ON Semiconductor Corporation — Q3 2017 Form 10-Q
Reporting period: Quarter ended September 29, 2017; nine-month period ended the same date. The filing was signed November 6, 2017. ON Semiconductor makes semiconductor products for automotive, industrial, communications, computing, consumer, medical and other markets. Its reporting segments are Power Solutions Group, Analog Solutions Group and Image Sensor Group. The year-over-year comparison is affected by Fairchild, acquired September 19, 2016, whose operations were included for only part of the prior-year quarter.
Financial performance and liquidity
| Metric | Q3 2017 | Q3 2016 | Nine months 2017 | Nine months 2016 |
|---|---|---|---|---|
| Revenue | $1,390.9 million | $950.9 million | $4,165.6 million | $2,645.9 million |
| Gross profit / margin | $524.2 million / 37.7% | $329.0 million / 34.6% | $1,519.6 million / 36.5% | $912.4 million / 34.5% |
| Operating income | $177.3 million | $46.7 million | $514.9 million | $180.4 million |
| Net income attributable to ON Semiconductor | $108.7 million | $10.1 million | $280.8 million | $71.2 million |
| Diluted EPS | $0.25 | $0.02 | $0.66 | $0.17 |
- Q3 operating margin was approximately 12.7% and net margin approximately 7.8%. Nine-month operating and net margins were approximately 12.4% and 6.8%, respectively.
- Q3 revenue increased 46% year over year; nine-month revenue increased 57%. Management attributed much of the growth to Fairchild, particularly in Power and Analog. The nine-month comparison also includes a $155.1 million first-quarter revenue-recognition change for eligible distributor sales.
- Q3 gross margin improved to 37.7%, which management attributed mainly to Fairchild, higher factory utilization and product mix. Nine-month gross margin was 36.5%; excluding the distributor-recognition change, management reported 36.4%.
- Nine-month operating cash flow was $869.9 million, versus $351.8 million a year earlier. Capital expenditures were $211.8 million, versus $160.8 million; operating cash flow less capital expenditures was approximately $658.1 million, versus $191.0 million.
- Cash and cash equivalents were $901.2 million at quarter-end, down from $1,028.1 million at December 31, 2016. Current assets were $2,815.4 million and current liabilities $1,429.3 million, for working capital of $1,386.1 million including cash; management reported working capital excluding cash and short-term investments of $484.9 million.
- Gross debt including current maturities was $3,191.1 million; net carrying debt was $2,942.9 million. At December 31, 2016, the respective figures were $3,806.8 million and $3,622.3 million. The company prepaid $200 million of term-loan borrowings in Q3 and had no revolving-credit borrowings at quarter-end.
- Management said cash, operating cash flow and available financing were expected to fund operating and capital needs for at least the next 12 months. Approximately $255.3 million of cash was available within the United States.
Material changes and unusual items
- Fairchild acquisition: The acquisition materially affects year-over-year comparability and added revenue and costs to the consolidated results. Research and development, selling and marketing, and acquisition-related amortization rose in Q3, largely reflecting the combined business.
- Distributor revenue recognition: Starting in Q1 2017, the company began recognizing certain distributor sales when shipped, after it could estimate returns and allowances. It recognized $155.1 million of revenue from this change for the quarter and nine months; the reported pre-tax income benefit was $59.0 million, or $0.09 per basic and diluted share. Estimated returns reduced revenue by $8.1 million and pre-tax income by $5.3 million.
- Other income items: Q3 included a $12.5 million gain on the Xsens divestiture and $21.5 million of licensing income. Nine-month licensing income was $45.4 million. The licensing arrangement included $10 million deferred pending technology qualification or potentially refundable if qualification is not achieved by June 21, 2018.
- The prior-year Q3 included a $92.2 million divestiture gain, compared with $12.5 million in Q3 2017. Q3 2017 also included a $6.7 million loss on debt prepayment. Nine-month debt refinancing and prepayment losses totaled $32.9 million.
- The Q3 income-tax provision was $59.4 million, with a 35.3% effective tax rate; the nine-month provision was $144.5 million, with a 33.9% effective rate. Management expected the rate to approximate the U.S. federal statutory rate of 35%, excluding discrete items.
Outlook, risks and contingencies
- Q4 2017 outlook: Revenue estimated at $1.325 billion to $1.375 billion; gross margin estimated at 36.3% to 38.3%. Backlog represented approximately 80% to 85% of anticipated Q4 revenue. These are management estimates subject to risks and uncertainties.
- Management cited semiconductor cyclicality, demand and pricing pressure, customer inventory and cancellations, supply and manufacturing risks, execution of cost savings, foreign exchange, acquisition integration, and substantial leverage and debt-covenant compliance among the risks that could affect results. The company was in compliance with debt covenants at quarter-end.
- Patent litigation: The company estimated possible losses across Power Integrations cases at approximately $4 million to $20 million, while disputing liability. Several proceedings and appeals remained pending; the effect of USPTO decisions finding certain asserted patent claims unpatentable was uncertain. Acbel sought approximately $17 million in a separate case, with a court decision pending.
- Other disclosed exposures include product warranty, product-liability and indemnification matters, environmental remediation matters, and guarantees. Management said it did not expect environmental costs or payments under standby guarantees to be material based on information then available.
- A 50-basis-point increase in interest rates, including swaps, was estimated to increase expected annual interest expense by approximately $6.9 million. A hypothetical 10% currency-rate change was estimated to affect pre-tax income by approximately $73.1 million absent hedges or correlated offsets.
Important facts for investors to verify
- Separate organic growth from Fairchild’s contribution and the $155.1 million distributor-recognition change when assessing revenue growth and earnings quality.
- Review whether Q4 revenue and margin guidance was achieved, and whether backlog converted as expected.
- Track debt repayment, interest expense, refinancing costs, liquidity and compliance with credit-agreement covenants.
- Assess the durability of margin improvement against factory utilization, product mix, and acquisition-related costs and amortization.
- Monitor the HSET technology qualification deadline and deferred $10 million, along with the outcomes and possible financial effects of the PI and Acbel litigation.
- Consider that the filing’s cash-flow figures are for nine months and that interim results are not necessarily indicative of full-year results.