ON Semiconductor Corporation — Q2 2017 Form 10-Q
Reporting period: Quarter ended June 30, 2017; unaudited. Comparisons are with the quarter ended July 1, 2016, and the six months ended June 30, 2017 versus July 1, 2016. ON Semiconductor supplies semiconductor products across automotive, industrial, communications, computing, consumer and other markets. Its reporting segments are Power Solutions, Analog Solutions and Image Sensor. Results include Fairchild, acquired in September 2016, so year-over-year comparisons reflect the acquisition.
Financial performance
| Metric | Q2 2017 | Q2 2016 | Six months 2017 | Six months 2016 |
|---|---|---|---|---|
| Revenue | $1,338.0 million | $877.8 million | $2,774.7 million | $1,695.0 million |
| Gross profit | $492.1 million | $307.9 million | $995.4 million | $583.4 million |
| Gross margin | 36.8% | 35.1% | 35.9% | 34.4% |
| Operating income | $154.2 million | $75.3 million | $337.6 million | $133.7 million |
| Net income attributable to ON Semiconductor | $93.9 million | $25.1 million | $172.1 million | $61.1 million |
| Diluted EPS | $0.22 | $0.06 | $0.40 | $0.15 |
| Operating cash flow | Not stated separately | Not stated separately | $541.7 million | $219.1 million |
| Capital expenditures | Not stated separately | Not stated separately | $121.7 million | $124.9 million |
- Q2 revenue rose about 52%; six-month revenue rose about 64%. Management attributed most of the increase to Fairchild, with six-month results also including $155.1 million of revenue recognized earlier on eligible distributor shipments.
- Q2 gross margin improved by 1.7 percentage points, attributed to Fairchild contributions, higher factory utilization and product mix. Six-month margin excluding the distributor revenue-recognition change was 35.7%.
- Q2 operating expenses increased to $337.9 million from $232.6 million, reflecting Fairchild-related costs, including higher payroll and variable compensation. Six-month operating income increased to $337.6 million from $133.7 million.
- Q2 interest expense was $34.7 million, down from $42.1 million; for six months it was $73.1 million, up from $57.7 million, primarily due to acquisition-related borrowing. Six-month other expense included a $26.2 million debt refinancing and prepayment loss.
- Q2 included $23.9 million of licensing income related to the sale and licensing of Mobile CIS assets. Management expected another $20.0 million to be recognized in Q3 and $10.0 million to be deferred pending qualification; the deferred amount is refundable if qualification is not achieved by June 21, 2018.
Liquidity, cash flow and debt
- Cash and cash equivalents were $871.6 million at June 30, 2017, down from $1,028.1 million at year-end 2016. Six-month net cash provided by operations was $541.7 million; investing activities used $120.9 million and financing activities used $579.5 million.
- Working capital was $1,401.1 million including cash and short-term investments, and $529.5 million excluding them. Management said cash, operating cash flow and available financing were expected to cover operating and capital needs for at least 12 months. Approximately $292.8 million of cash was available within the United States.
- Gross debt, including current maturities, was $3,407.3 million; net carrying debt was $3,140.5 million, including $268.2 million current and $2,872.3 million long-term. Gross debt declined from $3,806.8 million at December 31, 2016. The revolving facility balance was zero at quarter-end; the company reported compliance with debt covenants.
- In March, ON issued $575 million of 1.625% convertible notes due 2023 and used most proceeds to repay term-loan borrowings. It also amended its credit agreement to reduce applicable borrowing rates. During the first half it repaid $1,191.3 million of debt and completed $144.7 million of convertible-note hedges, partly funded by $85.2 million from warrant issuance.
- A 50-basis-point increase in interest rates, including swaps, was estimated to increase annual interest expense by approximately $8 million. The company had $1,599.2 million of variable-rate debt at June 30.
Material changes, outlook and risks
- Power Solutions generated Q2 revenue of $671.4 million, Analog Solutions $468.5 million and Image Sensor $198.1 million. Growth was concentrated in the Power and Analog groups, mainly reflecting Fairchild; Image Sensor revenue increased about 6% year over year.
- From Q1 2017, the company began estimating distributor returns and allowances at shipment rather than waiting for resale to end customers. The transition recognized $155.1 million of revenue in Q1 and increased pretax income by $59.0 million, or $0.09 per basic and diluted share; estimated returns reduced revenue by $8.1 million and pretax income by $5.3 million. ON planned to adopt the broader revenue standard on January 1, 2018, and was evaluating possible timing effects for ASIC and custom-product contracts.
- Q3 2017 outlook: revenue of approximately $1.34–$1.39 billion and gross margin of 36.0%–38.0%. Backlog represented about 80%–85% of anticipated Q3 revenue. These are forward-looking estimates subject to risks and uncertainty.
- Fairchild integration and cost-reduction work continued. A post-acquisition restructuring program had incurred $30.3 million of expense to date; management said further charges could occur. A Japan voluntary workforce-reduction program could involve up to 50 employees and estimated expense of $3–$4 million.
- ON disclosed eight outstanding civil proceedings with Power Integrations and estimated possible losses across those cases at $4–$20 million. A separate Fairchild-related case included a $139.8 million jury damages award plus approximately $7 million in prejudgment interest; execution was stayed pending appeal after a bond was accepted. Acbel seeks at least $30 million in a separate case, where the court had not yet issued a verdict.
- Other stated risks include semiconductor cyclicality, pricing and demand changes, customer order cancellations, manufacturing and supply-chain disruptions, foreign-exchange exposure, substantial leverage and covenant constraints, acquisition-integration risks, product liability and intellectual-property litigation. Management reported effective disclosure controls and no material quarterly change in internal control over financial reporting; Fairchild control integration was expected to continue through Q4 2017.
Important facts for investors to verify
- How much reported growth and earnings improvement is attributable to Fairchild, distributor revenue-recognition timing, and nonrecurring licensing income rather than underlying organic performance.
- Whether Q3 revenue and gross-margin guidance is achieved, and whether backlog conversion, demand and factory utilization support the outlook.
- Debt repayment progress, cash generation, variable-rate exposure, covenant headroom and the effects of the convertible notes and related hedge and warrant arrangements.
- The resolution and potential financial exposure from Power Integrations and Acbel litigation, including appeals and the stated loss estimates.
- Whether the remaining Mobile CIS payment is received and technology qualification is achieved, given the $10 million potential refund and associated asset write-off.