys have the hybrid manufacturing model.

Yes. So in terms of the hybrid models, most of you know, about 60% of our wafers come from third-party foundries, 40% internal. Our internal fabs, we own 4 8-inch factories, one in the Netherlands, three here in the U.S., and we have a joint venture with TSMC in Singapore. We have no intention to building a new fab internally. What we are doing is we're refining our hybrid model a bit, where we're taking any bulk CMOS that we currently build on our internal fabs and we're pushing it into the foundry marketplace. And so what we'll end up with is our internal fabs will be pure mixed-signal proprietary processes, and we'll buy most of our product -- our bulk CMOS product externally. Bill talked earlier in the year about our CapEx being 10% this year, target. About half of that going towards internal front-end, reorienting the lines to be able to adapt to this kind of pure mixed signal approach to manufacturing. In terms of the external foundry partners, most of our product is built on trailing edge products, 55, 40, 28 nanometer. These are products where there's been underinvestment in the industry. And I think it will continue to be a challenge for us for some time.

So how does that transition from the more bulk CMOS to more specialized processes? How long is that going to take to get your internal production almost exclusively that more specialized?

I would say probably ongoing, Bill?

Ongoing, I would say, started probably over about 1.5 years ago on this transition. This year, of that 10% CapEx that Jeff just mentioned, 50% is going to the front end, specifically on that proprietary technology and so forth. So it will continue along the journey. We're within our 4 walls, of course, Ross. And it's a matter of optimizing those sites, and it will extend the useful life of those sites as well.

Exclusive to the switching what you're building where side of things, the kind of the bulk versus the proprietary side, the other dynamic that the hybrid model always at least used to provide for companies is kind of a governor in hot times, you could always keep your own fabs running full, I guess, is the easiest way to say it. And you could use the flex capacity externally. Do you believe that still exists? Because the foundry side says it doesn't. Some of the hybrid folks or fab light say it still does. And I'm wondering who's going to win that battle.

Well, I think for us, our model -- we call our model a hybrid model. It's not a fab-light model. So when we put a product out into the foundry marketplace, it's a one-way street. We can't build that product internally. The demarcation between what we build internally and externally tends to be on a process node. Anything 90 nanometers and below is outsourced. And so ours is truly a fab-light model. Now while we might have dual sources externally, we can't then pull it back in.

Got you. So the fungibility internally, externally is never...

It's a true hybrid.

It's a true hybrid model.

Not a flex.

Got you. Got you. The last couple of questions at a bigger level. On the pricing side of the equation, kind of aligned to this tightness in the market. You guys have been very, very consistent with your messaging on that, just passing along costs. Your gross margin has gone up, but not in any sort of crazy way that would look like you're gouging your customers at all. Talk a little bit about how you're seeing the pricing environment maybe in the last 6 to 12 months and what you're looking for in the next 6 to 12.

Yes. As you mentioned, we continue to do a really good job passing along our higher input costs on to our customers, but nothing more than that. And the reason for it is really strategic reasons. We're not here to pad our margins. We see, from a design win standpoint, we're gaining a lot of traction from our long-term customers. Time to revenue is about 3 years out for the auto industrial space. So overall, we're very, very pleased with how that's going. From a cost side, we are still seeing higher input costs, right? And that'll continue. We're getting that, and we'll continue to pass that along in the second half of 2022. And we're also starting to see higher input costs for 2023 as we work with our foundry partners, and we'll continue to go do that. Pricing, if I recall, last year, we grew about 28% for a company. And pricing was in the low single digits. Obviously, this year, it is larger in our growth plans, but it's not all of it. And we'll break that out once a year.

And what happens if the input costs start to actually fall? I assume your customers would say, "Hey, this is a two-way street. You raised prices to pass it through. Will you cut prices?" And again, I know you just said that's unlikely, at least in the first half of next year. But is that something that would weigh against revenue growth?

We think if we can get back to equilibrium. And at this point in time, as Jeff mentioned, it's not going to happen in 2022. Who knows if it happens in 2023 because we can only service 80%? I have our derisked demand. I would say if we do find that in a couple of years from now, you have to remember, you're also starting at a much higher base. Last time I checked, labor costs and salary costs don't go backwards. They're always there. So I think the model itself is more robust. And specifically with the products that we support for our customers in auto, industrial, they're very application-sticky. And obviously, we would do and make sure we're staying competitive. But at the end of the day, we see a structural problem in the investments in the areas of what Jeff mentioned earlier in 40, 55 and 65. And we've seen it's been underinvested in quite a while. So we believe we'll be in a supply imbalance for a couple of years now.

That's a perfect segue to the CHIPS Act and the equivalent thereof in other regions. How is NXP going to take advantage of those? Are they going to be tailwinds and some CapEx offsets, R&D offsets, those sorts of things?

Yes, it's very important to think about any subsidy dollars. You don't go after subsidy dollars. You go for your strategy first. So if your strategy makes sense and you get subsidy dollars second, okay, that's great. That's a tailwind. But anything that we do is not addressing and going after because there are subsidy dollars out there, I would tell you. Again, we're active across the globe. There are subsidies around the world. We're constantly involved in them. They're a process with governments. Think along more of the R&D front, our specialty technologies that are very unique. Yes, we'll participate, but that's not the reason why we will just go after subsidy dollars. Again, it's strategy first in everything we do.

So when you said you're not going to be building any bulk CMOS fabs, the fact that there's a CHIPS Act isn't going to change that?

No, we're not going to go build a $12 billion fab because there's subsidy money out there.

Okay. And I think that's a good point, Bill, because I think what these folks forget is, while we may, let's say, decide at some point, we might build a fab, somebody will give us the money, we don't own the process technology that we lever with our foundry partners, right? And that's billions of dollars of R&D investment that our partners have made into that process technology. So just building a fab doesn't really solve all of your problem, right?

So last, I guess, it's another segue to the cash side of the equation, what you will or will not spend money on, after your last quarter, I get tons of questions on the buyback or lack thereof. That's persisted for a little bit of time. I think early in the first quarter, you bought back some, but you really didn't in the second. Talk to us a little bit about why didn't you. And has there been any change to your capital allocation plans?

Yes. First off, there is no change to our capital allocation plan. If I look back last year, we returned 198% of our excess free cash flow back to the owners of the company. I think if we look at our trailing 12 months, as of Q2, we returned about 132%. As I mentioned during our earnings call, we do expect to return at least or above 100% of our excess free cash flow back to our investors. I wouldn't read too much into it for Q2. Just to let you guys know, as you all know, we're a much larger company. I felt comfortable I want to build up the cash position inside the company from a $1.5 billion to a $2.5 billion. And then you saw recently this past week in an 8-K filing with the SEC, we have also increased our credit facility revolver from $1.5 billion to $2.5 billion. And again, you see also from a net debt leverage ratio, I believe we like to run anywhere between 1.5 and 2. If we're above 2, we won't buy back the stock. If we're below 2, we will buy back the stock, and we'll continue doing that.

Got you. So bigger company, bigger balance sheet.

More working capital needs.

More working capital, et cetera. Is there any bit that, that's a reflection on -- I know what you said earlier about the markets, but if you look at macro and things are a little more concerning, was it -- was that part of the reason you wanted a bigger kind of rainy day fund?

No. It's just more proper due diligence of being -- I'm different than my predecessor, maybe perhaps a little bit more conservative. But at the end of the day, I want to make sure that we have a very strong financial balance sheet and generation of cash flows going forward.

Got you. So let's switch gears to your biggest segment, your Automotive business. It's been a really, really strong performer. I think the biggest debate right now is, for semiconductor companies in the automotive sector overall, are they over shipping versus SAAR? That whole delta, Jeff, you and I and your former CEO, on a roadshow kind of came up with some of the charts that we highlight about auto semis versus SAAR. How do you guys, at this point, explain the delta? I know you get the question all over the place. But as you look at it right now, is that something you can more easily explain? Or is it something that's getting more difficult to explain as the SAAR keeps being low and you guys keep growing nonetheless?

Yes. I think, first off, you have to remember, there will never be a period in time where SAAR, in any one given quarter, matches our Automotive revenue. You got to remember, our cycle time to build our products is 3 to 6 months, best case. And then between the time we ship a part before it turns into a car can be anywhere from 6 to 9 months, depending on the supply chain. It's a very extended supply chain. I think you also have to think back -- and we talked about this a couple of quarters ago, the seeds of the current supply shortage we're seeing right now got sown in late '18 and early '19. If you go back to that period of time, entering 2019, you had the first period of time where auto sales in China were down first time in 10 years. We also -- if you remember back, our auto business didn't really look that outstanding in 2019. It's a little punkish, if you will. And what we realized in hindsight is a lot of our Tier 1 partners were burning off inventory they had. As we entered into 2020 with the pandemic, a lot of our customers blew out whatever excess inventory they had, canceled orders on us. So you really ended up with a situation where we were completely kind of having to restart a very large extended supply chain. And very much like a motor where you need a little bit of oil or inventory at each stage of that supply chain, we've been struggling with that for the last 18 to 24 months. How do we feel comfortable with it? Escalations with our customers continue unabated, that continue to be elevated. And this is even against an environment where we are getting improved incremental supply every quarter, right? So I think it is also not a single golden screw problem with one part of the supply chain. It's more of a whack-a-mole kind of a game. One day, it's one part with one supply chain partner, different part of the supply chain. I know it's -- you guys would like us to give you a nice neat algorithm for it, but it's not as clean as that. Pricing is a part of it, as Bill said, and we will break that down and bridge that for you at the end of the year. But we feel fairly comfortable that what we're shipping is not just going into inventory and some warehouse in the world.

If we went back a couple of downturns ago, people accused you of carrying too much inventory in a downturn. Then you go into the '18, '19 downturn, and you guys slammed on the brakes hard. And then you did the same thing when COVID hit. Given what we've had with this pervasive shortage issue, do you guys change your inventory management, your utilization strategy as a reflection of that to create more buffer?

No. Our model is -- 55% of our business goes through the distribution channel. As you well know, many of our folks in the audience here today know, we watch the distribution channel like a hawk. We will look at everything that gets shipped in by product type, by distributor, by geography, every day. And we can see what gets sold out of distribution, right? So we manage that very, very tightly. Our model and distribution has been to run at about 2.4 months of supply. We've been, unfortunately, stubbornly down about 1.5 months of supply for 7 quarters now. And it's just -- it's a very tight environment there. In terms of our own balance sheet, we'd like to run about 95 days. We're at 94 days since this last quarter. We don't see that number changing dramatically. We're not going to raise the metric, if you will.

Do you think the customers change their behavior to mitigate some of these shortage issues?

We do. We do. But from conversations we've had with the large auto OEMs, supply is becoming more strategic and assured supply is becoming even more strategic. I think you're going to see the OEMs and their partners try to build up enough inventory, safety stocks to offset what may be the cycle time of their big semiconductor suppliers. So for us, cycle time is 3 to 6 months, with a few different variance of that.

How do you guys delineate between that sort of changed behavior from a customer and the double ordering that you had to scrub that you talked about in answering a prior question?

Yes. I think the double ordering is not as much in the automotive sector, if you will.

Let's talk about a couple of the big themes in the automotive side of things. On the EV side of things, you guys have a strong position in the BMS side of the equation. Talk a little bit about how the growth is there, the competitive environment. Obviously, EV adoption is being pushed very aggressively around the world much more so than I think most people hoped a couple of years ago or thought. So talk about how your positioning is in that market?

Yes. So I think that's one of the tailwinds of the content drivers, this whole shift towards xEV has been much faster than we anticipated. Last November at our Analyst Day, we had an estimate that we thought the penetration of xEVs this year would be about 17% of total SAAR. That's what our expectation is. It's about 19%, 20% now. It's faster. That's actually even carrying it through into future periods as well. Our play in electrification, and that's the term we use, think about electrification as having 2 kind of growth pieces. One part is the transfer of stored battery power to the electric motor via power discretes. That's not a market we're interested in. We can talk about that in a minute. But we're very much interested in the control and management of the overall electrification system. So that's kind of 4 subsystems: battery management systems, inverter control, AC to DC charging and propulsion control. In terms of battery management systems, we are the #2 vendor. We have aspirations to be #1. We compete with ADI. After the merger with Maxim, they did evolve as the #1 player. We have different solutions. Ours is more of a complete system solution with analog, connectivity and processing solution, whereas we believe their solution is more of a precision analog solution. We think it's a great growing market and enough space for 2 strong vendors to participate. In 2021, that was, the year is right, our electrification business is about $200 million. We expect it to grow at about $500 million by '24.

What about the wireless implementation of that? Is that something that you believe is truly going to be an evolution across the industry that you need to address? Or is it something that...

We think it's more of a niche. I think -- we don't have anything new to announce in that area. We know our competitor talks a lot about it, but we think it's a bit of a niche solution.

Do you have the capabilities to do it, should you choose to do it?

We've looked at certain areas like that, yes.

And then you mentioned a couple of the other areas outside of BMS that you're addressing. Talk a little bit about those. I think those aren't as well known to people.

Yes. So the inverter control -- and this is probably a little above my own propeller head capability to speak to, Ross, it's one more aspect of the overall control system of the electric vehicle. We have some early design wins. We're designed in with 9 of the top 20 auto OEMs. Going well. A little bit -- if you think of it as kind of phase, BMS was our lead vehicle. Inverter control is kind of behind that. [ AC to DC ] charging behind that, then the propulsion control.

Got you. Okay. But overall, that should be a nice tailwind for you guys as you...