Regeneron Pharmaceuticals, Inc. (NASDAQ:REGN) TD Cowen 4th Annual Oncology Innovation Summit May 30, 2023 12:30 PM ET

Company Participants

Izzy Lowy – SVP, Solid Organ Oncology Development

Andres Sirulnik – SVP, Translational & Clinical Sciences, Hematology

Ryan Crowe – VP, IR

Conference Call Participants

Tyler Van Buren – TD Cowen

Tyler Van Buren

All right. We’ll give it a couple of seconds for everyone to join. Okay. So with that, welcome, everyone, again, to the TD Cowen’s 4th Annual Oncology Innovation Summit Highlights for ASCO and EHA. My name is Tyler Van Buren, Senior Biotech Analyst here at TD Cowen. For our next session, we’re very pleased to have a fireside chat with Regeneron. And it’s my sincere pleasure to introduce Izzy Lowy, Senior Vice President of Solid Organ Oncology Development; and Andreas Sirulnik, Senior Vice President of Hematology (ph) Development. Izzy and Andreas, it’s a privilege to have you both here. Thank you very much for joining me.

Andres Sirulnik

Thank you for having us, Tyler.

Tyler Van Buren

Ryan, Head of IR. Ryan Crowe, Head of IR. Thank you very much for being here as well. I know you have some forward-looking statements to go through, so I’ll hand it over to you for that.

Ryan Crowe

Most important part of every presentation, Tyler, I would like to remind you that remarks made today may include forward-looking statements about Regeneron and each forward-looking statement is subject to risks and uncertainties that could cause actual results and events to differ materially from those projected in such statements. A description of material risks and uncertainties can be found in Regeneron’s SEC filings. Regeneron does not undertake any obligation to update any forward-looking statements, whether as a result of new information, future events or otherwise.

Tyler Van Buren

That was awesome. Very exciting. And I’ll hand it back to you for a brief overview, but before I do, for those of you tuning in, feel free to e-mail me at first.last or [email protected] if you have any questions for the team during the fireside. You could also submit them via the Ask a Question box in the panel.

So with that, Ryan, to start, maybe you could provide a brief overview of the data sets that we can expect to see across Regeneron’s pipeline at ASCO this weekend, and then we’ll pass it over to Andreas and/or Izzy, if they’d like to add anything as well.

Ryan Crowe

Yeah. Thanks, Tyler. I think this is another important oncology conference that shows an incremental progress that Regeneron continues to make and expanding its presence in oncology, and it’s really centered around two foundational and synergistic approaches PD-1 inhibition with Libtayo and our investigational bispecifics. In the two presentations that are oral at ASCO, we’re going to be sharing longer-term results for the BCMA targeting bispecific Linvoseltamab, which Andreas will speak to. This is in a relapsed/refractory multiple myeloma setting. Most of these patients have had at least three prior lines of treatment.

And then we also have an exciting update for the Fianlimab program with results in advanced melanoma patients that were previously treated with anti-PD-1 therapy in the adjuvant setting. So important updates for both of these programs. We actually issued two press releases last week previewing these data sets. So you may have seen some of the highlights there. And our comments are going to generally remain within the balance of that until the presentations.

Linvoseltamab data will be presented on Saturday afternoon in the Heme Malignancies session, while the Fianlimab, Libtayo data will be presented on Monday morning — I’m sorry, Monday afternoon during the Melanoma and Skin Cancers Oral Presentation session.

With that, I’ll hand it to Andreas for some brief remarks about Linvoseltamab and then Izzy can speak to Fianlimab, and then we’ll get to your specific questions, Tyler.

Tyler Van Buren

That would be great.

Izzy Lowy

Thank you, Brian. So at an oral presentation at upcoming ASCO, we will be presenting longer-term follow-up of our ongoing Phase I/II potentially pivotal study with our Linvoseltamab, BCMAxCD3 bispecific. In a press release last week, as Ryan mentioned, we highlighted some of the key outcomes of what will be presenting. We continue to be very encouraged with data that is emerging with longer follow-up in terms of the level of efficacy, durability and safety profiles that are emerging.

Just to give you a quick bottom line is that our response rates continue to increase in our higher dose of 200 milligrams that has been chosen to move forward. The safety profile remains very manageable and promising. And I think that in terms of dosing is a place where we will be differentiating and we’ll talk a little bit more about it later. But I think that when you put it all together, we have a highly active competitive BCMAxCD3 bispecific with an overall response rate of 71%, which is very encouraging and competitive.

And as I mentioned, the safety profile with — just to highlight low levels of CRS in the other of 45%, but mostly grades 1 that reassure us that we are on the right track there.

So saying that maybe Izzy, you want to highlight a little bit what we will be sharing.

Izzy Lowy

Sure. Thank you. So the other oral abstract we have at ASCO is on our updated data on our Fianlimab program, anti-LAG-3. It includes additional follow-up from two cohorts that we previously discussed that gave us test and retest confirmation of very high response rates in patients with first or second-line melanoma who are naive to anti-PD-1 therapy with response rates north of 60%. And in this abstract, we’re also providing information on patients who receive systemic therapy in the neoadjuvant or adjuvant setting, including over a dozen patients who received anti-PD-1 as their adjuvant therapy. But unfortunately, after completing that therapy subsequently relapsed, and they too had a — in that group of 13 patients, we had a 62% response rate in these patients.

So what we are very excited about is that we’re looking at responses — response rates that are double — nearly double that of what you would get with anti-PD-1 alone and highly competitive with the currently approved anti-LAG-3 therapy out there and give us a lot of confidence and hope there are ongoing Phase III studies in melanoma, both in advanced melanoma and in adjuvant melanoma will be successful. We have quite a few other studies also underway, and I’m happy to answer any additional questions as they come up.

Question-and-Answer Session

Q – Tyler Van Buren

Great. Andres, and Izzy, those were perfect introductions. Thanks for all the background. I’ll plan to start with linvo and a couple of questions on odro and maybe a CD28 before we get into Fianlimab. But so — with the linvoseltamab data, very pleased to see the updated data in the abstract, right, three months of follow-up at ASH, very limited follow-up. So I’m not surprised to see the response rates continue to deepen.

But I guess — so we have six months as of the ASCO abstract. When we get the ASCO presentation, we should have hopefully, even more time right with an additional cut? And I guess my question is, would you expect that — is there a potential for that 30% CR rate to continue to deepen as we look to compare it to program — other programs like Tech Valley’s 39% CRA.

Andres Sirulnik

Maybe I’ll start with the last part of your question, I want to highlight that based on what we have learned and as we are following the data and what we know about the linvo, we do expect those CR rates to increase over time. Again, you highlighted that what we will be presenting at ASCO is a longer follow-up on, I would say, two large cohorts of patients. A patient that was — a cohort of patients treated at 50 milligrams and cohort of patients treated at 200 milligrams. Those were the two doses that we expanded.

And at ASCO, there will be approximately 60 additional patients in the 200-milligram cohort compared with what we show at ASH and for both, we have longer-term follow-up, particularly for the patients at 50 milligrams because we initiated that expansion earlier.

And what I can say is that we continue to see high rates of responses. I mentioned to you the overall response rates of around 71%. And we are seeing a consistent safety, when it comes at what we’ve seen at ASH and we will be presenting now. So both remain consistent with high response rates, the manageable safety profile that we will be showing. So the safety is based on the pool of patients, over 200 patients and then, we’ll talk about efficacy, primarily at the 200 milligram dose, which is the one that we have chosen to move forward.

Tyler Van Buren

Okay. That’s clear. And in terms of linvo safety profile, I think it’d be helpful to just understand the evolution of safety in these trials and the changes that you made over time to get to where you are today.

Andres Sirulnik

Yeah. So I think that when it comes to safety, most people focus on cytokine release syndrome for the class, all right? And I am very pleased to say that — even when you look at the 50-milligram cohort, the 200-milligram cohort, we see consistent rates of CRS and that is to the point that CRS occurs almost invariable in the first 1, 2 doses of linvoseltamab with very rare cases beyond that. And we observed 45% of CRS in the 200-milligram cohort.

And as I mentioned to you earlier, there were no cases of Grade 4, no cases of Grade 5. I think all you know, there was one case of Grade 3 and the rest were primarily out of 45%, the vast majority were Grade 1. Just to remind you, that’s just fever. So we touched about, in terms of the cytokine release syndrome. Of course, the overall safety remains very consistent with what we presented at ASH and in line with CRS, the most common adverse effects reported.

I think that I alluded to this, but what is important to note is that we have a very predictable and early onset of CRS. As I mentioned, it occurs in — mostly in the first two doses within 15 hours of initiation and results within one day. And this has led to how this program evolved in terms of hospitalizations. And I think that that’s where we have, what I believe, a competitive edge.

Unlike other CD3xBCMA bispecifics, we only have two in total hospitalizations as per protocol. We hospitalized for 24 hours on the first dose, and we hospitalized for 24 hours on the second dose on day eight and that’s it. In fact, we are — our protocol allow investigators potentially to do away with the second hospitalization if they have not experienced any CRS and they are tolerating well the treatment.

And in addition to that, we allow investigators in the trial to reduce the infusion time. So we initially start with 4 hours. And if patients are tolerating this well, we reduce it to 30 minutes. An infusion of 30 minutes is the time that you spend on a shelf for subcutaneous dose, all in all. So we think that this is the a very competitive edge to linvoseltamab.

Tyler Van Buren

Yeah. That’s clear. So the rates are a lot lower. It’s earlier, more predictable, clearly differentiated on the safety side, particularly with respect to CRS. Why do you think you guys may be seeing that. Is there a clear mechanistic reason or a way that linvoseltamab was designed that explains it or?

Andres Sirulnik

I think that it’s very difficult to tease out what is due to the antibody vis-a-vis the treatment paradigm in terms of how we premedicate and so forth. But all in all, I would say that not all bispecific antibodies are the same. And we are starting to see this not only here, but we’re starting to see that with other bispecifics. So I think that, that is important. And talking about differentiation, I’m going to focus for a minute on efficacy, excuse me.

I mentioned we have 71% overall response rate. These are incrementally better than what we showed at ASH, but very competitive and very impressive in my view. I think that — what is important here is that when you look at the patient population that was included in this trial, vis-a-vis the patient population that have been reported for teclistamab, for example, and others, and I mentioned teclistamab because we have a label to look at.

Our patients seem to have higher disease burden. And when we see our responses, what we see is that there are consistent both in patients that have low disease burden and patients that have high or very high tumor burden. And what we look at is, for example, the number of plasma cells, tumor cells in the bone marrow.

When we look at patients that have high risk cytogenetics, when we have patients that have high soluble BCMA, which is another market of a tumor burden, our patient population have, I would say, more than double on what the patients that have been included in other studies and we would see consistent, very good responses in all these subpopulations that we study. So that, again, is very encouraging on how this antibody is differentiating.

Tyler Van Buren

Okay. That’s very helpful additional context as we think about comparing the efficacy data. So you guys remain on track to submit the BLA for linvo in third line plus multiple myeloma in the second half. Before we leave linvo and ask odronextamab question, can you briefly discuss your future plans for linvo in terms of earlier lines of therapy and what the broad strategy looks like there?

Andres Sirulnik

Absolutely. So for linvoseltamab, yes, we will remain on track for filing in the second half of this year. And we are expanding the program, we’re moving to early lines of therapy. We are initiating a pivotal trial in second plus lines of therapy where we are going to be comparing linvo monotherapy versus standard-of-care. I mentioned the overall efficacy that we are seeing is such that we believe that monotherapy is an option for patients and could potentially spare the toxicities associated with multi-drug regimens.

And with that in mind, we are exploring as well combination with other therapies in early lines of therapy as well as late lines of therapy, we are moving into first line and potentially even into premalignant conditions. That’s one aspect that I think may differentiate us here. So that’s it.

Tyler Van Buren

Okay. That’s great. In the essence of time, I’m going to get to fianlimab, but because there’s so much to discuss there as well. Obviously, the odronextamab follicular lymphoma data at ASH looked great. DLBCL is strong, and that data will probably continue to improve and you guys plan to file by the end of the year, and you’ll have CD28 updates as well, more and more to discuss in oncology for you guys as time goes on.

But now turning over to Izzy and LAG-3 and fianlimab, very helpful overview of the data that we’ve seen a nice continuance in the naive data that we saw at ESMO. But in checkpoint experienced patients, I saw that 62% response rate and was pretty surprised, frankly, albeit a small sample size, but surprising nonetheless. Can you explain why you guys might be seeing that in this patient population and how you view the opportunity moving forward?

Izzy Lowy

Sure. Thank you. So let me make sure people really understand the patient population because I don’t want people to get the impression that we’re taking patients who are progressing on PD-L1 or PD-1 and adding LAG-3 and getting a high response rate. We’re talking about people who at the time of their resection of their melanoma, a curative intent resection, but with certain high-risk features, receive a course of adjuvant anti-PD-1 finished and then were followed and six months or more after that relapse.

So I think the question that we all had was that pre-existing relatively remote exposure to anti-PD-1 going to impede the ability of a PD-1 containing therapy to cause a profound response rate. And the answer so far in this small set of patients is very encouraging and seems to be no, that after six months or more after therapy if patients have relapsed, they basically have reset and they can receive a combination of PD-1 and LAG-3.

We do — we have reported in the past that if you add LAG-3 to patients who are rapidly or in the process of progressing on anti-PD-1, we don’t see the same kind of response rate. It’s much more in the order of 10% to 15%. They’re real is much slower. And that’s consistent with what everyone else has seen in the field. But I think given the increasing prevalence of patients who will receive an anti-PD-1 in the adjuvant setting or the neoadjuvant setting, it is good to know that should they recur in the future, a PD-1 containing regimen, including LAG-3 has the potential to be just as potent as if they were completely — PD-1 completely naive.

Tyler Van Buren

Okay. Very interesting. I guess obviously, Merck and Moderna have presented and will present more data at ASCO with PCB combination in the adjuvant setting, but that is kind of more the true adjuvant setting and not after they’re relapsing, right? So you guys would be looking to kind of come in even after then, right, with the LAG-3 combination.

Izzy Lowy

No. We’re — well, we’re doing a study in patients who are — we have two studies underway that are registrational. One is in the advanced melanoma setting, patients who have unresectable or metastatic disease, whether or not they received adjuvant PD-1 at this point for the testing of the combination of Fianlimab and Cemiplimab against standard of care Pembrolizumab. We also have an adjuvant study underway for patients who are having a resection of the high-risk — resection of melanoma with high-risk features at risk for recurrence. And there, we’re also testing the ability of anti — of Cemiplimab and Fianlimab to offer a better relapse free survival than the use of anti-PD-1 alone.

Now whether or not the combination of an anti-PD-1 and an individualized patient vaccine also offers a benefit remains to be seen. That was as initial promising data, although it was a relatively small study. But we’re very optimistic based on the high response rate that we’ve seen. The fact that we have not seen the duration of response has not reached the median yet. And a progression free survival in the advanced setting of 15 months based on current estimates compared to the 10 months that was presented in the dual LAG study, we think we have a very promising option for these patients.

Tyler Van Buren

Okay. That’s very clear. Thanks for clarifying that. And then could you just give a brief overview of the potential timeline to top line data for both of those Phase III studies?

Izzy Lowy

Sure. So we’ve given general guidance that we hope to have data in 2025 from both the advanced melanoma setting and potentially an interim look in our adjuvant study as well.

Tyler Van Buren

Okay. And then for the advanced melanoma Phase III readout, what do you think you guys need to show to be successful and compete effectively against Opdualag?

Izzy Lowy

Well, I think if the data that we’ve seen in the three different cohorts that we’ve tested now hold out, and we continue to show a higher response rate, a longer duration of response and an even better progression free survival, we’ll be in a very competitive space.

Tyler Van Buren

Yeah. And in the metastatic setting for IO LAG-3 combination, how do you view the ultimate long-term opportunity? Where do you think this combination will truly exist and what sort of share do you think it might be able to take?

Izzy Lowy

Beyond melanoma, you mean?

Tyler Van Buren

Sorry, within melanoma. Obviously, even Opdualag is still relatively early in its launch.

Izzy Lowy

Well, I think we’re relatively — we’re not very far behind. So if we have a better agent, usually the better agent wins. So as I said, we have really compelling efficacy. The first cohort we did where we saw a 62% response rate we were stunned, so we repeated it. We saw another one. And now the third time around, we’re seeing it again, even in patients who had adjuvant PD-1. So we believe it. It’s obviously a total experience of only 100 patients or 98 patients. So we need to have a full-fledged Phase III to nail it, but this is not subtle.

And it rivals the type of efficacy that has been observed with combinations of anti-CTLA-4 and anti-PD-1 with a much superior tolerability and safety profile. So we have to see that it — so we have very high expectations for it. And we believe it has potential in multiple other indications. So we are running a Phase II/III lung cancer pair of trials, one with chemotherapy and one without chemotherapy to nail down and see whether or not our initial signal in a much smaller cohort really holds up as well. And if it does, we’ll flip that to Phase III programs and we’re exploring a number of other indications as well.

We don’t know for sure, but we’re hoping that LAG-3 Fianlimab in combination with Cemiplimab can emerge to be a next sort of incremental step-up from PD-1 monotherapy that is versatile, well-tolerated and applicable on a large number of tumor types.

Tyler Van Buren

That sounds good to me. We’re over time now, but maybe we’ll just wrap up with a final question. Both Andreas and Izzy, what would you consider the most underappreciated aspect of Regeneron’s oncology pipeline by investors?

Izzy Lowy

The most underappreciated is our people.

Tyler Van Buren

I like that. Andres?

Andres Sirulnik

I think that people — I think that we have a tremendous opportunity to make a difference. And when I look at linvoseltamab, for example, I think that we have the potential to be best-in-class when we look at our CD20xCD3 bispecific odronextamab, I think that we have an opportunity, particularly in follicular lymphoma to differentiate. And I think that when you look at the potential of continuing to solidify our presence in oncology will bring a tremendous value proposition to the table.

And to highlight, I think this is the same in the solid tumors as in the heme space, we are coming with the next generation of co-stimulatory molecules. We are already in the clinic in prostate cancer. We are combining already, we dosed our first patient with odronextamab with a CD28xCD22 bispecific and eventually, we’ll enter the clinic with a CD28 by another antigen in myeloma, giving us an opportunity to really differentiate from others.

Tyler Van Buren

Absolutely. You guys have a lot going on. Andreas, Izzy. Ryan, thank you very much for the time.

Andres Sirulnik

Thank you, Tyler.

Izzy Lowy

Thank you.

Ryan Crowe

Thanks, Tyler.

Tyler Van Buren

Take care.

Ford Motor Company (NYSE:F) Morgan Stanley Sustainable Finance Summit Conference Call May 25, 2023 10:15 AM ET

Company Participants

Jim Farley – President and Chief Executive Officer

Conference Call Participants

Unidentified Analyst

Great. Welcome everyone, and thank you for joining us all today for a conversation with one of the leaders in transformation of a critical piece of the real industrial economy. I’m thrilled to be joined this morning by Jim Farley, Ford Motor Company. Jim has been part of Ford since 2007. And assumed the role as President and CEO in October of 2020 as the company and the industry drove into its most significant transformation since the innovation of the [model key] [ph] assembly line.

Under Jim’s leadership, Ford has introduced the Ford Mustang [last year] [ph] and Ford F-150 Lightning, daring to lead the past for the electrification with two of Ford’s most iconic and critical vehicles. Ford has also recently reorganized the company and its reporting along the lines of its traditional gasoline powertrain, electrification, and commercial vehicles, providing a pioneering transparency and accountability in the industry.

We’re thrilled to have Jim with us today to discuss how he has approached revolutionizing a 120-year old purpose driven company and an industry with its stakeholders. Before we dive into some questions, we’d like to share some background on Ford’s mission and transformation journey with a short video.

[Video Presentation]

Great. So Jim, thanks for joining us today. Can you start by telling us a little bit about Ford’s journey to transform into a leader in electric vehicles, and how is your strategy unique amongst your peers?

Jim Farley

Sure. Well, first of all, I want to thank those of you who are partners for Ford and the Ford team for being here. We are the number 1 employer of Americans in our industry. We’re about 60,000 hourly workers, about 20% higher than anyone else in our industry. And my grandfather was an hourly worker. Started the company in 1913. So, this is a – and I worked at Toyota for 25 years. So, I came back to Ford as, kind of a volunteer really to make sure to do everything I can to make sure this American company makes it through the great recession and transformation. I would say, we’re entering the second inning of a nine inning baseball game.

It’s in execution now. Kind of no longer are questioning what we need to do. We now know exactly what we have to do. The second order problems that we couldn’t see in the first inning are now clear, like, the geopolitics or raw material processing for lithium and nickel, the labor overhang, vehicles that are 20% to 30% less labor content. Those kind of real issues are very clear now. Working through them. Everyone in my leadership team is new except for one person.

So, it’s been very difficult on a personal level throughout the whole company. We’ve gotten out of India, gotten out of manufacturing in Brazil, which we were in for a 100 years. We’ve restructured Europe and we’ve restructured China. Tens of thousands of people have lost their jobs, hiring lots of new ones. And as we get into this, I guess, how we’re different? We’re leaning into what we’re really good at. So, we don’t want to do any more generic vehicles. We want to lean into work vehicles or 41% share of commercial vehicles in the U.S.

So, if you have a health problem, you’re probably going to be in a Ford ambulance. If you get pulled over, you’re probably going to get pulled over by a police officer on a Ford, or if your house burns down, the fire department is probably going to show up in a Ford. And if you have a plumber, electrician, they’re probably going to be in a Ford. That’s the same with Europe. So, we do really, really, really well in commercial vehicles, and they’re very difficult, complex business. It requires physical service of the vehicle [as it breakdown] [ph]. And 95% of the market is small and medium-sized business, is very complicated.

We do very well with passionate products like Bronco’s and Mustang’s and F-150’s, and we do really well on trucks and large SUVs. So, that’s what we’re going to focus on our product strategy. Everyone thought that the transition is going to be to electric. It turns out that’s actually not very interesting. It’s necessary, but it’s not interesting. The most important change is to go from an analog to digital product. So, we now know we didn’t a year ago of what the three shippable software will be for the car like your phone, it was like e-mail and listening to music in 2007, 2008. We now know it’s like safety security productivity software and partial autonomy.

So, it’s really exciting to have the teams build-out the software and upgrade all the electric architectures in-source all of that, all the software that controls the vehicle inside the company. And now we’re in the midst of that. We come out with our second-generation products. We’re Number 2 in the U.S. in hybrid; and we’re Number 2 in the U.S. in EV sales behind Tesla and Toyota. And we come out with our second generation products, which will be radically different than the first in about two years. And we sell about for 4 million to 4.5 million vehicles a year at Ford.

We’re like a middle weight in our industry. We’re heavyweight when you look at our overall revenue because we have very high expensive vehicles, priced. The average F-150 today is $63,000. When I joined the company 15 years ago, it was $25,000. So, actually, Ford’s transaction price in the U.S. is just about $10,000 less in a BMW now. They sell 200,000, we sell 2 million. So things we sell very expensive vehicles now, and that’s our strategy. But our second cycle product will be 2 million units of incremental capacity.

The company has never grown since my grandfather was at the company, 2 million vehicles. So, a 30% growth in revenue. And our software business will go – we have 600,000 subscriptions now in software, and that will grow by 10-fold. So, our revenue will start to be in the billions in software over the next couple of years. So, we’re building the platforms, both the consumer-facing platforms and the vehicle, electric architecture platforms for all that software and redoing our distribution. And at the same time, we have to fix our industrial system to make cost competitive and to restore competitive quality so we can fund it all. So, that’s where we are. We’re in the messy middle. Lots of hard work.

Unidentified Analyst

So, you’re coming out of all these new products, consumers are going to be adopting them and help them, you know Ford is going to grow, but a lot of these are going to be EV products, and there’s an infrastructure issue related to that. How do you think about improving the charging infrastructure to support your customers as you grow this part of your business?

Jim Farley

Yes. It’s a good question. I think the – on the commercial side, it’s not an issue – most of the commercial customers do depot charging. They know exactly what route they do and they do the same [miles] [ph]. They don’t overbuy batteries. Anyone with EV in this room is probably over – way over bought your battery, but the commercial vehicle customers don’t. And so, the commercial side, we’ve gotten this far with mostly home charging.

If you look at a place like Norway, which has been 50% electric for 10 years now, you can kind of find the answers to retail charging and how it will play out. The government tried to do it there, it didn’t really work. It was really – Tesla did a great job building out the supercharging network. And then the building standards got serious and retailers started putting fast charges in front of their stores, like supermarkets. So, people can plug in and it took 2 seconds to fill up your car with electrons because people were shopping anyways.

So, I believe we’re, again, like maybe in the first inning of the infrastructure. I think we’re most concerned about the grid. On the infrastructure side, I think it’s room for some collaboration between the auto companies, which is totally unnatural for us. I keep thinking like in the 1800s, which train – how did the train companies agree on the gauge.

The Western railroads had narrow gauge to go around corners, and then the plains gauges were much broader, wider for cargo. Someone had to agree to what gauge you use. Right now, we have two different plugs, for example, [NACS] [ph], the Tesla invented; and then SAE that invented the CCS are completely different, and it seems totally ridiculous that we have an infrastructure problem, and we can’t even agree on what plug to use.

So, I think we need to start – I mean I think the first step is to work together in a way we haven’t probably with the new EV brands and the traditional old companies. That’s one. For us, we have to take commercial charging into our own hands like Tesla do with Supercharger network. I need to do that for commercial vehicles. So, we create our own charging company, own charging software company. And now we have about 50% attach rates, which is really high.

So, 50% of people who buy EVs, pick-up trucks or commercial vans are buying our charging equipment. That was a good move, I think. On the retail side, there’s no easy answer. It will take a long time. Of course, everyone wants an easy answer, but there is no one. It’s going to be really difficult like it was in Norway.

Unidentified Analyst

Speaking of things, there’s no easy answer, the big theme around the auto industry recently has been the price cuts around Tesla, the competitive landscape when we look at what the product…

Jim Farley

Sure. I have no idea why everyone is surprised in all that. Yes. Henry Ford did it in 1913 with the Model T. His intro price is $810. Four years later, it was $500.

Unidentified Analyst

How do you think about – you’ve talked about how Ford is focused on the things that you’re really good at and I’d like to find that first. How do you think about preserving that in the face of new competitive products coming from China? And how do you think about Ford’s position relative to, sort of that transformation and the competitive landscape?

Jim Farley

Thank you. First of all, the most important thing that we’re learning about electrification is that some of the most appealing parts of the vehicle aren’t actually the propulsion system. One of the main reasons why 50% of the Lightning customers are new to pickup truck, and new to Ford is because you can power your house for 3 days with the truck. It has nothing to do with the fact that the truck goes 0 to 60 in 4 seconds, which [indiscernible]. But it’s actually the grid in the U.S. in Florida and Texas and California, has lots of problems, and people don’t want to buy big expensive generators or if you’re on a job site, and you don’t want to have 6 Honda generators humming away to build a new home.

The Lightning is a portable battery system, and a lot of Americans really want portable energy to power the house or job site or a giants tailgate or whatever. So, we’re learning that, that actually, we have to challenge ourselves to use the battery more creatively than just move the vehicle. I think that’s really important. And I don’t think the competitors have figured that out yet. The other thing is that our industry is obsessed with large batteries because the customers are worried about range anxiety. And really, we think the solution is actually not a big battery. It’s a small as possible battery for competitive range.

The humans normally taking a long trip are going to stop after 200 miles to 300 miles. So, actually, if you can fast charge and get another 200 miles in 10 minutes, that would be better than having a 500-mile range battery, which costs like $30,000 extra. As the batteries are heavy, you actually have to put more batteries in to power the batteries, to move the batteries because they’re so heavy.

So, I think as far as the Chinese is concerned, it’s going to be really humbling. They produce 70% of electric vehicles in the world in China 70. And the winners are BYD, Geely, Changan, SAIC, Great Wall. And if you add the Western brands up in China on the internal combustion engine, a 60% share. But not one name I’ve given you is a Western company.

BYD’s scale is way bigger than Tesla now. And they developed LFP technology, which is a better battery, no fire risk basically doesn’t use – we use a little lithium, but it does not use cobalt or nickel, and it has twice the charging cycle of iron of lithium-ion battery. So, the Chinese are going to be the powerhouse, I think, we think. To be then, you either have to have a very distinct brands, which we think we do by [leaner icons] [ph] or you have to beat them on cost. But how do you beat them on cost if their scale is 5x yours? So, I don’t know.

The Europeans let them in. So, now they’re selling in high volume in Europe. We have a decision to make here in the U.S. And they have some of the best battery technology, as I said. So, if the politics of the battery get caught up, the battery localizing their technology in the U.S. it’s caught up in politics, the customer is really going to get screwed. So, we have to work through that in our country. And I think they’re really interesting companies. So, I think we see the Chinese as the main competitor, not GM or Toyota.

Unidentified Analyst

You’re talking about the batteries and just how important it is to secure the supply. Your targets require a lot of batteries, right?

Jim Farley

Yes, 70 kilotons of lithium and nickel in the next 4 years.

Unidentified Analyst

How do you work with your suppliers and the supply base to make sure that the building of those batteries is aligned with your values and your ESG commitments?

Jim Farley

So, Bob and the team are here, it’s not easy. We have requirements. Ford was one of the first

auto companies to have a sustainability policy, whether it’s zero or use or 100% carbon-free electrons to power our plants in the U.S., we were one of the first. So, child labor, corruption, all those basic things we feel like we have to not only go secure the offtake agreements, we have to physically be at the sites where the processing takes place and the mining takes place. And we’ll have an audit validation process to make sure that this is done right.

It’s going to be very difficult because the scale mining and processing of raw materials is very complicated supply chain. The processing of lithium and nickel is boats go across the ocean multiple times just to develop the raw materials for battery, cathode nano materials. So, it’s going to be very challenging to say hand on heart, we’re good, but I think we have as good a process as anyone in the industry, but it’s going to require physical oversight.

Unidentified Analyst

So, you talk about that value chain. You guys have recently announced this JV to procure nickel in Indonesia, which we helped advise you on. And you’ve made it covered earlier this week related to lithium, how important is it for you to go upstream? And are you done?

Jim Farley

Well, the issue is, like, lithium is super plentiful. The problem is, it takes – like there’s not enough now. And so, it takes time. Does anyone know the average permitting in the U.S. for a mine? Who wants to have a mine in your neighborhood? It’s like 12 years to 15 years just to get permitted. So, there’s plenty of lithium. But to actually get it out of the ground and then processing it, there’s zero processing capability in North America other than Tesla’s Corpus Christi site.

So yes, it’s critical. I mean this is just like what happened in mobile phones. You have to have the best product strategy, and you have to have the best strategy. But if you don’t control the supply chain, you won’t win. You have to secure the raw materials, but that’s necessary, it’s not sufficiency. Sufficiency is back to your product strategy and your cost competitiveness, all the basics. But it’s – so it’s – there’s a land rush right now for us, working with you and many others to secure 100% of the raw materials.

We need for 2 million vehicles growth. We’re building the assembly plants and go down to [Tennessee] [ph] right now. We have our largest industrial site ever. It’s 6 miles by 6 miles. And we have like 4 battery plants in construction right now. So, we got to have raw materials in all that. So, it’s absolutely essential. And there’ll be losers. Some people won’t – they’ll rely on their JV partners, the battery companies, the battery companies, ‘Oh, sorry, we just didn’t get it or it’s too expensive.’

So, there will be winners and losers in the supply chain as we go – let’s put, and again, I just want to say the most important thing is not the batteries. It’s not the electric motors or the inverters, it’s the electric architecture that’s what’s going to transform our customers’ experience. It’s going to be shipping software to them.

Unidentified Analyst

So, on the software theme, I mean software has the ability to make these vehicles safer, better over time, flexible, but you have to build that architecture in, and it brings in all these new concerns that you haven’t had to traditionally deal with data privacy protection. How are you maximizing the benefits of that software and managing those risks that are new and how you’ve approached your business?

Jim Farley

It’ll all come down to getting the [8 players] [ph] on the town side because they attract [8 players] [ph], which our industry doesn’t really get, kind of think of a mechanical engineer, like they’re all kind of the same. But software is so different. And if you can get the best person, it’s a force multiplier. And those – but then you have to have company values around privacy. And you have to, kind of pick your brand positioning. I think we really like not because apples-to-apples we really like their idea around privacy.

You can imagine how personal data is on a vehicle like where you’ve been, how would you get there? Who are you with? So, it’s really intimate data. So, we think for our commercial customers, too, like their clients, like we really want to be on the right side of that. But we have to use the data off the car to make the experience really good to make the software better. So, it’s a huge tension. I’ll give you an example, real one.

So, how many of you rented cars and lied about the amount of gas that was in it when you turn it in. Like all of us, right? Yes. So the rental cars company comes to us and says, ‘Hey, that little float in the gas tank, don’t you know exactly how much is in there? Yes. Why don’t you just sell us the data, and then we’ll charge people based on how much fuel is actually in their car.’ So, what do you do then?

Now, we can sell the data to the rent-a-car company, but if they’re driving a Ford, what’s our contract with the renter of that Ford. Should we sell their data because we happen to know how much fuel is in there, even though it’s actually, frankly, their data. That’s like trillion examples like that of vehicle data coming off the car, how do you handle it practically from a privacy standpoint. I think we have the right details and values, but we almost, kind of don’t know what we don’t know yet.

So, we’ll get into it. I don’t want to be entrepreneurial about consumers’ data after looking what happened with Facebook and a lot of social media, I don’t want to be too entrepreneurial with my team. On the other hand, I definitely need the data to make predictive failure of the components better for a plumber because if I can sell them a car that never goes down, it’s very valuable to them. If you’re a plumber in [indiscernible] Manhattan, you lose that van, you’re going to lose the revenue for that day.

So, if you have a vehicle that can self-diagnose itself and send warning signals to the owner two weeks before it fails, that’s really valuable to them. So, I have to use the data to make it better, but I can’t – there’s a line.

Unidentified Analyst

You talked about in this, how important Ford’s values are. And you’ve also mentioned there’s this big labor dislocation. A lot of your core leadership team has actually changed. How do you change the people and the talent in the way that you’re doing it, but preserve that 120-year-old culture and core values of Ford? I mean this seems like an enormous challenge. How do you balance that?

Jim Farley

You’ve got to recruit for people upfront that share that. One of the things values the company is [greediness] [ph], people. We found a lot of technology people who don’t have the [greediness] [ph]. So, we have to recruit for the values. And then you have to codify them. We have in our behaviors what we expect from leadership team. And then you have to evaluate people based on them and give them regular feedback. It’s not easy though because some people don’t know what they don’t know.

Some people don’t know what good looks like. So, it’s not easy. And many people haven’t dealt with the reality of firing 5,000 people because they happen to be just in the wrong place. So, I think there’s only so much you can do, but you just have to overcommunicate. You have to make it really clear, and you have to recruit the right people. Anything I missed, Team?

Unidentified Analyst

So, the other thing is, you’ve talked about Ford values, but they’re not stacked, right? You’ve actually maybe shifted some of the priorities in it. You’ve started to prioritize a little bit more speed, innovation, and efficiency. You’ve talked a lot about Lean and how important that is in the organization, reducing complexity was a big theme of your Investor Day on Monday. How have you shifted that prioritization and the values of the organization overall because that’s going to be all the way down to the bottom, right?

Jim Farley

Yes, just tied it to the business results. I mean, we’ve had a, kind of culture personality of CEOs in the car industries that kind of fall in love with quality and someone doesn’t care. And so, like if you want to be world-class in quality, you want to be world-class in waste elimination, you have to do it culturally with something like Lean or else it will fall apart the next person, which I wanted to get better. I’m a transitional CEO.

I want the next person, but to get better for them, they don’t have to worry about it. So, I think the needs of the business really speak very clearly on what changes need to happen in our behaviors. Speed is really important. Like there are a lot of – I know my competitors are snickering in the lighting right now. But they haven’t sold 100,000 lightnings, I have. What they’re like, well, it’s not a ground-up EV. It’s – yes, but you were three years late. Like the President drove our vehicle like we were the first one to innovate in full-size trucks.

So, speed really does matter a lot. And we want to be the first one with hands-off autonomy on a highway in a sunny day in New York. And we want to be – we have to be first sometimes. So, it’s just the needs of the business.

Unidentified Analyst

We’ve spent a lot of time today talking about electric vehicles, but the fact is, is that people are still going to be buying gasoline-powered vehicles for a long, long time. What opportunities do you see from the work that you’re doing around EV and efficiency and improving those vehicles and pursuing those ESG goals even in the context of a product that some would say is counter to that?

Jim Farley

Yeah. I think what we learned – when we went to aluminum on F-150, we learned a lot that actually – the image of people buy full-size truck for work actually, they don’t want to get left behind. They actually want technology like everyone else. In fact, there are probably more inclined to use technology in the inside of the vehicle than a retail customer. So, we’re Number 2 in hybrid in the U.S., which we don’t [toot our horn] [ph] about, but we are. We put hybrid on F-150. It’s extremely popular because they can power your house for 7 days.

So, we use it for other things than just more efficient propulsion like more network to Toyota with Prius, but we have – so we have to modernize the drivetrains. So, no one who buys Ford blue or internal combustion engine vehicle feels like they’re left behind. Like they need to feel like, hey, I got the most efficient vehicle, but what we learned is that there are certain duty cycles or drive cycles that will never go electric because electric vehicle is a really bad solution.

If you’re towing in [indiscernible] in Wyoming, you do not want electric vehicle because it all go like 100 miles. If you’re towing something really heavy or doing real work. So, we took our internal combustion product lineup, and we only invested in areas that won’t be disrupted quickly from electrification and then modernize and then also invest in electric architecture upgrades.

I think a lot of my competitors will go student body left and invest in electric architectures, [Adam] [ph], that only on the new stuff. And I think that would be a terrible mistake to our Super Duty customers, and it’s the most profitable vehicle for – and how customers love [indiscernible] the highest net promoter score any vehicle in our fleet, and we’re like 50% market share. They’re going to like shipping software to their car just as much as our key customer.

So, you just have to keep investing, but you have to make sure that the products are durable. The revenue is durable as much as you can. And then you need to have really ruthless operators who operate that business to get the most out of the value for the company.

Unidentified Analyst

So, foreign purpose is helping to build a better world. That’s your mission. How do you feel about your stature in the industry? And how – what is your responsibility to lead from the front?

Jim Farley

I think we’re a family company. Bill Ford is Chairman. Thankfully, our family is very involved in the business, fifth-generation now, Ford’s involved in the business. So, there’s a long arc to the company. It’s like 120 years in a few months. So, we’ve gone through wars, depressions, all sort of [indiscernible] happens and we kind of made it through. So, I think our responsibility is to be a leader. It’s maybe not fair, but it’s great. And we accept that.

We accept that we want to be – like our competitors do stuff like this. We only have carbon-neutral electrons in our manufacturing. But then what they’ll do is, we go to Florida and buy credits and still run their Michigan plants off coal. We don’t do that. All of our plants will get low-carbon electrons. It’s just the right thing to do.

Same with [indiscernible], same with child labor and corruption with the raw materials, a rare. And I think we also take a lead in things like making – reaching across from an old company like Ford to a new company like a Tesla or NEO or BYD to, kind of work together in a non-natural way as competitors. You’ll see Ford do that just because that’s what kind of company we are.

Unidentified Analyst

All right. We have a few minutes. Ready for the lightning round?

Jim Farley

Yes, sure.

Unidentified Analyst

All right. So, first of all, how is the F-150 Lightning with customers?

Jim Farley

Good. We’re in our – going into our third year, we’re sold out. We’ve increased the price [to] [ph] $11,000. Tesla has reduced their price by $7,000. We had a fall in our Mach-E, but it’s only one-third of our volume, two-thirds are e-trains and lightning. We thought we’d sell 20,000. We upgraded to 70,000 capacity, and now we’re rebuilding the facility for the third time in 3 years to 150,000 capacity in September. So, yes, we’re [still down] [ph]. So far, so good. But the competition is going to get really exciting here by the end of next year. There will be a lot of choices for customers.

Unidentified Analyst

Good. Tell us the principles you are [going to apply] [ph]?

Jim Farley

Pretty simple for me. When someone asked how are you doing, I would say, I’m learning.

Unidentified Analyst

Growing up, before you joined Toyota, before you joined Ford, what was your dream job?

Jim Farley

Be a product planner for a car company. To be like the person who invented the product concept. Still doing that work. It drives my team nuts, actually. I think we need this. No, [at least I don’t say] [ph] my son likes that or my daughter likes that. But – no, yes, I just love – I actually get as excited on minivan, as I do on Ford GT or a Raptor.

I just love seeing – I was a product planner, came up with the idea of a unibody lightweight crossover for women and combine it with a great dealership experience called the Rx 300 or Lexus in 1992 and it created the – we became the Number 1 luxury brand in the United States. So, I always love finding a [hole] [ph] in the market that others can’t see because in our business, it’s a big advantage. That’s what I love. Product planning, yes.

Unidentified Analyst

[Name a] [ph] manufacture in any industry, any part of the world, who’s getting it right?

Jim Farley

I like BYD. Totally vertically integrated, aggressive, unapologetic. They’re even doing silicon carbide and [indiscernible] themselves now. Very, very impressive company. And they always were committed to electric. It was never a fashionable thing. They did a way before it was fashionable. I like also what Larry is doing at GE, a lot. If anyone can install a lean manufacturing system an American company, it’s Larry Culp.

Unidentified Analyst

What cars are in your garage today? And what cars are going to be in your garage in 10 years?

Jim Farley

I have no idea, I [just] [ph] flip cars for profit. So, that’s – my hobby is buying old cars and fix them up and sell them for a profit, so it changes a lot. Probably my [daily driver] [ph] in 1973 Bronco. It’s all original. There’s nothing fancy about it. No. I guess my favorite car, I have a 1950 [Lancia] [ph]. That’s a company who went bankrupt because their engineers were too good. Cost is too high. They were bought by Fiat and they made a better car than Ferrari in the 1950s. They were first V6, production V6 in our industry. First, [DDR rear suspension] [ph].

They’re the first independent suspension car. First, GT design is beautiful, designed by [Pininfarina] [ph], who end up doing all the Ferraris. So, I love that car. It’s very complicated. I could see why they went bankrupt, but it’s really fun to drive because it’s actually faster than Honda Accord and better to drive, but it’s a 1952 car. You cannot believe how modern it is. Those are probably my favorite.

Unidentified Analyst

All right. Best book you’ve read recently or favorite podcast?

Jim Farley

My favorite podcast is, mine. Sorry, I do think I’ll drive – I interviewed like Tom Brady last year and only talked about cars. I just did Jimmy Fallon, just did Neil, [indiscernible] Tyson. And so, that’s what I do in my weekend is usually a podcast. I guess, I like any podcast about well-being, staying calm, rejuvenating yourself, I’m kind of a junky for that stuff.

Unidentified Analyst

You seem like a very calm person.

Jim Farley

And books, I’m very diverse. I read a lot about native Americas.

Unidentified Analyst

All right. Superpower you’d most like to have and why?

Jim Farley

Kindness. I’d like to be more kind. I’m not. I have a – yes, so the CEO of Corning, Wendell, he’s really special guy. He gave me a [indiscernible] that I have on my desk that says, please be kind because most people are carrying a big burden that they don’t share. So, I kind of live by it. I mean, I wish I had that super power. Like I see a lot of really kind people and that’s one I’d love to have.

Unidentified Analyst

Well, thank you for joining us today. It was a great conversation. We’re going to have a short break, but please join us here in 10 minutes for a panel discussion on emissions data and disclosure.

Jim Farley

Thank you.

Question-and-Answer Session

Q –

The Boeing Company (NYSE:BA) Wolfe Research 16th Annual Global Transportation & Industrials Conference May 25, 2023 9:10 AM ET

Company Participants

Brian West – Chief Financial Officer

Conference Call Participants

Myles Walton – Wolfe Research

Myles Walton

Great. I think we’re good to get started. So welcome back. It’s a pleasure to have with us from The Boeing Company, Brian West, the company’s Chief Financial Officer. I’m Myles Walton, the Aerospace Defense Analyst here at Wolfe Research. So welcome to day three, the final day. And with that, I think, Brian, you have some opening remarks or an opening comment perhaps.

Brian West

Probably just to reference the forward-looking statement disclosure thing. I think that’s about all I had in my opening remarks. But otherwise, it’s great to be here.

Myles Walton

All right. Awesome. That’s a good opening remark. The lawyers will be happy.

Myles Walton

So let’s kick it off with this year, look to the present, we’ll look to the medium term and then we’ll go and dive into each of the businesses. So the present this year, you look forward to a $3 billion to $5 billion free cash flow target. Some things have gone your way, some things haven’t. I know front and center in a lot of people’s minds is the fitting issue on the 737. So maybe update us on that as well as other moving pieces to the current year free cash flow outlook.

Brian West

Sure. So $3 billion, $5 billion is the number for this year. And when you put any plan together, there are going to be some things that are pressures and opportunities, and let’s talk about a couple of the pressures. First one is the 737 fuselage [indiscernible] escape that we talked about last month. It is on track with everything we talked about as we move through the recovery. In fact, we’ve begun to deliver airplanes — reworked airplanes out of inventory. So it’s a very important proof point and we will proceed. Lots of resources focused on this, incredibly constructive with our supplier partner. The times that we had thought would take on the front end or the back end, very different cycle times is holding firm. So good progress. More work to do. But there is a level of confidence with the team. And in terms of the costs, just as a reminder, the cost of this rework was immaterial and it was booked in the first quarter in our closing position. And by the way, we still had margins on the 37 that were up — program margins. So that’s all behind us. We’ll make sure that it’s very clear.

And as we think about deliveries on the 37, we still believe — so April was 18, that was pretty much expected, given when this NOE hit. We still expect the first half of the year to be about 30 per month and the back half of about 40 per month, and that puts us right within the range of our 400, 450 deliveries for this calendar year on the 37. Now that range will be dictated by the performance of this recovery on the 37 fuselage. But so far, so good. Another pressure, defense being a little bit more pressured than we originally thought, and it will take time to work through a few programs that we just have to get stability around. But we will get there and it will just take us some time. And then on the opportunity side, order front feels really good. We’ve had some very nice wins with Air India, Saudi, Riad, which we’ve talked about before. Very proud to be the continued partner of Ryanair as they think about their growth plans across Europe. That was a very important one for us. We’re proud to help and support them. So when you — I’ll shake that all out, high conviction on the low end of that range of the $3 billion. Is the upper end a bit pressured? Sure. But we have more time to go in the year and we are committed to delivering that range.

Myles Walton

Okay. Good. And I think the implied 37 delivery is in the high 60s, so it sounds like you could even be trending slightly above that level given what we’re seeing in May, and if that holds for June, it sounds like it’s about the right assumption…

Brian West

So far, so good.

Myles Walton

Okay. All right. And one of the other things that you’ve talked about and will move and evolve to the medium term outlook is the 37 margins and their opportunity to get back to close to where they were, but probably a little bit below where they were pre-crisis. Can you talk about why can’t they get back to where they were, is it a pricing issue, is it a cost issue and is it more of a time to get there…

Brian West

You’re talking cash margins?

Myles Walton

Yes. Let’s talk with cash margins, which is what…

Brian West

Sure. It’s all about cash. For that — so with the 737, the underlying cost of the airplane hasn’t changed. Of course, you’ve got some concessionary tail impacts that will create some noise. On the 37, the things that are going for it, broadly speaking, is lots of productivity. Over time, you get a little bit of a price advantage. But the margins for that program are pretty solid as we look forward, mostly because on the pricing side, I’m sold firm through on the 37, 2026. So for the numbers we’re talking about in our guide, it’s pretty much baked in. And then it’s all about making sure we execute and can deliver these airplanes to our customers with a stable supply chain. So they will quite get back to where they were, but pretty close. And the more important thing is that longer term, the things that could help us expand and enhance margins further are things that we can control, mostly execution, maybe a little bit around price and performance.

Myles Walton

Okay. So I’m going to lead to the medium-term outlook. You provided the $10 billion of free cash flow and we’ll sort of come back in closer focus. But on that $10 billion guide, obviously, $6 billion is implied growth from the midpoint of this year. Give us a sense as to your feeling better or worse than maybe six months ago as well as under the covers, which are the more challenging elements of the walk to get there?

Brian West

Sure. The $10 billion is still our number. And as you note, the $6 billion path are things that are pretty clear. We know how to execute what is underwriting that delta, the production ramp, right? We have our sights set on for the 37 getting to 50 per year from what today is 31. On the 87, we have our site setting at 10 — I said 50 per month. And the 87, it’s 10 per month, which today is in the 3s headed to 5. So just that natural volume ramp is going to be very powerful. At the same time, as we get through the next two years and we unwind the big inventory balances on the 37, the 87, remember, there’s essentially two small factories that are doing that work. Once we liquidate that, that will all go away and that will be a natural proactivity lift. So those are two very important compelling parts of that delta. I also think the BDS business will look a lot more normal once we work through some specific programs with cash flows, and cash conversions are ones that you will be more familiar. We also have some things that we expect to go the other way. We expect R&D to get a little bit higher as we invest in the business as a priority. We expect, based on the profit growth, there will be a cash tax implication, which is normal and natural. And we also know that on the 777X, as we’re in that zone of 25, 26, there will be a natural use of cash as that airplane will, successful is my expectation, going to service. So all of that nets into that $6 billion delta in that ultimate $10 billion outcome. And we’re just as confident today as we were before, mostly because it was underwritten by execution that we feel we have good line of sight to be.

Myles Walton

And in terms of the elements you mentioned [Technical Difficulty] what would you subscribe to those to?

Brian West

I would say, what does not keep me up at night is the demand outlook. Every time we look at it, it is very robust and we can talk more about that. What you’re seeing and what we have to get through in the next year or two is the supply chain fully recovering. And we had never counted on it fully recovering this year or even next year but we expect that by the time we get to that 25, 26 and the $10 billion, we always characterize that as normal. What you all would recognize from Boeing and getting the supply chain from where we’re at, which is better but not healed to that point in time where it’s normalized, that will always be something that we’re going to be very focused on, trying to make sure that we can do all we can to help that supply base heal.

Myles Walton

I think one of the questions I get is, is $10 billion the end, is 50 per month the end, what’s after that? And I know it’s something you don’t want to necessarily entertain, but in the sense of why $10 billion is normal if it’s actually absorbing a couple of billion dollars for 777X, if it’s actually 50 a month, which the industry probably wants something higher than that.

Brian West

Look, there’s no doubt that when you get out of our planning period, there is a robust backlog. And that robust backlog underwrites all of our confidence. And as we think about the recent orders that we’re very proud that I mentioned, that’s a good moment because you keep on building out a skyline. We’re not sold out. We just keep on selling in the future. And that’s something that we have a lot of confidence in and our customers are putting the confidence in the product plan. So will that go up over time? Sure. But right now, it’s important for us to focus on near term execution, get through this year, deliver that 3 to 5, get through the ’23, ’24 liquidation of all those airplanes on the 87 and 37, take small steps forward and then get to a point where we feel really confident, and we will get there. And then what goes beyond that, we’ll talk about when we can. But right now, we’ve got more than enough to work on that’s right in front of us.

Myles Walton

That’s fair enough. And you mentioned the 37 sold out through ’26. I think Airbus has talked about something closer to ’28, even ’29 at times. Does that normalize price at this point? Are we at a point where customers should not be expecting sweetheart deals, we’re well through that phase and now we’re in a price, maybe not a price give mode, but pretty close?

Brian West

Well, what I would say on that question more broadly is that the environment that we’re in right now, the current environment, it’s pretty good for price realization. And why is that? Because you see the skyline, the deliveries keep moving to the right, which is a good dynamic. We will be disciplined on this topic. We know that the demand environment right now is favorable. As long as we stay disciplined, we think that the environment will be normal. But I also remind you that every campaign we compete head to head, and that’s the nature of our business. And the good news is if you look at our track record recently, we feel really good about the wins. So that is something that over time, I think, we’ll be just fine not anything we really worry a lot about.

Myles Walton

Supply chains have been talked about for a while since we’ve sort of shut down everything and restarted it. And David Calhoun had some comments earlier in the week in Qatar regarding supply chain normalization end of 2024. There was nothing incremental to that, I don’t think, but maybe give you an opportunity to clarify if there was?

Brian West

No, exactly. And we have been consistent, he’s been consistent just to set expectations that our planning always assumed that it was going to take time to recover. And that’s just an important reminder. Parts of the supply chain have gotten better, parts of the supply chain aren’t quite where they need to be. And we need to work with key Tier 1 suppliers to get them to a better spot, and we help them. We’ve got resources that are forward deployed to help the entire supply chain stay more coordinated so that we can all deliver to the customer with reliability, predictability. But there’s always going to be some part right now that is not quite where it needs to be. And that’s not anything that is going to, all of a sudden, be a flip of a switch. It will take us into this year, it will take us in the next year, that was always contemplated when we put out our view of the future. And then when we get out of 2024 and into the ’25, ’26 time frame, normal, meaning the supply chain is back to something that we all recognize is more consistent. We’re just not there yet, but that’s not new news.

Myles Walton

Okay. And it would appear, at least on the surface that maybe the 87 ramp could be conceptually more challenging than the 37 ramp, just in pure numbers, but at the same time, you were well above your targets just a few years ago. So maybe lay out those two in particular, maybe which is the more gating?

Brian West

Well, they’re different. They’re both incredibly important to our cash flows as we think about that $10 billion. I would say on the 37, we’re at the moment where we had a lot of confidence to break rate up and then we get a little hick up. Rest assured that last month, we, for the first time said, we’re going to move to 38 this year. I don’t know exactly when, but that is in our game plan. And that just gives you a signal of our confidence that the supply chain while not completely recovered, it’s getting better, and we’ll be able to meet those ramps. And then, of course, the master schedule has us going at rate increase all the way up to 50. And that is just making sure the supply chain stays coordinated and confident. On the 87, similarly, we’re at three per month now, we expect to get to five per month as we exit this year. Of course, very important Tier 1 fuselage supplier that is going to be important to deliver on that and our expectation is that they will. And then they have a similar ramp in terms of going from five up to 10. The Charleston site, high confidence in that team, the consolidation is complete. They know how to do the pieces, not just the final assembly, but the other sections they’re responsible for. So it’s all come together pretty nicely. But I guess if I were to think of broadly the things that would be, concerning, still goes back to the confident supply chain. It’s getting better but we still need to make sure we’re laser like focused on that to make sure that no one is second guess the demand signal because the demand signal is real.

Myles Walton

Yes. One of the things that you mentioned at the top was the 737, you started delivering reworked planes. Could you maybe put a finer point on it, are those reworked fuselages that went through the system, are they reworked previously finished planes that you’ve got out the door?

Brian West

Those are the ones that had this Spirit NOE. So when we talked about the effort that it would take, we acknowledge that because of where that sits and what was required, it was going to take longer, measured in weeks. And what I’m saying is that we’ve begun delivering ones that we’ve corrected that fully. Complicated, but known set of work scope and we’re through it and we’re beginning to deliver, and that’s an important proof point. Because we talked about that was that it was an issue that was identified very quickly, escalated very quickly. We evaluated it, talked to our stakeholders, customers and regulators, founded it, got the work scope and then began to move forward, and a time that was very [speed] but also very transparently. And now we’re at the point where we’ve gone through that original set of procedures on airplanes and they’re being delivered, and that’s important, it gives confidence.

Myles Walton

Yes. And it’s holding to whatever your initial assessment was for the cost and…

Brian West

Yes. Cost and schedules on track.

Myles Walton

China, the other topic took us 18 minutes to get to, wouldn’t in normal times. But it seems like the breadcrumbs are there in place for a resumption of deliveries at some point this year. I know Dave has spoken more optimistically in recent months than not. What’s the current view, both of maybe the timing, the appetite and also the ability of Boeing to deliver planes to a customer who hasn’t taken them in a while?

Brian West

Sure. So we, like all of you, look at the demand signals of traffic in China, and they continue to be very, very strong and on their way back to pre-COVID levels. So it’s been very consistently growing. And for us what that has meant in terms of the signals we watch, first and foremost, is returning the full fleet to service in China. So of the 97 airplanes that were on the ground, 61 are back flying and that continues to be good progress as our customers return airplanes to revenue generating following the traffic growth, so nice signal. Second signal is the AER report that came out, important milestone that we got through. Again, another important point that will enable us to move towards eventually delivery. I don’t know when that will happen. We stand ready to support our customers in China when they make that decision. And it will likely happen over time, I just can’t give you a call and remind you that we’ve completely derisked our financial profile for that event. And even if it were to happen, it’s not going to be incremental, there’s no upper there. We are more interested in making sure we get our customers in China assets they need to meet the traffic needs that they’re seeing. And we will be patient and we will follow their lead.

Myles Walton

You say there’s no upper there, but by that, it’s more of the ’25, ’26, your supply side limited, not that — obviously, China is not an important customer beyond that time frame, clearly, it would be.

Brian West

Look, broadly speaking, outside of what we’re calling our forecast period of ’25, ’26, that’s arbitrary in our part. Longer term, it’s a big important market, we’ve been there for 50 years, we’ve got great customers, and we want to serve them.

Myles Walton

Okay. Switching to defense for just a second. So you laid out in the last call 15% are sort of the Red programs with the five we all know about, then you get 25% that are legacy that are sort of under earning, you have 60% of the portfolio that’s doing exactly what it should be doing. Maybe talk about the steps to get from where we are today to that high single digit margin you’re targeting?

Brian West

So the part of the portfolio that isn’t performing as we would expect are programs, and there’s only a few, we know how to make these assets. We just happen to be at a moment where some of the supply chain shortages, labor instability, both in our four walls and with our suppliers, it is creating problems, right? It’s up and down, and it’s frustrating. My confidence is that we will figure this out. The same way that we talk about the supply chain healing of the commercial side, the exact same dynamics play out in this space. So while it is frustrating and we are not expecting much in a way of profitability in the second quarter from BDS, because it’s going to take time. But as we move through this year and into next year and that supply chain heals and our labor stability gets better and better and we get more productive on labor and we get the benefit of things like lean manufacturing, we could see the point where in ’25, ’26 that those programs that are a few will get back to margin levels that you recognize. And that’s on us and we are going to execute on that. I just — it’s not going to be as fast as you might think, it will take us some time.

Myles Walton

And you had mentioned the second quarter from an EPS perspective, it would look similar to the first quarter, excluding the charge. So just when you think about the businesses, I think you’ve said that services might be down on margin because you can’t replicate what was very high teens. Within commercial, you’ve got a slightly worse mix because fewer MAXs. Are the BCA margins going to actually get better on a worse mix?

Brian West

Yes. So BCA margins last quarter were negative 9.2%. And even with lower volume on the narrow-body, two things are going to get that sequentially better. One, the wide body mix. So if you remember in the first quarter, 87 was paused for a period of time, we’ll be able to pick that up. The 767 because of the deferred quality escape, that will get a little bit better and there’s some 777 timing that will benefit us in the quarter. Plus, we will have the benefit of lower abnormal. So those dynamics, despite the fact that we’re going to have a little bit lower volume in the 37, net-net, will get sequentially better.

Myles Walton

Okay. Does that paint the picture of exiting the year with positive BCA margins?

Brian West

What I’ll tell you is that long term, when we think about the ’25, ’26 time frame, when we think about BCA being low double digit margins, lot of confidence. Because we will work our way through these persistent things we’re dealing with, we’ll have retired those two factories, production will ramp, and we’ll get to these margins that you’re very familiar with. It’s just going to take us some time. And the thing about a recovery, nothing is linear, things are lumpy. And we’ll go through it, the teams are focused on it and we’re well positioned as we go through the year to be able to fulfill that demand on behalf of the customers and the margins over time will get better.

Myles Walton

Okay. And what is the right capital structure for Boeing? A number of years ago, we run a neutral balance sheet, net cash almost. Is that where you need to get to or is a modest amount of leverage okay for a sustainable business like the Boeing?

Brian West

Important questions that we’re just not ready to answer yet, mostly because our focus is what’s in front of us more near term, and what we’re focused on right now is the strength of the balance sheet as we move through the next two years. And what gives me confidence is, first of all, a little under $15 billion of cash as we close the first quarter, $12 billion of untapped credit line. So liquidity, solid, very solid. And then you think about the maturities that are in front of us. This year it’s a little over $5 billion maturities, they’re already substantially taking care of. So confidence. And then you think about the investment grade rating, which is very important to us. And as we execute with the liquidity position I just described, as we execute on delivering and then generating free cash flow, we expect that rating will get better and better and better. And then, when we get a few more points on the board, there’ll be a moment to stop and look and say, okay, what’s the future look like in order to answer that question, but we want to get a few things done before we start to engage in that discussion.

Myles Walton

One of the big picture questions I get a lot is, does Boeing have the systems engineering controls, expertise it needs to manage the complexity of the programs that it signs up to. And it’s hard for me to dispute some of the data points that would say there’s a lot of work that needs to be done. So what kind of trust can you rebuild for launching a new program, which I understand it doesn’t happen imminently or competing on a new defense program. What’s changed such that we’re not going to step into bad business cases, we’re not going to make assumptions that we shouldn’t have made?

Brian West

Broadly speaking, I am very enthusiastic about our ability to attract the best engineers in the world. We hired 10,000 last year. And the brand sells, the mission sells, and I’m very proud that we have the technical knowhow across the board and confidently can say that we can deal with complicated things and deliver innovative products for the customers. There’s no doubt about that. As we think about your question on BDS specifically, we’ve got lessons learned like anybody does. That’s behind us. We’ve been through that many times. I would say that right now, we are committed to disciplined underwriting. Bidding proposals that happen every day or programs that probably aren’t quite as big as it would get to anyone at the level in this room. But we know how to do this. And as for every next program, we’ll get better and better and better and we will not make the same decisions or mistakes that we might have made in the past, because what our objective is, is to get innovative differentiated technology to the customer and the war fighter as a win and also have a win for the business. And I’m convinced you can do both.

Myles Walton

Services, obviously, a pretty bright point in the portfolio, great returns, really good trajectory of growth ahead of it. Maybe talk about how you can grow it, expand the margins maybe even above what you’re targeting for the target period given you’re almost — well, you are above them today?

Brian West

Love our service business, it’s just a franchise that is there for a very long period of time. And we have made certain decisions, our leadership team is making certain decisions to make sure that we are not chasing big unrealistic targets, but we’re trying to have steady, stable growth in ways that can be capital efficient and margin accretive, and that is the game plan that they’re running to. In terms of the things they get excited about, we get excited about, intellectual property. Any IP that we can go out there, love that. Anything that is around digital assets in and around the cockpit, we want to make sure we’re feeding that business to grow responsibly. And for us, if we have a steady grower in the mid single digit top line, it can continue to reliably deliver mid-teen margins and have very high cash flow conversions. Love that business, you’ll love it. And if it can, from time to get a little bit better, great. But having that as a foundation over a service franchise that goes over decades, I think you’re going to like what we have. We do.

Myles Walton

Okay. And then maybe just a final one. So the tanker has a service component at some point, a long tail to it. Is it going to be — the kind of service business you have in the C-17 is amazing. Is there a future for the tanker to actually have an annuity stream that is compelling?

Brian West

We’ve always thought about the tanker despite what the past has been as a very important airplane. It is delivering its mission 100%. The customer is giving it high marks. And as we continue to deliver those airplanes, and it continues to do the job it’s tended to do, it’s going to have a very, very long tail, and we’re going to enjoy our piece of that. There’s no doubt about it and we have to take the long view. I also think recent decisions on how they’ve chosen to think about their path going forward on the tanker program gives us opportunity. And in those opportunities, we’re going to look to make sure that we’re priced competitively and that we are thinking about that long term. But yes, we feel very good about what that could be over a very long period of time, and it’s a great airplane, and it’s meeting its mission.

Myles Walton

All right. Well, we’re exactly out of time. So thanks so much, Brian. Really appreciate it.

Brian West

Thank you.

Question-and-Answer Session

End of Q&A

Qorvo, Inc. (NASDAQ:QRVO) 51st Annual J.P. Morgan Global Technology, Media and Communications Conference Call May 24, 2023 8:40 AM ET

Company Participants

Bob Bruggeworth – President & Chief Executive Officer

Frank Stewart – President of Qorvo’s Advanced Cellular Group

Doug DeLieto – Vice President of Investor Relations

Conference Call Participants

Harlan Sur – J.P. Morgan

Harlan Sur

Okay, good morning. Let’s go ahead and get started. Welcome to the third day of J.P. Morgan’s 51st Annual Technology Media and Communications Conference. My name is Harlan Sur, Semiconductor and Semiconductor Capital Equipment Analyst for the team. Very pleased to have the team from Qorvo here with us today. We have Bob Bruggeworth, Chief Executive Officer; Frank Stewart, President of Qorvo’s Advanced Cellular Group here with us today. It’s been a pretty busy earnings season.

So I’ve asked Bob to kick us off with a brief overview of the company, summary of the March quarter results, June quarter outlook and profile for the year. So gentlemen, thank you for joining us today and let me turn it over to you.

Bob Bruggeworth

Good morning, everyone and thank you, Harlan, for inviting us. It’s a pleasure to be here today. I do want to remind our audience that our safe harbor language that accompanies our press releases also applies to our comments today. I thought, first, maybe what I would do is just remind the group, it was about a year ago where we went from 2 product groups to 3; we had IDP and Mobile. And in IDP, there were 3 product lines that we moved into what’s our CSG group. And that is we moved our WiFi, our automotive connectivity business, along with our SoC that did BLE, Zigbee, Thread and Matter; that’s what went into CSG.

And then in the Mobile business with 3 product lines that also went into CSG, WiFi, our pressure sensor business, along with our SoC for ultra-wideband. So that’s the 3 product groups. So I want to make sure we have that. So recapping the quarter, Harlan, I just want to say that from HPA which was one of the businesses, we had a very strong quarter in our Power Device business. That’s our silicon carbide. That’s the United Silicon Carbide acquisition that we have made, along with our defense business is doing very well. However, our infrastructure business is suffering from — we talked about inventory. Some of the infrastructure manufacturers built up a lot of inventory. They were expecting a much more robust rollout of 5G. And as the world economy slowed down, they ended up with too much inventory and we said that’s going to take well into probably next fiscal year to clear. So that business is doing well. We like how that’s positioned.

On CSG, we saw some pretty good business there and particularly in ultra-wideband and filling in the funnel and we talked about some of the activities that are going on there. WiFi is also one of the businesses that’s struggling a little bit from consumer-facing businesses, access points to what have you. So we’re going through there and that’s bottoming out and also expected to grow.

And then in ACS, we talked about; we had an extremely strong ramp at Samsung, where we had large dollar content, that I know Frank will love to talk about what’s going on in his business units. So we saw strength there. We believe we saw a bottoming in the Android ecosystem, in particular, in China. So just to remind the group, we have been significantly reducing channel inventories. We’ve been shipping way lower than what the market demand is. We reduced our channel inventories about 20%, 2 quarters ago and last quarter, 25%. And we expect that to persist through June, September and pretty much be clean by the end of the quarter.

So as we talk about a little bit further out in the year, I want to point out that one of our competitors yesterday, Broadcom, had an 8-K and they talked about an agreement they had with our largest customer. Well, I’d like to at least share with you that we also have a multiyear agreement with our largest customer. I mean these are common. We don’t disclose them because we don’t see it as a risk factor, it’s just how we do business with them. And that leads me to when we kind of look at the September quarter because there are questions about how can you guys grow 50% September versus June? And what we talked about was we’ve seen content gains and share gains. And I’ll take a minute just to talk a little bit about that at our largest customer.

The one area that we have done extremely well for multiple years is our tuners and other small components that — I love when people tear down phones, they can’t find all our content. And we continue to gain share there. So that’s one of the largest share gainers we have and they added content. I don’t think people understand how much tuner content there is in phones, particularly when we get into foldable phones which Frank can also talk about. But at any rate, that’s the largest part. The other point I’d make is, we have been in the ultrahigh-band socket which is ultrahigh band PA in a filter, for 3 years now. And we’ve shared that with other competitors all along the way.

And I’d point out, Broadcom has always had an agreement and we still were able to grow that business. So we’ll gain some share there, just a small amount of share there but that’s most of the content gain. So that’s why we’re confident in our ability to grow in September because it’s already known what we’ve won. We’re not planning on a market recovery. We made that clear on the call. What we are saying is our channel inventories are coming down and we’ll slowly start to grow our business and we talked about that as well. So things are looking pretty good there. So as we look at the year, there’s no change in our guidance because of that announcement, whether it’s the June quarter, our comments on September or for the full fiscal year. We stand behind what we said.

So if you step back and we look at what’s driving our growth, clearly, the transition to 5G, as most of you know, in the Android ecosystem, most of those phones are not yet 5G. We see that growing out. We’ve got WiFi 7 coming. In fact, the migration from WiFi 6 to 6e has really slowed. Many of these manufacturers are moving to WiFi 7. We’ve got what’s going on with our Power Device business that, like I said, that funnels, growing nicely. We’ve got our SoC for ultra-wideband and Matter and things like that. So we’ve got many growth drivers as we look forward.

Harlan Sur

Perfect. That’s a great overview. So I’ll kick it off with the first few questions. And then I’ll turn it over to the audience to see if they have any questions. Since we have Frank here today, I’d love to start off with Frank’s view of the 5G smartphone market. Based on our hardware team’s estimates, there are about 585 million 5G smartphones shipped last year, fairly muted growth, right, because most of us had 5G smartphone shipments coming into last year, targeted at about 650 million, 700 million.

So clearly, the macro environment, muted consumer demand profile during post-COVID were factors, especially in China. The good news is that if we look at the Android market, as you mentioned, Bob, a key focus for the team. 5G is still only 40%, 50% of the Android mix. And so how do you guys see the 5G Android penetration mix unfolding over the next few years? And where do you think things start to really sort of saturate out?

Frank Stewart

Yes, yes. So thank you. Overall, I’d say our models are roughly aligned. I think we’re on the same page. We do see 5G growing this year, 5G smartphones. We see the overall market continuing to be soft but that growth of 5G is going to continue this year and we’ve said in the 5% to 10% range this year. Going forward, we see that 5G penetration continuing. We think we’re going to grow off of the — especially in Android, like you said, we entered this year with 5G smartphones on the Android side only being at about a 40% penetration rate. And we think that’s going to have double-digit growth on an annual basis for the foreseeable future.

Harlan Sur

Perfect. And the team has articulated RF content per 5G smartphones increasing $5 to $7. You also continue to gain main path. You continue to gain WiFi, power management content as well. You’ve done a great job of bringing more integrated RF solutions to the market and the design win pipeline is strong, right? So given all of the success, is the $5 to $7 step-up in content, looking into your forward design win pipeline across all of your customers, is that ending up to be too conservative of a view of the content capture for the team?

Frank Stewart

Yes. Thanks. I would say it’s still a good estimate but maybe I’ll emphasize a couple of points. One, when you go from 4G to 5G, that is new opportunity for Qorvo in a big way. We’ve been very focused on 5G. So we’ve got little to no footprint in 4G. So when you go from a 4G phone to a 5G phone, even in the entry space, that’s all new opportunity for us. So that is a big driver of the future. Also, as you look into the smartphone space and we can talk about this more in a little bit. When you look at the flagship portion of smartphones, we see added content there coming to us nicely in the next few years.

Bob Bruggeworth

Harlan, can I make one comment though. So when you say $5 to $7, just to be clear, that’s the RF content. That’s not whether or not we’re addressing the power management, ultra-wideband, things like that, the additive content of WiFi because now they’re running WiFi MIMO and that, things like that, that’s added dollar content for Qorvo but $5 to $7 is on the RF side.

Frank Stewart

The RF cellular side.

Bob Bruggeworth

Yes, just to be clear.

Harlan Sur

Okay. So 6 to 6E to 7 transitions, that will be incremental.

Bob Bruggeworth

Correct.

Frank Stewart

That’s right.

Harlan Sur

Okay. No, that’s helpful. And then this year, as Bob mentioned, team is looking for a very strong step up in the second half of the year. Most of it is content driven, right? I think consensus has — the team modeled up — revenues up 50% calendar year second half revenue growth versus calendar year first half qualitatively. And I know you addressed some of this, Bob, how much of the second half step-up is share gain versus content growth on higher complexity versus just new complexity?

Bob Bruggeworth

Yes. Most of its content gain, not necessarily share gain. And again, we’ve been very conservative on the market. We expect smartphone sales to actually be down in that 5% to 10%. And we do expect 5G to grow. So if you want to call that added content, that’s fine. So we look at it that way, not necessarily share gain. As Frank pointed out, we don’t really participate in 4G-only phones. We have obviously the 4G included in our 5G solution. So we look at that. So it’s primarily that.

Then, what we also, as I said earlier, we’ve been under shipping to end demand in the Android ecosystem. So when you get to the back half of our fiscal year, like I said, we’ll pretty much have our channel cleared out, best we can tell by the December quarter. So you start to see that growth really in March to offset seasonal decline in our largest customer.

Harlan Sur

And you mentioned Samsung. So the unfortunate thing about where we are in the cycle and the smartphone demand dynamics is that the design win pipeline, the content capture has been totally masked, right, by the weakness. And so maybe you Frank, or Bob, you guys can help us understand what the traction has been like with Samsung, what the content capture looks like and what the forward pipeline looks like with one of your largest customers here?

Bob Bruggeworth

Yes. I think, Frank, you ought to go through what you’ve done both at the flagship as well as the mass tier.. I think Google when talking about the Fold, would be a good example of the antenna content as well.

Frank Stewart

Absolutely, absolutely, lot of good stuff. So maybe start with Samsung. We’ve talked about the Galaxy S23, super excited about what our team accomplished there. So inside the Galaxy S 23, we’ve got Qorvo’s ultrahigh band, mid-high band, low band, tuning content, WiFi content. It was really a breakthrough for us in terms of our footprint in their flagship phones. And it’s something we’re really excited about and we’re excited about that going forward as well.

The beautiful thing is a lot of those products that are in the Galaxy S23 are the same products that we provide for Samsung in their mass tier which is great from a volume and scale perspective. So that’s a strong area for Qorvo. Maybe the other one to emphasize, as Bob said, is what we’re doing at Google. So they just released a really nice foldable phone, that’s got a lot of Qorvo content inside, including our MHB. But one thing to really emphasize, Bob said before about — a lot of times, its underestimated how much antenna tuner content is in these phones. And we’ve got a really strong footprint in a standard smartphone today. But when you go to a foldable phone, we’re seeing significant increases in tuner content, sometimes upwards of a 70% increase in the amount of tuning content that you need to add to a foldable phone versus a standard phone. So that’s a really nice growth driver for us.

And then maybe looking into the future to the pipeline question, one of the things we’ve talked about that we’re excited about is our next-generation mid-high band product, where in addition to a lot of content that’s already there, we’re adding secondary RX MIMO diversity receive content in that MHB. So that’s a whole new content area for Qorvo that we’ve typically not addressed in the past.

Harlan Sur

And actually, on that note, you guys had introduced at triple combo, I don’t know how you guys want to call it, right, mid-high band plus integrated diversity receive. Very small footprint, more efficient cost. Obviously, more efficient power envelope. I think you guys started sampling that first half of this year. Maybe can you give us an update, first half sampling, are customers already taking it through qualification? When do you expect this to start to contribute to revenue?

Frank Stewart

Yes, very exciting product for us. We have sampled. We do have a lead customer. We’re on track to bring that to production in about a year. So summer of next year. And we’re looking forward to expanding that to other customers as we proceed through sampling and development.

Harlan Sur

Perfect. Before I continue, are there any questions from the audience, just feel free to raise your hand and we’ll get a mic over to you. So you were able to reduce Android channel inventories, as you mentioned, right, 20% December quarter, another 25% in the March quarter, expecting it to reduce again this quarter. Your Android business is growing this quarter but that’s more just, I think, shipments moving more closer to towards consumption, right, as you work down inventories. You’re not baking it into your forward guidance but it certainly helps if in demand were to pick up, are you starting to see some signs of a pickup in sell-through, especially in China where post reopening the demand profile has just been very muted?

Frank Stewart

Yes. We agree that it would be nice if in demand would start to pick up. As you said, we’re happy that we’re seeing the channel clearing out but we’re staying conservative on our outlook in the smartphone space. We’re — if it improves, that’s great but it’s not in our model. It’s not in our plan. We’re continuing to stay conservative on how the year is going to play out from a shipment perspective.

Harlan Sur

And as you — yes, go ahead.

Bob Bruggeworth

On the call, we talked about that we had a record booking quarter which was a good sign, not record but the largest in a year.

Harlan Sur

For your China business, right?

Bob Bruggeworth

And then also for our China business. And again, I don’t — I think people start to say, well, that’s in demand. No, we’ve been under shipping so much they started to place orders because we’re starting to come off the bottom. That’s all we were trying to signal. It is not a comment on end demand picking up.

Harlan Sur

Perfect. And your assumptions around channel inventory is normalizing as well as your second half profile, as I think is, not dependent upon a pickup in China?

Bob Bruggeworth

It is absolutely not required, any end demand change. If it stays flat, it goes down a little bit, we’ll be fine. We’re under shipping to the demand.

Harlan Sur

Okay, good. So based on your discussions with your customers, I assume — or just give us a sense of how the overall demand picture looks like outside of China, North America, Asia ex China and Europe?

Frank Stewart

Yes. Staying conservative is probably the best I would say to that. We don’t see enough yet to make us feel like the demand environment is improving. So we’re continuing with that conservative view in our models.

Bob Bruggeworth

And we commented, I think it was two quarters ago that, given what’s going on in the world and the consumers, et cetera, that no tier in the smartphone market is immune from what’s going on. So to Frank’s point, we’ve taken a pretty conservative look. And I think also what’s affected our businesses, many of our customers based in China also have an export market, they went into Eastern Europe and that’s not exactly booming right now either.

So that’s also impacted what we’ve seen, not just the China market. There’s a lot of good data on the China market but it’s their export market that’s also been impacted.

Harlan Sur

Again, the current environment, sort of the weak environment sort of masks a lot of the upcoming advancements that are happening in the cellular parts of the market, right? Obviously, the 5G interface is not a static interface. There are multiple upgrade cycles, multiple standards and enhancements. But there does appear to be a lot of focus on the upgrade to advanced — 5G advanced, right? I think they call it Release 18. What’s the timing of this transition? What enhancements does it bring to the 5G interface? And more importantly, how is this going to benefit the team?

Frank Stewart

Yes, yes, good question. So we agree there’s going to be 5G Advanced just like there was 4G Advanced when we went between 4G and 5G. I would say it’s more of a continuum than a discrete event. So it started with some of the enhancements in Release 17. As you said, it’s going to flow through Release 18 and it’s going to culminate with more advancements in Release 19. So you’re going to see incremental additions to requirements in RF content in each of those releases as we go through the next 5, 6, 7 years together, some examples. So satellite or non-terrestrial networks is an addition to the RF section of the phone. And it’s — and again, it’s not just 0, 1. It’s not just a single event. It’s going to be continued added content, added bands, added support and added capability. We’re going to go from emergency services to data capability. And you’re going to see increased power levels. And you’re going to see increased power levels not just for those NTN networks, for other bands in the phone as well.

So, some of you know Power Class 2. And now we’re even talking about Power Class 1.5. So that puts a lot more demands and opportunity on the RF. We’re talking about added MIMO, so additional RX and TX. There’s even talk in one of the releases of a third uplink as a possibility. We talked before about, as we address new form factors like foldable phones, you’ve got added tuner content. So yes, we’re excited. And again, it’s not just one event. It’s not like okay in year 2026, there’s going to be Release ’18 and you’re going to go 0 to 1. It’s going to be more of a continuum over the next 5 years.

Harlan Sur

Well, the nice thing about the Qorvo team is, for a lot of these enhancements, it’s not only at the smartphone level, it’s back at the radio access network, right? And so you guys both benefit on the HPA side of your business, obviously, with the benefits on the advanced cellular part of the business.

Bob Bruggeworth

Yes. We’ve got a real strong position there, particularly in a lot of the small signal components. And the 5G that’s rolling out in India, we’re participating in. And like I said, some of the 5G elsewhere slowed down. But the other area we’re pretty excited about is we’re taking a lot of the same technologies that Frank has in his group and doing power amplifier modules for massive MIMO applications as well. So bringing all that in and then also working on filters to also be able to handle that higher power. So we’re building some of those same type of parts now to be able to roll out for 5G as well there.

Harlan Sur

I apologize. We also have up on stage with us Doug DeLieto. He’s the Vice President of Investor Relations.

Doug DeLieto

Thanks, Harlan.

Harlan Sur

Yes. No, thank you. Competition always seems to come up. We have a Asia team and there’s a lot of noise that comes out of Asia, right? Lot of chatter on increasing competition from the China RF-based companies, Maxscend, Richtech, Vanchip. You can name a whole bunch more. And they seem to be making some progress on more integrated RF solutions but still seem to be 2, 3 steps behind the team’s very, very highly integrated solutions. Certainly, they don’t have the type of in-house capability and technology. What are your thoughts there? Do you see the China competitors as legitimate threats to your market share, maybe over the next sort of 3 to 5 years?

Doug DeLieto

Yes, it’s a good question. What I would say is that us having local China RF competition is not new. If you go back over the past 15 or 20 years, there’s always been a local competitor dynamic that is coming on. The names have changed a number of times over those 15 or 20 years. But there’s always been something to deal with. What we’re excited about is that the architectures that we’re very big on which is integrated modules, pulling all of that content into something that’s really compelling to our customers, that continues to grow and expand and our design win activity is strong. So we’re excited about that.

And we are deeply engaged with every smartphone player in the market, talking about next-generation, architecting that next generation together with them. So we’re excited about that and the future is looking good.

Harlan Sur

I guess maybe the best way to think about it is if you look at your design win pipeline with your China Android customers pre — right, pre this weakness and you compare that to your design funnel now with your China customers, how does that look?

Doug DeLieto

Yes. I would say solid, strong, stable, going in the right direction. That’s how I would try to characterize it.

Harlan Sur

Perfect. Before I move to the high-performance analog and connectivity section, does anybody have any questions for the team? Again, feel free to just raise your hand, we’ll get the mic over to you. So let’s pivot over to your HPA and your connectivity and sensors business. I really like this business, through the cycle, I think it brings a level of stability but it really exploits the product portfolio, technology portfolio for the team, right? And so back in 2021, you acquired United Silicon Carbide, very timely, right, given all the focus on wide band gap transistor architectures for power applications like electrification, EV, energy infrastructure. Your silicon carbide architecture is actually quite different, right, using your JFET transistor architecture versus conventional MOSFET-based transitions.

I read some of your white papers. So some of the figure of merits like ON resistance is much, much better than conventional MOSFET, right? And that drives better performance, better power efficiency. So why has this transistor architecture not become more mainstream? And from a design win perspective, designing cycle times for our customers in auto and energy infrastructure can be quite long. So maybe articulate how large the forward revenue pipeline is?

Bob Bruggeworth

Yes. Let me start with the acquisition, it has been very successful. In its first year, it actually did better than the forecast that we put together, collectively, what we thought we would do. So check the box there. And to your question, the sales funnel has been filling in very nicely. Now one of the challenges that the organization had quite honestly was they have the balance sheet to continue to expand. And quite honestly, a lot of these players wouldn’t bet on a start-up. So once we made the acquisition, things really started to accelerate. We feel really good about that. Now as far as the JFET architecture goes, to your point, we’ve got a lot of know-how as well as IP around how to actually drive that device to make it so you get that efficiency. And there was just a Power Conference in Europe and it was quite flattering to see the world’s largest competitor we have in this actually have us on their chart saying, we have the best MOSFET efficiency but there’s this company called Qorvo that actually has better and it’s quite challenging.

So we’ve got a great architecture, great product and a great team and it’s filling in very nicely. And to your point, we’re already in auto, we’re in the charging stations, we’re in solar inverters, we’re getting into data centers. And it just takes a little bit of time because they’re more of the infrastructure plays, coupled with the automotive industry but we feel really good about that business.

Harlan Sur

Within your HPA business also, you team has a strong footprint in aerospace and defense with your pretty broad compound semiconductor portfolio — obviously, portfolio wide band gap silicon carbide, you have gallium nitride. In addition, you do have Department of Defense ITAR, trusted foundry status with your domestic manufacturing facilities. Defense spending outlook is quite strong. And then in addition to that, this kind of went a little bit unnoticed. But the National Defense Authorization Act which was approved by Congress in December, actually had some additional restrictions around China-based semiconductor products into U.S.-based government applications.

Has this been a catalyst in driving more government programs your way? That’s the first question. And the second question is, give us a snapshot of the types of aerospace and defense programs that the team does participate in?

Bob Bruggeworth

Yes, let me start with, we haven’t seen a significant shift in our business due to that requirement that’s out there. But what I will say is, as you pointed out, we’re a trusted foundry, so that’s for our filter capabilities. It’s for our gallium nitride capabilities, it’s for our high-performance gas as well. So all of that. And then also, we’ve also talked about the SHIP’s program which is packaging that we’re actually doing in the U.S. as well. So we’re kind of like the one-stop shop for this. And what’s going on is primarily for RADAR is one of the areas that we’re very big in, you need to continue to reduce the size because we’re going from, as we say, 1 to many, used to be 1 airplane to now drones. So size is very important and that’s an area that we’re doing very well; so that business.

Then the other point is we’ve got a lot of allies as a country. So we’re picking up business with other countries’ defense systems as well. So we’re seeing that but we haven’t seen any shift in demand for the — where maybe the U.S. government suppliers were buying from China or anywhere like that. So — but great business, great backlog, just a little lumpy from quarter-to-quarter but continues to grow year-over-year.

Harlan Sur

And I know you gave us some examples over the last couple of earnings calls. A good example of sort of leveraging the technology development across portfolios, your BAW filter capability, right? And so I think you’ve been able to take that BAW filter capability that you’re doing quite well with now on cellular and kind of moving it into CSG, HPA and so on, right?

Bob Bruggeworth

That’s correct. And I touched on a little bit earlier, working on some filters with higher power to be able to work for massive MIMO applications. That would be one for the infrastructure side. We’re also working on it in WiFi for WiFi 7. We talked about some of the new releases where we’re covering all 3 bands there now. So to your point, we are able to proliferate that. But what the team has really done extremely well in BAW filter technologies is reducing the size.

That part that Frank talked about, that’s a mid-high band pad with the diversity received has almost twice the number of filters as a regular MHB and the footprint is actually smaller. So it’s our next-generation die shrink for our filters that’s going to be coming out next year. So I also want to give kudos to the team for also expanding where we can apply the technologies but also reducing the size and that’s what gets into your question on the integration, being able to continue to integrate more in a smaller size which is much harder for some of our competitors to keep up with.

Harlan Sur

Right. In 5G infrastructure, radio access networks, you mentioned a little bit about this strong position in RF power, RF front end, mixed-signal analog, you are burning through some excess inventories here. How do you see the timing of driving your shipments more towards consumption levels? And what are the geographies that are going to drive maybe that next wave of 5G RAN expansion?

Bob Bruggeworth

Yes. Our primary customers for this are in Europe and it’s no secret, they’ve got too much inventory. And by our estimation, it’s going to be the next calendar year before they really burn through a lot of that. They were gearing up for tremendous rollouts of 5G. I thought they would pick up even some in China. They did not. India is a bright spot. We’re seeing that go. The U.S. has throttled back some, the same with Europe. We do expect that to pick up next year as well. The other point I would make, Harlan, is we’re also developing now power management for some of those applications as well. The power management that’s in HPA now, we’re looking at it in the defense industry, we’re looking at in infrastructure, we’re looking to get in some of the mobile phone industry, all different places there.

Harlan Sur

I’ve got a question from one of our investors that’s listening on the webcast. And so thanks for the presentation. Bob, you mentioned in your prepared remarks that a lot of the content uplift, 50% content uplift that your large customer is more content growth. Can you help us understand what are the architectural dynamics of these next-generation phones that is causing such an expansion of content, right? You mentioned the diversity receive, I believe, right — no, you mentioned the tuner capabilities, right? And so give us some examples of where you do see a bigger-than-expected shift or growth in content because of the complexity of these next smartphone platforms coming to the market.

Bob Bruggeworth

Yes. Let me clarify one thing. What we said is our revenues will be up 50% in September over June.

Harlan Sur

Yes, right, right.

Bob Bruggeworth

So let me first clarify that. So what’s having that content is Frank talked about all the complexity that’s going on in the number of radios and the different frequencies that are going on, that’s what creates antenna problems and they run out of space. So tuners enable them to use the same antenna for multiple frequencies. So as you continue to add radios, you continue to have a challenge with the tuners. So the primary area that our growth is in is actually in tuners and then we did gain some share there as well. But again, that’s the strength that we’ve had for years and years since I’ve been using tuners there. We’ve built on that.

So that’s primarily the number one driver and then I said, “Hey, we’re going to pick up some share in the ultra-high band but we’ve been sharing that socket for 3 years now with various competitors.” So — but that’s the 2 primary areas where we’re growing.

Harlan Sur

Perfect. Okay. And then on the financials, so you guided 44% gross margins for this fiscal year. Underutilization is driving 10 percentage points of the gross margin headwinds. You got a little bit of inflationary pressure as well. But how should we think about these headwinds reversing if the inventory work down profile plays out as you expected, the launch of new models, content gains plays out as you expected. How do you expect that to play out? Does the team think you can get back to 50% plus gross margins next year?

Bob Bruggeworth

Team absolutely believes we won’t get back to 50%. The timing of that, to your point, depends on how we work through what we call our higher cost inventory that’s been burdened with the factories that were underutilized over the past year. What I think is one of the reasons why we want to shape the year this year was because a lot of our business that’s our largest customer is outsourced. So it’s like we’re — in that sense, we’re a fabless company. So it’s not burdened with the absorption of the factories when they were not utilized, right? So as we move forward, we’re working through that. So we didn’t guide when we’ll be through all this but it’s not going to be this fiscal year. It will be next fiscal year by the time we burn through all that inventory. But those products that are outsourced for us, the silicon-based, we’re not burdened with that and it’s got very attractive margins which is why we said our margins will go up and then come back down which follows the normal profile of our largest customer.

Harlan Sur

So on the manufacturing front and we’ve touched upon this several times but I feel like this is a key differentiator for the Qorvo team right. The integrated solutions using our BAW filter technology, you’ve done a great job continuing to scale that technology, right, die shrinks, 6- to 8-inch wafer transition. And then I think often overlooked is blocking and tackling, just yield, manufacturability, efficiencies. I mean what else is the team doing to unlock more capacity and drive a lower cost profile for the BAW portfolio?

Bob Bruggeworth

More of the same. As I mentioned, we’re just coming out with the next generation next year die shrink in the BAW filters. We’ve got another generation that will be coming out after that. They continue to do fantastic work there. And we’ve got about everything to 8-inch now. We still got some work to do there as well. So lots of activity, real pleased with how they’re executing. And Harlan, thank you very much for having us.

Harlan Sur

Thank you.

Bob Bruggeworth

I appreciate you saving a tough question for Doug.

Harlan Sur

Thank you very much.

Bob Bruggeworth

Thank you, everyone.

Frank Stewart

I appreciate it.

Doug DeLieto

Thanks, Harlan.

Bob Bruggeworth

Thank you.

Harlan Sur

Doug, thanks a lot.

Doug DeLieto

Yes, you bet. Thank you.

Question-and-Answer Session

End of Q&A

Operator

Good morning, and welcome to the Analog Devices Second Quarter Fiscal Year 2023 Earnings Conference Call, which is being audio webcast via telephone and over the web.

I’d like to now introduce your host for today’s call, Mr. Michael Lucarelli, Vice President of Investor Relations and FP&A. Sir, the floor is yours.

Michael Lucarelli

Thank you, Liz, and good morning, everybody. Thanks for joining our second quarter fiscal ’23 conference call. With me on the call today are ADI’s CEO and Chair, Vincent Roche; and ADI’s CFO, Prashanth Mahendra-Rajah. For anyone who missed the release, you can find it and relating financial statements and schedules at investor.analog.com.

On to the disclosures, the information we’re about to discuss includes forward-looking statements, which are subject to certain risks and uncertainties as further described in our earnings release and other periodic reports and other materials filed with the SEC. Actual results could differ materially from these forward-looking statements, and these statements reflect our expectations only as the date of this call. We undertake no obligation to update these statements except as required by law.

Our commentary will also include non-GAAP financial measures, which exclude special items. We’re comparing our results to our historical performance, special items are also excluded from prior periods. Reconciliations of these non-GAAP measures to their most directly comparable GAAP measures and additional information about our non-GAAP measures are included in today’s earnings release.

And with that, I’ll turn it over to ADI’s CEO and Chair, Vince.

Vincent Roche

Thanks, Mike, and good morning to you all. Well, I’m very pleased to share that ADI continued to execute well in the second quarter. We delivered our 13th consecutive quarter of revenue growth and record earnings per share. Notably, revenue was $3.26 billion, growing 10% year-over-year. And once again, this was driven by record results in our industrial and automotive sectors. Gross margin was nearly 74% and operating margin surpassed 51%, reflecting the innovation premium our portfolio commands and our strong financial discipline and EPS increased an impressive 18% year-over-year.

Now I’d like to spend a moment on the current business conditions. We previously shared that our business was at an inflection point due to uncertain economic and the geopolitical backdrop. After three years of steady growth, customers are beginning to adjust their forecasts and rebalance their inventories. This is most pronounced in Asia, while North-America and Europe demand is moderating, but at a more measured pace. We expect this normalization of revenue will persist through the second half of 2023. Importantly, given our customer conversations and proactive decisions to improve lead times and right-size our backlog, we’re in a position to deliver on our goal of delivering a soft lending.

Stepping back, we’ve successfully navigated macro challenges many, many times before. Today, ADI has an even more durable franchise, defined by an unmatched diversity of products, customers and applications. A hybrid manufacturing model that better adapts to demand fluctuations, and of course, a fortified balance sheet. These characteristics instill a resiliency, that helps ADIs mitigate market weakness, and invest through economic cycles in critical areas that will define our future.

Notably, unlike previous economic cycles, we have numerous concurrent secular growth drivers across all of our markets that drive more semi-content per dollar of CapEx. And we have exposure to sectors that will transcend the macro uncertainty, including areas like digital healthcare, aerospace, defense and the electrification ecosystem. So to that end, I want to highlight our digital healthcare business, which resides in our industrial end market. Healthcare is a market that is ripe for renovation and it’s one that requires the highest levels of performance.

Now currently, the United States leads the world in healthcare spending with more than $4 trillion spent in 2022 alone, approaching 20% of GDP. This amount has steadily increased over several decades, and unfortunately does not correlates to world’s leading health outcomes. Both the U.S. along with most international healthcare systems are still reliant on serving the majority of patients with critical or chronic conditions in large, centralized, acute-care hospitals, where specialized expertise and equipment resides.

The pandemic highlighted the fragility of the system, underscoring the urgent need for remote physician consultation and distributed clinical grade patient care. This vision of a decentralized system to improve the accessibility, affordability and efficacy of global healthcare can only be realized through the proliferation of edge-based diagnostic and therapeutic technologies.

ADI saw this promising opportunity early and made digital healthcare a strategic focus area over a decade ago. Over that time our R&D investments have expanded our portfolio from core signal processing, sensing and power technologies to more highly integrated application specific products to now full system level solutions. The result, our healthcare franchise has delivered seven straight record revenue years, generating $900 million annually and we’re on track to achieve a new high watermark in ’23 despite the macro backdrop.

Importantly ADI has become an industry leader in three primary areas. The first is medical imaging, where our highly integrated products performed critical functions. This includes enhancing image quality, minimizing radiation dosage, improving system assembly, and simplifying field maintenance. Today, we’ve strong share positions in areas like CT scanners, digital X-ray and ultrasound. Next is automation and instrumentation. For example, our broad portfolio enables us to create the optimized signal chains required in applications such as infusion pumps, ventilators and defibrillators.

Third is personal health monitoring. Here, our highest performance products are used throughout the operating room and the ICU, while more compact versions with lower power are designed into wearable devices performing both clinical and consumer wellness monitoring functions.

Now let me share some of the examples of how we’re seeing ADI’s solutions shape the future of healthcare. The ultrasound industry is migrating from large cart based equipment to more compact mobile systems. Recently, ADI won the design as a market leader for their compact ultrasound system. Our solution leverages our complete portfolio including high speed signal chain and high voltage power technologies, to deliver the highest quality images at the lowest power in a smaller footprint.

We’re also developing an echo to bits technology to untether the ultrasound modality from the hospital and enable hospital grade care in even the most remote locations. Our solution uses proprietary ultra-low power analog technology that performs both the data acquisition and beamforming functions at extremely low power levels with embedded software algorithms. This allows the user to get cart based performance in a handheld form, without compromising image quality, resolution, or functionality.

Now turning for a moment to robotic surgery. Currently, only about 15% of the world’s surgical procedures use robotic technology despite the many benefits. These include greater precision, flexibility, and control during surgery and shorter hospital stays, fewer complications, and lower levels of pain for patients. We already designed in, at the largest robotic surgical suppliers with our suite of precision motor control, signal processing, power management and sensing solutions.

And with content per system in the thousands of dollars and performance demands increasing exponentially, this application is poised to deliver significant growth in the years ahead. In the area of personal health monitoring, clinical grade vital signs monitors are converging with consumer wellness wearables. Now this is an emerging market for our comprehensive suite of technologies, including our sensor AFEs, microcontrollers and ultra-low power technologies, which has been strengthened by the integration of Maxim.

For example, in diabetes management, ADI has long been a leading supplier of blood glucose monitoring technology. Now we’re working with key customers in the next-generation of continuous glucose monitoring. Our solution increases the level of robustness, accuracy and power efficiency of the glucose sensor, thereby extending its life from days to weeks. And there is much, much more to come. We are extending our reach into innovative medical products that connect our hardware with cloud-based connectivity analytics and service. I’m delighted to share with you that our first non-invasive chronic disease management device is undergoing marketing clearance with the FDA and I look-forward to sharing more as this new market has the potential to significantly expand our healthcare segment (ph).

So big picture, we’re shaping the digital revolution in healthcare. ADI’s ability to go from component to system supplier underscores our deep domain expertise and unrelenting focus on innovation. Setting us apart from the pack, not only in healthcare, but in all of our markets. So while there is near-term uncertainty, we are excited about the long-term opportunities that lie ahead. The center of gravity for data processing is shifting from the cloud to the edge. And ADI where data is born is at the center of this evolution, enabling the next waves of innovation for our customers.

Now before I hand over to Prashanth, I want to address our announcement that he will be leaving ADI at the end of the fiscal year. I want to recognize, Prashanth for his many contributions and for his partnership over these past six years. He has played an important role during a period of extraordinary growth and value creation for ADI, including help build a robust finance function and fostering strong investor community engagement. Please know that Prashanth will be remaining in his full capacity and continuing to engage with all of you while we identify our next CFO through a search process that is now underway.

And with that, I’ll hand it over to Prashanth.

Prashanth Mahendra-Rajah

Thank you, Vince. It has been an honor to serve as the CFO of this phenomenal company and lead this world-class finance organization. As Vince mentioned, I’m fully committed to ensuring a smooth transition and I look forward to engaging with all of you during the coming quarters. I do want to express my deep appreciation to Vince, both as a coach and a mentor, but also for introducing me to this magical world of semiconductors. As my boss often says, we truly are the bedrock upon which the global technology industry is built.

Now turning to our second quarter results. As usual, my comments today with the exception of revenue will be on an adjusted basis, which exclude special items outlined in today’s press release. We delivered another very strong quarter, record revenue of $3.26 billion exceeded the midpoint of guidance and represented ADI’s 13th consecutive quarter of sequential growth. On a year-over-year basis, we grew 10%, led once again by all-time highs in industrial and automotive.

Breaking it down by market, industrial, our most diverse and profitable business represented 53% of revenue and finished up 3% sequentially. Year-over-year growth of 16% was broad-based, notable gains in sustainable energy, aerospace and defense. These markets in addition to healthcare, which Vince just highlighted are much better positioned to withstand cyclical slowdown and together they represent roughly 40% of industrial revenue.

Automotive, which represented 24% of revenue, once again exhibited broad based strength, growing 10% sequentially and 24% year-over-year. Secular tailwinds fueling content growth continue to drive ADI’s leading battery management and in-cabin connectivity solutions, which combined increased nearly 40% year-over-year.

Communications, which represented 14% of revenue, decreased both sequentially and year-over-year, due to the ongoing inventory corrections across this end market. And lastly, consumer at 9% of revenue was down more than 20% sequentially and year-over-year, after several quarters of softness, consumer revenue is close to its COVID low, suggesting that the correction is nearly complete.

Moving on to the P&L. Gross margin of 73.7% was up slightly sequentially due to favorable product mix. OpEx at $733 million was in line with last quarter and op margins of 51.2%, up roughly 100 basis points year-over-year set a new record. Non-OP expenses were $48 million and our tax rate was 11.4%. Remember that Q2 is typically our lowest rate. All told, EPS came in at $2.83, up an impressive 18% year-over-year.

Moving to the balance sheet, we ended the quarter with approximately $1.2 billion of cash and a net leverage ratio of 0.8. We’ve discussed many times our decision to hold more finished goods inventory versus restocking the channel. Thus, our days of inventory increased to 168, and channel inventory weeks were basically unchanged. As we outlined a quarter ago, we expect inventory dollars will decline in the second half as we balance the replenishment of die bank and moderate external purchases.

Moving to cash flow. CapEx was $284 million in the quarter and $930 million over the trailing 12 months, representing 7% of revenue. As a reminder, we outlined at our Investor Day that we expect CapEx to be high-single digits as a percentage of sales in 2023 and then declined in subsequent years to our longer-term target of mid-single digits. These investments will support our long-term growth plans and enable strategic swing capacity between our fabs and our foundry partners.

The flexibility of our hybrid model across different geographies, enhances our resiliency. It offers our customers additional optionality and it provides an important financial shock absorber during times of volatility. Of note, our CapEx spend to-date does not include the benefits of both the U.S. and the European tax credits and grant funds that we anticipate from both the U.S. and European CHIPS Acts.

Over the trailing 12 months, we generated $4 billion of free cash flow or 31% of revenue. We’ve returned $5.1 billion to shareholders, $3.5 billion in buybacks and $1.6 billion via dividends. We remain committed to our shareholder friendly policy of returning 100% free cash flow over the long term.

Now before moving to the outlook, I do want to provide some additional details on the evolving business conditions. As Vince shared in his remarks, customers are adjusting forecasts and rebalancing inventory. At the same time, our lead times continue to improve with over 70% of our portfolio now shipping in under 13 weeks. This gives customers high confidence into the timeliness of our supply.

The result book-to-bill as we outlined last quarter remains below parity in all markets and our backlog due in the current quarter has returned to its typical coverage range. As a result, total backlog continues to decline, but just under a year of revenue, it’s still 2x regular levels.

And lastly, after a strong start to the second quarter, demand quickly deteriorated in Asia, impacting channel sell-through. As a result, we plan to reduce channel inventory in this region. And in the third quarter, we are planning for sell-in to be below sell-through for the total company.

Given these dynamics, we are guiding third quarter revenue to be $3.1 billion, plus or minus $100 million. At the midpoint of our outlook, we expect industrial and auto to be down low to mid-single digit sequentially, communications down around 10% sequentially, while consumer will increase sequentially.

Op margin is expected to be 48.5% plus or minus 70 bps. The decline in op margin relates to our annual merit increases, changing product mix and a reduction of manufacturing utilizations given the softer environment. Our tax rate again between 11% and 13%. And based on these inputs, adjusted EPS is expected to be $2.52 plus or minus $0.10.

While the near-term operating environment is a difficult one, our diversification and exposure to key secular trends is expected to help mitigate the revenue impact. In addition, we have key levers to help us minimize margin volatility. This include our flexible hybrid manufacturing model, which allows us to quickly reduce spend on external wafers and moderate the impact on internal utilizations.

Our variable compensation program, which has a true accordion like function, allowing us to reduce spend, while still investing in key long-term areas. As a result, we expect a durable earnings stream, and solid free cash flow generation, enabling us to take advantage of any share price dislocations.

Before handing off to Mike, I want to remind folks that in June, we will be doing a deep dive on the burgeoning opportunity for ADI in the construction of gigafactories.

And with that, let me pass it to Mike for Q&A.

Michael Lucarelli

Thanks, Prashanth. I want to echo Vince’s comments and thank you for the partnership over the past six years, but I will warn you, it’s not done yet, we’ve couple of more earnings calls together.

So with that, let’s get to the Q&A session. We ask that you limit yourself to one question in order to allow for additional participants on the call this morning. If you have a follow-up question please requeue and we’ll take your question if time allows.

With that, can we have our first question please.

Question-and-Answer Session

Operator

[Operator Instructions] Our first question comes from Vivek Arya with Bank of America Securities.

Vivek Arya

Thanks for the question and thanks and best wishes to Prashanth. So my question really is, I’m trying to understand where is the incremental weakness, is that limited to Asia and within Asia is that industrial or automotive or both? And what about non-Asia demand, how has that changed versus what you had thought three months ago?

Prashanth Mahendra-Rajah

Yes. Thank you. Thank you, Vivek. It’s been a pleasure to work with you, Vin, (ph) we still have a few quarters together. Everyone is focused on quarter-over-quarter, but I — before I get to your answer, I do want to take a step back and look at the year-over-year because I do think that tells the story of share gains and the increasing content per dollar of CapEx, which is what we believe delivers that long-term shareholder value.

If you look at our industrial and auto business, they are up year-over-year at the midpoint of guidance. Industrial call it roughly mid-single digit and auto mid-teens year-over-year. And this comes at a time when PMIs are below 50 and auto SAR is relatively modest. So while the economics and the cycle dictate the number of units our customer sell, which will impact our business, our share gains and our increasing content per dollar of CapEx is what we expect to help us outperform, which means we’re going to decline less in bad times and accelerate good — accelerate in good times.

To your specific question, China definitely was, sort of the piece of new information that has developed over the year, over the more recent period. We are — we have had three quarters of decline in China and we’re expecting a fourth. We did see an uptick following kind of the resumption or the return to office after Chinese New Year, but that did fade quickly, and the result was we’ve got inventory a little higher in the channel there than we expected. Very confident that this is not a share issue. This is a reflection of what’s going on in those markets. And it’s broad-based across both the industrial and auto.

Outside of China, I’d say that industrial and auto is holding up relatively well, especially North America, Europe and Japan. Not as strong as it was prior quarter, but it’s not falling rapidly. And I would characterize it more as a measured slowdown. Comms and consumer, we’ve been talking about those in all those geographies, those remain weak.

Vivek Arya

Thank you.

Vincent Roche

Thanks, Vivek.

Operator

Our next question comes from the line of Tore Svanberg with Stifel.

Tore Svanberg

Yes. Thank you. Prashanth, it’s been great working with you. Wish you all the best. I know we’re together for a few more months, but anyway wish you all the best. My question is on utilization and inventory levels. So could you give us a sense for where utilization is today, what’s your plan for the second half, you did talk about inventory in dollar terms coming down in the second half, but if you could give us any color on the extent of that would really appreciate it. Thank you.

Prashanth Mahendra-Rajah

Yeah. Thank you. Thank you, Tore. It’s been great working with you. So, as we think about inventory, inventory is going to remain higher than normal because we’re keeping the channel lean. This is something we started two or three quarters ago. From a dollar basis, inventory has peaked in second quarter as I mentioned in my prepared remarks, and you should see dollar start to trend down from here, given the actions that we’re taking, which is both reducing our external wafer builds, which is an opportunity that we have because of our swing capacity in our hybrid manufacturing model, and that also allows us to balance out the die bank building in our internal factories with softer demand and tap the brakes on internal (ph) utilizations. Utilizations, I would say, still are at elevated levels, so we expect them to start getting closer to what we would consider normal levels in the — in our fiscal fourth quarter.

Vincent Roche

Tore, to give you a little context, in the outlook we gave, it’s about (ph) 48.5% operating margins that assumes gross margins come down from where they are today. That’s mix and also it is utilizations, Prashanth mentioned. And then, OpEx was up a little bit in the third quarter based on merit increase offset some by the variable compensation. So that’s kind of the math around that. And then as you said, as you look out, utilizations probably don’t go higher in 4Q after 3Q. Just kind of give you a feel for the back half of the year.

Tore Svanberg

Great. Thank you.

Vincent Roche

Thanks for the question. We’ll go to next one.

Operator

Our next question comes from the line of Ambrish Srivastava with BMO Capital Markets.

Ambrish Srivastava

Hi.

Vincent Roche

Hi, Ambrish. We hear you.

Ambrish Srivastava

Hi, sorry. Sorry, I lost you for a sec. Thanks. Thank you, Prashanth, pleasure working with you as well. I just wanted to come back to the backlog. And you just went through this comment a little bit too quick for me. So the backlog as you said, 2x regular levels, but book-to-bill below and it is where the typical coverage ranges at this point. So I was really unsure what that means. More importantly book-to-bill should then be trending lower, as we go over the next couple of quarters, is that the right conclusion I should take away from those comments?

Vincent Roche

What I would — I guess, let me, let’s do this in two pieces. First, let’s talk about our view on this correction. Obviously no correction is the same. But if you look over at history, Ambrish, most of these sort of downturns last for somewhere between two to four quarters, and it’s our view that, that we’re going to have weakness for the second half. But a couple of points around that. First, we are really seeing this as a rolling correction across the market, because obviously no market is fully immune, but I do think that we’re better-positioned.

Comms and consumer, I think we — you would agree with us, the worst is largely behind us with. We’ve seen those correct over the last couple of quarters and we’re actually being a little bit more optimistic about consumer as we go forward. Industrial and auto, we’re starting to see some softness, but that’s probably not going to just last a quarter. It’s important to point out that we do have some areas of strength in industrial. We mentioned that in the prepared remarks. And auto really is going to continue to be a function of the of the SAR activity.

From a bookings and backlog standpoint, the takeaways you want is, bookings overall continue to decrease, but they’re basically sitting at about a year of revenue, the total backlog. What that means is that the backlog for the current quarter is now to normal levels, which means that we’re back to a point where we will be relying on some book and ship to hit the guide and that’s back to normal pre-COVID levels, and on a book-to-bill were below parity, which we had said for a couple quarters now that this was coming and that’s pretty broad-based to sort of all markets, industrial and auto are a little bit better, but all markets, all geographies, I did call out on — in I think Tore’s question that China is certainly the weakest of that.

Ambrish Srivastava

Got it. Thank you. I’ll queue back for another follow-up.

Michael Lucarelli

Thank you, Ambrish. We’ll go to next question.

Operator

Our next question comes from the line of Joseph Moore with Morgan Stanley.

Joseph Moore

Great. Hi. Let me add my congratulations to Prashanth. Can you talk about the backlog being out over a year, when 70% of lead times are below 13 weeks. How much — I know you’ve been pretty aggressive scrubbing that backlog. How confident are you that, that reflects real demand? And then, can you sort of describe, it seems like you’re still getting a pretty decent amount of bookings, considering that people have booked out 52 weeks and can get product within 13. Can you just — are people still placing orders beyond lead time to try to assure continuity? Thank you.

Prashanth Mahendra-Rajah

Yeah. Great question, Joe. Thank you. So first, yes, you’re exactly right. When we talk about backlog being kind of roughly a year in value, that’s phased over several quarters. So we have delivery dates from customers that are in future quarters, which sort of gives us confidence to what the future looks like. And now, we’re sort of back to that stage that we’ve always operated in pre-COVID levels where there is a percentage of the current quarter’s revenues that comes from turns business.

So we’re back to that state of normalcy, with the lead times down as they’ve improved with our manufacturing capacity additions. Now, there’s no incentive for customers to keep giving us orders out with a significant advanced notice, they can get most of what they need pretty quickly. And that’s the transition that you’re seeing being reflected in the book-to-bill rate. But again, as I mentioned, we are expecting. And Vince has talked for a couple quarters now that, that we were expecting the macro impact to hit us, but we remain very confident that the content story we have is going to help mute the impact relative to others and given our end market exposure, as I mentioned, it’s sort of going to be rolling through us.

Consumer and comms are largely behind us, we will see auto pressure on units for a couple of quarters — sorry, industrial pressure on units for a couple of quarters. And auto, we can’t give you a good sense of, except to say we know we have a phenomenal content story growth there and it really will depend on consumer purchases.

Vincent Roche

Yeah. I think, Joe, at the margins, I think our customers have changed their behavior. It used to be that the world expect to be able to operate on a very rapid turns cycle. Now I think that, that will persist, but what will also persist is the change in behavior around aligning long — customers allowing their long-term or longer-term demands with supply. And those are conversations that we’re having continuously. So I think the behavior has changed somewhat, and perhaps we’ve got a new normal.

Michael Lucarelli

Thanks, Joe. We’ll go to next question.

Operator

Our next question comes from the line of Chris Danely with Citi.

Chris Danely

Thanks, guys. I’ll add my congrats to Prashanth. I wish I was retiring too. I just had a, I guess a question or some more color on the correction. What do you think triggered it? Do you think it was just a function of the shortages going away and people always had a little bit inventory out there. And now they can — they can start to cancel orders and then how bad do you think it could get. I mean your auto businesses tripled and your industrial business has doubled in the last two years unchanged. So what should we think it for like the October quarter and beyond?

Prashanth Mahendra-Rajah

Yeah. Chris, I don’t know that I would call it a trigger per se. I think that — as I mentioned, we’ve been sort of rolling through this. It is just that there has been enough growth in some parts of our market that have overshadowed the pressure we’ve seen on comms and consumer. Now industrial, which is really the flagship is starting to feel a little bit of the impact from the higher interest rate environment. So that’s coming through. But again I would call out that we’ve got a pretty sizable portion of that industrial market that is very recession resistant, that’s the healthcare business, which Vince talked about the aerospace and defense, as well as our energy business.

I think what I mentioned I think to Ambrish’s question is, the piece that perhaps with most surprising to us is, we were expecting a stronger bounce in China, as they reopened from COVID and they got on the other side of Chinese New Year, and that recovery has not happened. And again, as I mentioned, we know that it’s not a share issue. It is macro issue to that market. And what was the — what was the second part of your question?

Chris Danely

Just how bad do you think it could get? Any color on October and beyond?

Prashanth Mahendra-Rajah

I’m going to — I’m going to turn to the 40-year veteran of this business, who has seen multiple cycles and let Vince take that.

Vincent Roche

Yeah, Chris. I think first and foremost, what we’re seeing now in our business is that the troughs are not as deep and the peaks are steeper than they used to be. There is more and more content in every one of the market segments that we participate in. So I think that’s the way to look at the troughs are probably going to be — they’re probably going to be shallower. And also we’ve been very careful at managing our factories and making sure that we don’t unnecessarily build inventory and ship product that perhaps isn’t needed.

So my sense is, we set ourselves for a softer landing just given how we’ve managed through the cycle and try to match demand of our customers as tightly as we can with the supply system. So, I think perhaps just given where PMIs are at, we would see at least a couple of quarters here of muted demand. And my sense is, when the central (ph) begins to turn, it will turn quickly.

Prashanth Mahendra-Rajah

Yeah, Chris. I’ll add a little bit about — unit demand for the couple of quarters here. It’s good to think like, we’ve grown 13 quarters of relatively. I think investors and sell-side people forget that you do have down quarter sometimes. And we’re kind of going back to, what I’ll call a bit more normal and a more normal 4Q, you kind of — you see industrial kind of flat to down from 3Q, orders about flat.

Comms not much activity happening right now in that market and consumer usually up a little bit. And if you look at our 1Q, a normal 1Q for us, the B2B markets, which is industrial, auto, and comms are down, kind of low mid-single digits and consumer is down a bit more due to holiday builds. And then you get a 2Q pickup. Now that’s not an outlook. That’s kind of what the normal shape was pre-COVID.

Vincent Roche

Yeah. I can tell you as well, Chris, from conversations with our industrial and automotive customers, their sentiment is quite strong. I met the CEO of one of the largest industrial automation companies, very, very recently. And they see tremendous secular growth drivers. There is a rebound in demand from the pandemic stage, where a lot of factory, the CapEx to improve factories, efficiencies and so on was not spent, so that continues. The whole sustainability challenge is on everybody’s mind.

So there are many reasons to believe that we’re going through a short-term period here of reconciliation, normalization of demand and supply, but my sense is, things will recover in the industrial market pretty rapidly. And in automotive, it’s a case of, we’re getting more and more share in the areas that count with our connectivity products, the electric vehicle portfolio that we’ve got. And there still reasonable demand, I would say, for mid to high end automobiles. So, we see this as a relatively short-term reset.

Chris Danely

Thanks, guys. Thanks for the color.

Operator

Our next question comes from the line of Ross Seymore with Deutsche Bank.

Ross Seymore

Hi, guys. Just want to echo the congrats for Prashanth. A quick clarification then a question. The clarification is when you talk about the second half being a little bit weaker is that fiscal year or calendar year? And then the two question is on the automotive side of things. You’ve mentioned a couple of times that it’s kind of SAR dependent, but the bigger trend in automotive over the last few years has been mainly content. And you guys have benefited from that as well. I think you’re one of the first companies in the semi side to guide that down, albeit minimally on a sequential basis. Has something changed there, that you’re seeing that others aren’t, is it inventory, is it demand, just anymore color on that would be helpful?

Vincent Roche

Yeah, Mike. You want to take that?

Michael Lucarelli

Yeah. I’ll go the first part, Ross, I gave a little bit of comments around kind of what I thought would be for our fiscal 4Q and fiscal 1Q outlook based on kind of normalization. So you can kind of take from that and parse that with your question about is it fiscal second half or calendar second half and put it along that, it’s both. With that, I’ll pass it to on the auto side.

Prashanth Mahendra-Rajah

I’ll take it. All right. Yeah. So look, we’ve grown 10 quarters in a row and the growth was — for the last quarter was very broad-based, again across all applications. As we think about the outlook, we are beginning to see some softening though the underlying content growth continue and our top line should still prove to be a strong multiple of SAR. There is some decline that relates to our strong position in China EV.

So when you asked about what’s different for ADI, Ross, I think that the share position we have in China EV is probably one of those differentiating factors. And that is going through an adjustment as well. While China EVs are still expected to grow, it’s not going to be growing as fast as we had originally thought. And so, as this market comes back, it’s going to provide the tailwinds we need for our automotive businesses because we have very high share.

Again take a step back, we remain very confident that this is a business with the strong product portfolio we have, battery management, in-cabin connectivity with GMSL, A2B, and functional safe power. These represent about half of our business and in a flat SAR environment, we are still going to be able to do double-digit growth.

Ross Seymore

Thank you.

Michael Lucarelli

Thanks, Ross. And Liz, we go to our last question, please.

Operator

This question comes from the line of William Stein with Truist Securities.

William Stein

Thank you for taking my questions. Two quick ones, if I can squeeze them in. First, I wonder you’ve been very optimistic or relatively optimistic about pricing in the past few discussions we’ve had, essentially highlighting that foundries are either still raising or certainly not lowering and you’re having no problems passing that on. I’d like you to comment if there is any update in that regard.

And then the other is just to try to get maybe linger a moment and get a better understanding for what happened in China, because earlier in the quarter, I think you’ve met with us and some other investors and discussed how business there was recovering. What — how can you explain how quickly this seems to have changed from improving in China to suddenly getting even worse? Thank you very much.

Prashanth Mahendra-Rajah

Yeah. Thanks, Will. I’m going to do the China one first, so Vince can address the pricing one. The China one is pretty straightforward. We — as most of the industry, we were watching the recovery coming out of the multi-quarter shutdown in China as well as the Chinese New Year activity looking to see business begin to return to normal levels, given that we had couple of down quarters.

We saw a pop-in activity and order activity in the — as we came out of Chinese New Year. Based on that, we made supply available to the channel that supply did not move as things kind of quickly got softer or didn’t move as much I can say, didn’t move as much. And therefore, that’s why we’ve now said, for the current quarter, we are going to ship in less than we sell-through to help readjust that level in primarily in Asia.

And with that, I’ll hand-off to Vince to take the pricing question.

Vincent Roche

Yeah. Thanks, Prashanth. Yeah. Well, I think that the headline of pricing, is that it is very, very resilient. And I expect that to persist. In general, we’re getting — we’re putting more value to our customers, we’re giving more value to our customers. And in fact the core ASP of our product portfolio has been increasing, not including incidentally inflationary cost that we pass to our customers.

So, I think one thing we can say for sure about our franchise is. Our products are very, very sticky, our products persist for many, many decades for example in the industrial sector. And we’re in the post Moore’s Law era, where the economic conditions have changed fundamentally. So I expect the pricing arena to be very steady across the industry. And in general in the years ahead and we will look for opportunities to pass on inflation, which is going to be persistent in the industry, I believe, in the coming quarters.

William Stein

Thank you.

Michael Lucarelli

Thanks, Will. I thank everyone for joining us this morning. A couple of items before I’ll let you go on your way. First, we are playing combined, our general ledger (ph) ERP systems this quarter. This represents one of our final steps for the Maxim integration. Given our typically fast reporting cycle, we’ve given ourselves an extra week to ensure everything runs smoothly. As such, we plan for our earnings call to be held in the third-week of August versus the second.

Also, I wanted to flag that during these more uncertain times and consistent with our commitment for transparency for our owners, we plan being even more available for investors. Vince and Prashanth will be in New York, Boston, The Bay Area and London in the next quarter. Please reach out to the IR team if you be notified when we are in your neighborhood.

And with that, a cognitive transcript will be available on the website. Thanks again for joining us and your continued interest in Analog Devices. Have a good day.

Operator

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

CSX Corp (NASDAQ:CSX) Wolfe Research 16th Annual Global Transportation & Industrials Conference May 24, 2023 8:35 AM ET

Company Participants

Joseph Hinrichs – President, CEO & Director

Conference Call Participants

Scott Group – Wolfe Research

Scott Group

All right. Really happy to have CSX for our next Fireside Chat, Joe Hinrichs, President CEO, been, still less than a year,

Joseph Hinrichs

Less than eight months.

Question-and-Answer Session

Q – Scott Group

Less than eight months. Okay. Well, so first time at our conference, thank you for being here. We are going to get right into questions. Again, I’ll start but if you have any, raise your hand, not good to see a full room. So maybe just Joe give us a state of the railroad. What you’re seeing from a demand standpoint, what you’re seeing from a service standpoint, obviously, lots going on in the industry with labor, politics, maybe just quick statement. And then we’ll get into all the nitty gritty.

Joseph Hinrichs

Yes. Good morning, everyone. I thought I was joining a industry really got less attention in the auto industry. But certainly since my tenure here has gotten a lot of attention. I mean, at CSX, we’re obviously very proud of the progress we’ve made on the service front, talked about it in our earnings call for the first quarter, but we had our best ever service metrics in the first quarter, and then we’re seeing that continue in the second quarter.

We’ve had a number of kind of third-party endorsements of that recently. Service Transportation Board came out and said we no longer needed to do the incremental enhanced reporting because of our service levels and because they weren’t really hearing about complaints about CSX from customers, which was good. Then in the last week or so, the Journal of Commerce came out with a survey with the customers and by far the largest first place votes for the best intermodal service provider on the rails.

So those are good indicators of where we are making progress. It’s been an interesting time though, as you said. So we’re looking at the things we can control on the operating side, our service levels, how our network is flowing, manpower levels, those kind of things. I’m encouraged by the things that are progressing the things that we can control. But the overall economy is a mixed bag, and you’ve seen it.

Intermodal business is down so far this year double digits. We have a higher percentage of international intermodal of our intermodal than perhaps some others. So the international business has been softer. We are hearing that should get better in the second half of the year, as we’ve heard a number of retailers talk about on their earnings call about they think they’ll get their inventory levels in sync, but we’ll have to watch the consumer there.

Domestic intermodal come back a little bit. But even all the intermodal shipments, even the international shipments have sequentially increased the last couple of months but still much lower than they have been in the last several years. So intermodal, we’re watching very carefully.

But on the merchandise side, we’re having a strong start to the year. I guess we’re almost through May, so it’s almost halfway through the year. But our merchandise business is up, which is really good for us, being driven by a number of factors. So it’s a mixed bag. I think the consumer-facing stuff is a little softer. But the — for us, because of our service levels, we’re gaining share, we’re gaining share of wallet on the merchandise side, which includes coal and auto, we’re seeing a good start to the year.

Scott Group

Great. So I typically start the short-term volume trends, but there’s one thing you said I just stood out, I just want to follow up on it. So you talked about the Journal of Commerce ranked number one, twice so many boats as anybody else. We’ve seen in the last year or so, some big shifts in channel partners out West, seeing some in Mexico. We haven’t really seen any out east. And to your point, right, you’ve got a much bigger international than domestic intermodal franchise. Are there opportunities for you to get bigger with some of the big larger IMCs and get some market share wins given the service product?

Joseph Hinrichs

Yes, we do believe there’s an opportunity for CSX. We’re obviously talking to everybody. We have partnerships or relationships with everybody. Schneider moved to Union Pacific. We already had pretty much the strong relationship with Schneider there. We’ve been growing business with J.B. Hunt. But on the rail side, there’s two factors. Of course, there’s the CPKC opportunity, which is creating some different dynamics in the industry. And we see these as opportunities. Do you have good conversations because we can lead with our service product?

And so when you’re talking to a customer and you’re shipping from Mexico or from the West, obviously, the eastern piece of it is important, but so is the western piece of it or the Mexican piece of it. So we’re having good conversations. Again, I’d much rather be leading with our service levels where they are compared to our competition in those conversations. And we’re having — so for us, we’re having good conversations. And for us, I see it as opportunity.

Scott Group

Let’s bring it back more near term. Overall, volumes down 2%, 3% to start Q2. What’s doing better than you thought? What’s doing worse than you thought? It looks like mix, which was a nice positive in Q1. It will be a nice positive again in Q2. But overall, how are things doing versus plan and from a volume standpoint?

Joseph Hinrichs

Yes, I’d say Intermodal is a little softer than we expected, even though expected to be soft, but the merchandise business has been even stronger than we expected. Coal has been stronger. Now the thermal coal in the first quarter, replenishing a lot of inventories and with natural gas prices where they are, thermal coal may come off in the second half of the year if natural gas stays where it is. But met coal has been strong.

We expect that to continue throughout the year exports. But other areas, automotive year-over-year has been strong. Metals, grain, aggregates have been very strong year-over-year, actually, which is really good for us. So on balance, I think so far this year, we’re up about 4% on merchandise, which is with — in a healthy pricing environment.

So we feel good about that part of the franchise. Obviously, we want to see the intermodal come back as well. But on the software side, on the merchandise side, chemicals have been a little bit softer than we expected, mostly export plastics and some of the things of that nature. That’s the one that kind of sticks out. It’s a big part of our business. I mean it’s not down a lot, but it’s down a little bit, but that’s still a big one to watch.

Scott Group

And so as you think out to the second half of the year, it sounds like you’re hopeful international Intermodal gets something better.

Joseph Hinrichs

It’s starting to get a little better, although it’s still low.

Scott Group

Coal domestic coal, maybe with gas price gets a little bit worse. What about — what’s the visibility on merchandise. That’s been, I think, a nice positive surprise to start the year from a volume standpoint. Is that sustainable into the back half of the year? Or given macro, is that more of an upside sustainability or risk in your mind…

Joseph Hinrichs

Well, I think the things that are working for us this year will continue in the second half of the year. Aggregates for sure, which has been a good positive surprise. Metals, automotive. We see automotive being strong for the year and grain probably it’s more seasonal, but certainly grain could be as well. For us, those things should continue. We’re winning some business. We’re not giving out specifics, but we’re winning some business, winning some share. So that will help us in the second half of the year as well as some other things happening that will help us on the merchandise side.

I think domestic Intermodal has shown in the last couple of months’ progress. So maybe it’s bottomed. We don’t know if international has bottomed, but perhaps domestic intermodal has bottomed out, so maybe that we can see some sequential improvement there.

On the met coal side, that should continue exports should continue to be strong. We’ll see where pricing is. I mean, pricing is still healthy. It’s not the levels it was last year when it peaked, but it’s still healthy. So there’s a lot of puts and takes. But on balance, we’re seeing good positive revenue per unit growth largely due to the merchandise side.

Scott Group

Okay. So I want to talk about — you just mentioned every field, let’s talk about underlying pricing. I kind of see there’s some crosscurrents as I see it. It feels like we got surprised on inflation in the middle of last year. So it feels like maybe rails underpriced a bit versus their own inflation. So maybe there’s some catch up there. Your service has gotten a lot better. That should help pricing, right? Truck rates are under pressure. Maybe that hurts pricing at the margin.

So I guess with those crosscurrents, how are you feeling about overall pricing? Could it still actually accelerate from here? Does it naturally just start to slow? And then maybe just near term, like any color you want to share on how to think about like overall revenue per unit, railcar, Q1, Q2?

Joseph Hinrichs

Yes. As you know, we don’t guide on pricing. But we have said — we did said in our earnings call, we’ll continue to say that the pricing environment has been positive. And we’re pleased with where we are. We are very — we can easily discuss our inflation because the labor contract was very visible and things of that nature. And our customers are doing the same thing to their customers.

So the pricing environment should continue to be strong. We’ve already gotten through most of our contract negotiations for the year for the bigger ones, and so we feel pretty good about where we are. Our service levels being so much improved helps those conversations because clearly, it’s easier to have a conversation when you’re serving the customer better than you have been.

I think that from our standpoint, we should continue to see a healthy ability to price, certainly over the medium term above inflation. And so that’s a good environment for us to be in. We’re not really exposed to spot rates too much. I mean maybe on the fringe, a little bit of domestic intermodal, but not a lot, and most of our stuff is contract pricing. So we don’t get — we didn’t get the benefits of it a couple of years ago when it spiked up, and we don’t really get exposed to it too much right now.

Scott Group

Okay. You guys have been transparent and helpful around this storage revenue, $300 million headwind this year. Is that still the right number?

Joseph Hinrichs

Yes. We still see that being the right number.

Scott Group

Okay. So we should see 1 more step down in Q2, and that will sort of be the…

Joseph Hinrichs

Yes. I don’t know if we’ll be quite there at the run rate, but we think the number is still the right number for the year.

Scott Group

Okay. Now one other area where you’ve maybe been a little less sort of transparent helpful is like just the sensitivity around met. So we’ve seen met come in a little bit. Is there — how should we think — what is the — if we’re in this low to mid-$200 range. What is the sensitivity we should think about for coal ARPU? Does it go back to where it was in 2018, 2019? Or does it stay above that? Any sort of help color you want to?

Joseph Hinrichs

Yes. I mean I don’t have the experience from ’18, ’19, rather. But we think north of $200 where it’s still a pretty healthy environment. So we feel pretty good about that. Curtis Bay is running really well, knock on wood, which is our port in Baltimore. That’s allowing us to have more throughput through there. So we feel really good about where we are. And if it stays north of $200, we should be in — we’ll be in good shape.

Scott Group

Now you’re certainly bringing some fresh perspective, some fresh ideas. Just a thought, right? Do you have ever — do you ever think about, hey, we’ve got this met coal business that creates just earnings volatility. Let’s sort of reduce that volatility and not, we maybe lose a little bit of the upside and the way up, but not purchase not the risk on the way down. We’re sort of in this healthy range, around low to mid-200s, let’s sort of try — go back to our customers and try and lock it in. Is that something you think about?

Joseph Hinrichs

It’s a fair question. We’ve given some thought to it on a list of priorities of things we’re working on right now, that’s not making the highest priority list. Actually, what we’ve been really more focused on is getting more volume and with our customers who are seeing the service differentiation are talking to us about how can we get more volume flowing. There’s another mine coming on this year on our network. So we’ll look at everything, but that’s not something that we’re working on right now.

Scott Group

Okay. One more sort of near-term question and we’ll get to some of the longer-term opportunities. So I would just say we think is helpful to just help sort of get expectations where they need to be. Q1, excluding the insurance gain, $0.46, 61.7% OR, excluding that gain, right? That’s usually your seasonally weakest quarter of the year. Should we expect from that level, should we expect to see sequential margin earnings growth Q2, the rest of the year? How are you — how do you see the model playing out?

Joseph Hinrichs

Well, historical — as Sean Pelkey said in our earnings call, historically, second and third quarters are the better earnings or better margin quarters. So I don’t think there’s anything that changes that from a seasonality standpoint.

However, there are things still evolving, right? We talked about fuel surcharge is a lag. And so as fuel has come down, we have more benefit in the first quarter than we’ll have in the second quarter as an example. Met coal prices have come off a little bit more they were in the first quarter. So there are a few things that are — will change in the second quarter versus the first quarter.

But generally speaking, I think the trends are comparable. That’s one of the things we have to watch those on a year-over-year basis in all levels, even sequentially quarter-to-quarter. What are the things that are outside our control that are changing? And those are two of them. We’ve already talked about demurrage, but fuel surcharge is lagging. And met coal, while it’s also lags, we’ll see some effect of that if the prices stay down in the second quarter.

Scott Group

One of the offsets, though, in a good way is right, we had a lot of costs last year with service. Service has gotten a lot better. We start to see some of that cost come off in Q1. Is there more cost just from better fluidity that comes off in Q2, the rest of the year?

Joseph Hinrichs

Again, I think, Scott, as Sean mentioned this at the end of the first quarter earnings call, I think we should see some of that. We are still hiring a little bit. We’re trying to get to 7,400. We’re about 100 shy of that right now. So we’re still doing some hiring every week, trying to offset attrition and get ready for the summer months.

But the network is flowing pretty well. I mean obviously, we have incidents that occur on occasion, but I think, generally speaking, we’ve done more pay cyclic deals, which are not significant increases in cost, but are slight increases in cost. And then we have the fluidity of the network. And if we can keep the network flowing the way it is, we should be in pretty good shape.

Scott Group

So let’s turn to the network. Service metric is really good right now. Is the plan to — do we need to get service even better? Or is it from here, we just sort of let’s keep what we’ve got, maintain it. And then with that in mind, do we need to be — you said maybe 100 more people? Do we need to add more than that? Or is that — we get to that and then we’re sort of done on the headcount growth side.

Joseph Hinrichs

Yes. I think — so on the service levels, we always want to get better, but I think the highest priority is providing consistency and predictability over an extended period of time. So the customers get confident that we’re committed to these levels and that we’re going to be able to support them.

So the most important thing now for us is to sustainably do this over time. We’d like to get better. I mean, still — I mean, if you look at it, depending on the metrics and you look at the merchandise side, 85% to 86% of the time in the first quarter, we were there, that still means 14% of the time we weren’t there in the window that we were supposed to be. So — and they’re pretty big windows. I mean they’re not like trucking, which is usually a two-hour window.

So we have room to improve, and we should expect ourselves to improve. But the most important thing that we’re hearing from customers is we’re really happy with the improved service, just keep it going and make sure we can count on it.

On the manpower front, I wouldn’t be surprised if given what we’re seeing in some of the business, essentially, if intermodal comes back that we may need 100 more people or so, but it’s not a big — a significant number and it would be to support keeping our network flowing and also support vacation and whatnot. So I don’t see dramatic improvements or increases in headcount required to support more improvement or sustained improvement on the service side.

So we feel pretty good about where we are. It’s been a little struggle to kind of continue to grow the headcount because of attrition and hiring in the right spots. But we feel I mean says about where we are now. Same 400 is close to where we want to be. So we’re feeling pretty good about that.

Scott Group

So we had an intermodal panel yesterday with some of your channel partners. I ask what’s giving me range 1 to 10, what’s rail service right now? And they said, well, overall rail service right now is a 7. But, by the way, I would put CSX to 10. They said, but, right, all of our history says that volumes and service have an inverse correlation. As soon as volumes get better, service gets worse. And so I guess my question is, right, what — what are you going to do differently to ensure that whenever we get this volume recovery, right, that we can maintain the service.

Joseph Hinrichs

Yes. I mean I don’t think there’s a fundamental reason why there has to be that inverse correlation. I mean if you think about it, if you’re adding a few cars on to an intermodal train, it’s not going to dramatically change your network fluidity and should actually help your incremental margins. So I don’t understand why that’s happened in the past. I wasn’t here. But I think the key thing is the operational discipline and focus on the service metrics. And so it’s fundamental, and it sounds pretty basic, but it’s all about each yard, each terminal watching on-time originations and arrivals, and that’s — those are the building blocks.

If the trains leave on time, and arrive on time at the different destinations along the journey, they’ll eventually get there on time. And so it’s getting back to those building blocks. And if we keep that discipline and keep that focus, I’m really proud of our operating team, how they’ve been able to do this. There’s no reason why some — yes, if we had a 50% increase in volume, we’d have a problem.

But if we have a somewhat marginal increase in volume, the 10% that we — that’s been down, let’s say, intermodal, we should be able to handle that. And to be candid, our intermodal service over the last several years, maintained a pretty high level at higher volumes. It was the merchandise side that really struggled.

So obviously, they go across the same track, go through the same yard. So I’ll just reiterate what I said, there’s no fundamental reason why that has to be the case. I think we have to just make sure that we keep the disciplines that are working for us now if volumes come back on the intermodal side to support the service levels that we expect of ourselves.

Scott Group

So it sounds like in summer side, we’re not like we want more — we want a volume recovery, maybe a gradual volume recovery, it’s maybe a recovery, that huge snapback that could be tougher.

Joseph Hinrichs

Yes, because, again, if you need manpower, it’s hard to get it quickly, number one. And number two, the one thing that I’ve learned in my first 8eight months in this job is just how important it is to keep those yards and those terminals flowing. When things get gummed up, it’s like the airline industry, when you get people and equipment in the wrong place, and you can’t — it takes a lot of work to get it back into sync.

And so gradually, obviously, it’s easier to make sure that you can maintain that. If you bombard the system with a bunch of new trains, a bunch of — you have the risk of a certain yard or terminal getting locked up and then you’ve got the corresponding effects across the network. But for us, we’re watching all that every day. But we’ll take volume increases either way, and we’ll make it work.

Scott Group

But it sounds like you don’t feel like you necessarily need to do something very different that sort of limits the incremental margin on the way…

Joseph Hinrichs

Correct. We don’t. Again, I have a lot of confidence demonstrated by how they — how well they’ve been making the improvements in the last six, seven months with our operating team, Jamie Boychuk and the whole team, I believe that we can handle it and do it the right way.

Scott Group

And so just as I think about as not — when volumes start to grow and do you think, right, we’ll add headcount with that. Do you think over time that volume should grow faster than headcount as we add some cars to existing trains, do you think it’s more 1 for 1? How do you think about that longer-term algorithm?

Joseph Hinrichs

Yes. I think the volume can grow faster than headcount just because of the nature of — it doesn’t need extra — if you’re adding cars to existing trains, you don’t need additional headcount really to do that. But we want to make sure we’re growing headcount to support that as well. The nuance here that’s really important is that this is a service industry and a service business. It’s highly reliant on our employees to provide that effort.

And so making sure that, that balance of taking care of them and their needs in support of the service we’re providing is critical. So if we tip over where people aren’t getting time off. If they’re feeling rushed in the yard, we’ve got to add some people to help make that happen. But we still have very healthy incremental margins in that scenario. So there’s the nature of our business is such that the incremental margins are substantial.

Scott Group

And so you just mentioned employees like you’ve taken a leadership role here. Obviously, the whole industry, we’re paying a lot more. Now we’ve done some stuff with paid sick leave, like, are we in a place where like — are we in a healthy place — or do they — is there now, okay, we got this, we got this now we want that? Like is there — what’s the next thing that they want? Are we now in a place where like things are good again.

Joseph Hinrichs

Well, I wouldn’t say they’re good again. I think we’re in the early innings of a baseball game, but we made some progress, some substantial progress and important progress. There’s a long 100-plus-year history of Acromona’s relations between the companies and the unions and the employees in this rail industry. And — we believe in CSX. I personally believe very strongly that if we’re going to achieve the optimum results of our business, we’ve got to get our employees to feel value appreciated included.

And so the things we’re doing changing our attendance policies, the paid sick leave deals, which we led the industry on establish a template which are now progressing nicely. All those things are part of moving us forward. The union contract taking three years was a step backwards, having go to Congress to do that was a step backwards. So we have to continue to make progress. We start negotiations again at the end of next year on a five-year contract because we took so long to do the first one or the last one.

So I’d say we’re in early stages, but we’re making progress, especially at CSX, we’re making progress. But we’re hearing from our employees that they also like our customers, they want to make sure this is sustainable, that its — they were committed to listening and solving problems to be able to make it a place.

And it’s in our interest to do so, not just because they provide the service but because we need to attract and retain people in this industry to do the work. And it’s getting harder and harder to do that because the youth of our country don’t — they don’t think about these kinds of jobs when they’re playing video games or when they’re at home doing their homework. So we’ve got work to do.

Scott Group

By the way, if there are any questions, raise your hand. I’ll keep going. So it very much feels like this whole industry wants to start growing. And I talked to investors, they’re like, yes, but they haven’t done it, right? I mean I look at CSX, like your volumes have declined eight of the last 11 years, right? What fundamentally changes going forward that takes you from a down a little bit historical volume CAGR to an up a little bit volume CAGR. And is there anything that you see that’s specific to either CSX or the east that sort of says, “Hey, we can for about starting to grow, we can become a leader on growth”.

Joseph Hinrichs

Yes. I think there are a number of factors that help support us in that conversation. Our location, we’re in the East, the Southeast is where a lot of the distal development is happening on the nearshoring or onshoring or reshoring whatever words you want to use is helpful to us because it’s in the south — lot in the Southeast, which is where we’re based, and we’ve had a number of big wins there with our industrial development team.

I think on the intermodal side, we have to continue to demonstrate our service capabilities and continue to partner people to make that happen. There are other things like our acquisition of Pan Am, we see growth longer term in the New England region of our business as we get the Pan Am network where we want to be to be able to run the speeds and double-stack, et cetera, that we want quality carriers over time should be additive to our business as well with the solutions we’re providing there with the ISO tanks.

There are a number of things unique to CSX, our industrial development work. That being said, the fundamental improvement in service, sustainability of service makes it a lot easier to get with customers and say, okay, you can trust us now. We’re committed to this, let’s talk about what your needs are and you can rely on rail to provide those needs because we haven’t given them that confidence or that reason.

And so what we’ve been doing lately is going to customers and saying, okay, you see what we’re doing. We’re committed to it. Let’s do a whiteboard process where we get in a room and say, what are you really — how much do you move and where does it go and how can we be part of the solution. And we’re seeing more and more acceptance and even excitement around that because of our service levels.

So service begets the opportunity to talk about growth. But in addition, we have some unique things to CSX and on the Southeast part of the country especially that helps support us as well. And we’ve already have a number of wins, which you heard Kevin Boone say in our last earnings call that we think you can get one to two points of revenue growth from the industrial development wins in ’24, ’25 and beyond that’s also supportive.

Scott Group

Okay. So let’s — I’m going to assume we’re going to start to get some growth, okay? You’re a railroad. You’re going to get price. If we get volume and price, is there any reason why we don’t continue to get margin?

Joseph Hinrichs

There’s no fundamental reason why you shouldn’t see improved margin with growth because, again, the incremental margin is greater than the whole margin in most cases, almost all cases. Now the opportunity to dramatically improve margins from here is limited. That’s already at least at CSX and some other places has already happened. But as you said, you have — if you can show growth, you can have some small incremental margin improvement and return a lot of capital to shareholders, you can show strong earnings per share growth beyond your growth in volume and/or in price because you’ll be returning — as we have, you’ll be returning some of that excess capital to your shareholders.

Scott Group

I mean, right, so if you do volume price, a little margin and buyback, right, the pieces should be there to — or if you can sustain that, that’s a double-digit earnings algorithm. Is that…

Joseph Hinrichs

I’m not going to predict I’m not going to provide that guidance. But yes, that equation can work. And so we’ve shown the ability to improve margins. We’ve shown the ability to price certainly beyond inflation. We at CSX have shown the ability to start delivering much higher levels of service, sustainable now for five or months, and we’ll keep doing that. And we’re having — and we’re showing some wins and some merchandise growth volume — more merchandise volume growth, sorry. So — and Intermodal is where it is. So yes, those fundamentals should work for us and they should work for CSX in a strong way.

Scott Group

And so let’s keep going. If we get the volume growth, right, do we — does something have to change about the capital intensity or revenue grows, I’m sure CapEx grows, but does CapEx grow faster? Or do we sort of — can we keep this sort of 15%, 16% of revenue on CapEx side…

Joseph Hinrichs

Yes, we don’t see substantial capital growth beyond where, kind of where we are. Remember, we’re investing in quality carriers, ISO tanks, we’re investing in Pan Am, and we’re investing in — obviously, most of our capital goes in and investing in our network. I will say I’m very impressed and pleased with what the team has done over the last several years.

The CSX network is very — I mean, it’s not perfect, but it’s very healthy. We’ve got big projects like the Howard Street Tunnel in Baltimore and great projects in Chicago and stuff that we’re working on with our government partners. But generally speaking, we don’t see a significant increase in capital required to support growth.

Scott Group

So if the earnings come through the cash conversion should be very strong?

Joseph Hinrichs

It should be, yes.

Scott Group

Let’s just — we’re getting close on time. I just want to wrap up just on the DC environment. You’ve been very involved there. We’ve had some conversations. What if anything are you expecting out of this safety bill. It feels like we’ve had some progress taking some of the stuff on train length and train weight out. Is there more stuff we want to get out of this build? Do you think we’ll end up with a two-person crew mandate? What are you expecting from the safety bill?

Joseph Hinrichs

Yes. I think the Senate Bill is moving forward, and we think there are things in the Senate bill that aren’t good for the industry and don’t belong in that bill. The house is being more thoughtful, more waiting for the NTSB to give its comments and et cetera. So usually, it’s a Senate that takes more time and is a little more thoughtful. In this case, it seems like the house is where that’s happening. And so we think that’s productive.

We don’t believe — I mean at CSX, we weren’t pursuing a single-person crew or conductor on the ground as you know, but we don’t believe a two-man crew mandate should be in a safety bill. There’s no evidence of what happened has anything to do with how many people were in the crew. And we don’t know where technology is going to take us over time. So we don’t want to — but we don’t believe that should be in the bill, whether — but we’re not pursuing that.

There are other things like that, that are in the bill restrictions on automatic inspection and time standards and it gives a lot of authority to the secretary of transportation to have a lot of oversight, those are the kind of things we’re like we want to talk about. But there’s a lot of good stuff in the bill around tank cars, first responder training, some other things that we’re really supportive of.

So I think we’ll end up — we will definitely end up with a bill, I think, between both houses. I think it’s going to take a little more time as the house is taking its time to make sure it’s thinking it through. And in the end, I think the industry will be better off, because we’ve learned a lot from what’s happened working together on safety, et cetera. But there’s still more work to do in D.C. And we got to make sure that what we’re — that the Rail Safety Act is about rail safety and not about other agendas or other objectives that other parties have. So that’s what we’re saying focused on.

Scott Group

But do you feel like you’re making progress to that point of…

Joseph Hinrichs

I think we’re making progress I think there’s still things in the Senate bill that we think don’t belong in there, but we are making progress.

Scott Group

Okay. We’re going to have to wrap. Thank you so much.

Joseph Hinrichs

Thank you, everybody. Appreciate it. Thanks.

Warner Bros Discovery, Inc. (NASDAQ:WBD) 51st Annual J.P. Morgan Global Technology, Media and Communications Conference Call May 24, 2023 8:00 AM ET

Company Participants

Gunnar Wiedenfels – Senior EVP & CFO

Conference Call Participants

Philip Cusick – JPMorgan Chase & Co.

Philip Cusick

Good morning. Welcome to the third and last day of the 51st Annual JPMorgan TMC Conference. My name is Phil Cusick, I follow the communications and media space here. I want to welcome Gunnar Wiedenfels, CFO of Warner Bros. Discovery. Thank you for coming.

Gunnar Wiedenfels

Good morning, Phil, and thank you for having us here.

Philip Cusick

Congratulations on Max launching yesterday.

Gunnar Wiedenfels

Thank you.

Question-and-Answer Session

Q – Philip Cusick

Do you want to just talk about sort of the process there and what people should be expecting?

Gunnar Wiedenfels

Yes, sure. First of all, very, very happy how the launch went yesterday. It’s obviously a big priority for the company. If you think about it, one of the core theses of this combination between WarnerMedia and Discovery was to bring these two products together.

The team has done an enormous amount of work over 12 months, and yesterday was the big day, and it went very well. I was actually very surprised by the large number of subscribers that’s already started watching on the new product on Max. Very happy with the technical session metrics that are, already on day 1, better than the prior product. And no accidents, which is the most important point for an endeavor like that. So it’s day 1, but so far so good. And we’re very, very pleased with how that’s gone.

And again, thinking ahead here for the rest of the year and for the future of the company, this combined product opens up so much opportunity for us, and we’re going to learn so much over the next few months in terms of changing viewer behaviors, the cross-pollination between the 2 content portfolios now being combined into 1. Hopefully, lots of impact on churn and engagement in a positive way. So really a lot to be very excited about for this.

Philip Cusick

Let’s just dig into that for a second, because it’s so important. So I’m a Max customer. I’m going to download a new app. What am I going to notice that’s different? And why does it matter to you?

Gunnar Wiedenfels

To me, what was most evident or most obvious when I first downloaded and opened the new Max app was the speed. It was actually on the tarmac yesterday on the way out here, downloaded a couple of episodes. That’s one of my pet peeves, the download function in the prior product wasn’t very reliable. And between the taxiway and the takeoff, I was able to download 3 episodes, and that was just using the cellular network, and I had it ready to watch. And it actually worked on the flight up here. So that’s the biggest difference.

And then you’re going to see a lot of improvements in terms of the technical stability and content discovery. The way we’re serving this enormous, broad portfolio of content with different lenses, as we call them, for you to filter through what you want to see. But then over time, as we learn more about viewer preferences and behaviors, also a better recommendation that’s moving from a more manual curated approach to a combined manual and algorithmic approach.

Philip Cusick

Trying to show people more of what’s inside this rather than just the sort of small number of titles that have been watched for the most part.

Gunnar Wiedenfels

Right. And also to help them sort through this enormous amount of content.

Philip Cusick

Yes. So help me think about what you’re most excited about over the next year. It’s been a year since you closed the deal. Obviously, this was a big step. What else should we be expecting that’s the big priorities of management for the next year?

Gunnar Wiedenfels

The most important point is we’re continuing to execute every day. The launch yesterday was one big milestone, but we’re knocking out milestones every day along this big plan that we put together in the first few months of the combination of — or the foundation of Warner Bros. Discovery. And that’s going to be such an important factor.

We’ve given guidance, obviously, for the year. Financial guidance are $11 billion to $11.5 billion EBITDA range and the 1/3 to 1/2 free cash flow conversion, we’re on track for that. We’re seeing the quarter develop nicely in line with that. And that’s all, more than anything else, driven by our ability to continue implementing these initiatives that we put on a track a year ago and that are now being replicated elsewhere in the industry as well. But we’re just looking at a little bit of a head start here, and it’s very, very encouraging to see that we’re actually getting some financial results now.

The first quarter was the first quarter for WBD where we actually went back to profit growth. We’ve got another one coming up. I’ve given guidance to free cash flow growth. So that’s going to be a big factor because we want to be comfortably below 4x leverage by the end of the year, and that’s one of my big priorities.

In addition to that, we’re obviously hoping that the ad market continues to improve. I’ve said on the earnings call 2 or 3 weeks ago that we’re seeing some very gradual improvements. We’ve continued to see that. It’s not a full turn or a full recovery yet by any means, but there is some — a little more optimism in the market now than maybe a month or two ago.

And we’ve got a lot of other exciting stuff coming down the pike here for the second half. We’re very, very much looking forward to the film launches, The Flash in June and then Barbie in July.

Philip Cusick

I told Andrew I’m really excited about Barbie.

Gunnar Wiedenfels

It’s actually — I’m not a great Barbie guy, but the trailer is really interesting, so…

Philip Cusick

It looks funny, yes.

Gunnar Wiedenfels

And the tracking metrics are looking pretty good.

Philip Cusick

I meant my kids. I meant my kids. Yes.

Gunnar Wiedenfels

We’re obviously continuing to generate impact from Hogwarts Legacy. I got Mortal Kombat coming in September on the game side.

And again, as I said earlier, one of the big priorities is going to be really studying or learning in terms of viewer behavior and growth opportunities for the Max product.

Philip Cusick

So since you mentioned it, let me go back to a couple of things you said. One, you said the quarter is developing as you expected to hit the $11 billion to $11.5 billion. And you said advertising, you’re starting to see things a little bit — people a little more confident. Is that any indication of how your upfront went last week? Or it’s pretty early for that?

Gunnar Wiedenfels

It’s early for the upfront, no doubt. What I’d say, we see a continuation of that improvement. We had 2 better weeks in terms of scatter booking. Again, it doesn’t make a year, but as we said on the earnings call, it’s a gradual improvement. Q1 was better than Q4, Q2 is looking a little better than Q1. And intra-quarter, I think, we’re seeing a positive trend. Again, it doesn’t make a turn yet, but there’s — I think there’s reason for some optimism.

The upfront has obviously just started with presentations last week. We are in discussions with all the holding companies. We’re actually in advanced discussions with some of them. And as you would expect, discussions are very much sports-led. The uncertainty in the marketplace is a factor for this year’s upfront, no doubt. But I’m pleased with the progress we’re making as we go through these discussions.

Philip Cusick

Okay. The other thing we saw coming out of the first quarter was an acceleration in the decline of the linear ecosystem. Clearly, Max is a solution for your entertainment divisions. How do you think about the rest of the company and your exposure to linear?

Gunnar Wiedenfels

Well, clearly, linear is an important part of our business, and I don’t think anyone expects that business to be growing. If anything, I’d say sort of the consensus view is a gradual decline, and we’ll do our best to manage that business.

We’ve got a great team with Kathleen and Louise and Chris in the U.S., and then Gerhard Zeiler internationally. Very, very experienced teams with great skill sets when it comes to managing that kind of a business, which is finding the right balance between making the right investments, orchestrating content investments over a combined broad portfolio with 29 networks here in the U.S. There’s a lot of opportunity to just fine-tune where we’re spending, how we’re windowing across networks and across the broader group. It’s a big, one, Warner Bros. Discovery theme, how we’ve manage windowing.

So we’re not expecting any positive messages from the top line perspective, but we have a lot of flexibility still on the — in the cost structure so that we can continue managing that business for a lot of free cash flow for many, many years to come.

And then to your point, how does that dovetail with the D2C growth opportunity. The way I look at our group is we’ve got a lot of built-in hedges between the studio, the linear platform and the D2C platform. And in an environment where cord-cutting maybe accelerates a little more, you should be — you should see some additional tailwinds on the D2C side and vice versa. If there’s more competition for content, we’ll benefit on the studio side, et cetera. So we have that benefit of a somewhat hedged portfolio.

And when it comes to the D2C space, I think we’re really in the first innings. We launched the product. The basic thesis here is that we can get better engagement and a more satisfactory consumer experience with this combined portfolio, but we haven’t even started talking about other potential opportunities. And again, one of the great things about our competitive position is we have essentially an entire bundle, right? We’ve got all kinds of content, unscripted, scripted, news, sports in a major way and across a global footprint.

So — and as JB and David said on the day of our launch announcement for the D2C platform, we have worked on our contractual flexibility. We have flexibility in most of our deals to start experimenting with windowing for sports as well. For news, it’s obviously in our control. Again, we haven’t made any final decisions, but we’re obviously keeping a close eye on what’s going on in the industry, and we’re watching others that are breaking the traditional molds and starting to play with simulcast and different platforms a little bit. And I view this is optionality, and if anything, a major opportunity for us should we decide, when we decide, to take a more aggressive position on the D2C platform with these…

Philip Cusick

I know you’re not going to make news here on where you’re going to go. I’m just curious how you think about the comments from Brian Roberts last week, Bob Iger a couple of weeks ago. I would paraphrase Brian last week as saying, “The world is going to streaming. Sports are going to streaming. We’re just going to get on board.” And it seems like there’s going to be an acceleration even from here. Does that make you — give you more of a sense of urgency in terms of whether experimenting or taking some of those options?

Gunnar Wiedenfels

We’ve always had a very clear sense of urgency with everything we’ve done, and the team has worked really hard on creating as much optionality as possible. So we have the flexibility, again, in most of the key contracts and rights agreements.

And again, I don’t think we need to be at the leading edge of disruption here, but we’re clearly monitoring what’s going on. And I believe that there will be an opportunity for an equilibrium where linear doesn’t go away completely, but the — already today, there are more people outside of the traditional bundle than inside the traditional bundle. So as an industry, we have to acknowledge that, and we have to find a way to service, with any kinds of rights and any kinds of content, both of those populations.

And I think there is an equilibrium that will be beneficial, and we’re thinking through all the different scenarios. And again, as David and JB said, there’s a lot of planning going on, how that could look for Warner Bros. Discovery. But it’s premature at this point to talk about it more specifically.

Philip Cusick

Yes, not surprising. You do have some great assets in Bleacher Report, House of Highlights, things like that. Are those potential tie-ins to TV over time?

Gunnar Wiedenfels

Well, they are very important assets from the perspective of our ability to create broad reach across demos. We already have enormous monthly active users on Bleacher Report. House of Highlights is a key brand. Also on the news side, by the way, with CNN.com, that’s sometimes overlooked, hundreds of millions of people interact with the CNN brand globally on a regular basis. So they’re definitely part of it.

Specifically from an ad sales perspective, it’s important that we’re able to integrate those audiences and go to the market with a complete coverage, being able to serve whatever our advertising partners need. And certainly, the key value here is the younger demographics.

Philip Cusick

Okay. Okay. Well, let’s turn the page a little bit back to Max. You talked about the domestic rollout. How should we think about the international rollout sort of progressing over time?

Gunnar Wiedenfels

Well, the team has obviously focused on the biggest market, the U.S. market, for now. We have already announced Latin America is going to launch later in the year. We’ve got some EMEA markets in 2024. We’re going to be focusing on some fast follow implementation for all of the key markets in terms of additional features.

And then we’re going to continue, where we’re going to go back to the global rollout. But we’re going to do that in a way, as we’ve said many times, without religion. Without any, call it, objective of being in every territory in the world. So we’re going to be very thoughtful about it, and we’re prioritizing by market potential.

And as you’ve seen from some of the announcements that we’ve made, we don’t necessarily have to be in every single market with our own and operated platform. In some areas, we’re going to be brutally rational about it. That you’re going to deploy a lot of capital, it’s going to take a couple of years to break even in a specific market. And we’ll assess that market potential for an owned and operated platform. And in some markets, we may end up with a — more of a licensing or a partnership or a JV model. We’ve started making some of those deals in some international markets.

But as a general point, ’24, ’25, ’26, those years are going to be very much characterized by international expansion and subscriber growth in international markets as we — as more markets come online.

Philip Cusick

Okay. If you think about the U.S. Max product and trying to broaden the viewership within the product, driving that recommendation engine and things like that. How do you think about the relationship of price to hours viewed? There’s been a lot of discussion about Netflix, whether it’s the ad-supported or the premium product, and how many hours people are on that. What do you think needs to be viewership on Max to maintain a churn level that you can sort of really live with?

Gunnar Wiedenfels

Well, I think you just made the most important point of your question. There is a certain level of engagement that is a predictor of retention, the inverse of churn. So you want to make sure that you continue engaging with people ideally on a daily basis. And that’s one of the things that discovery+ has had, enormous daily engagement. It was much more difficult to get for HBO Max. So again, the thesis is the combination of the 2 is going to be a helper.

The — what we’re already seeing — and again, this is one day, but I was very pleased with the take-up of the premium tier, which we just introduced yesterday. So there was a lot of demand for that.

And I think the tiering of these packages is going to be incredibly important. If we look at both HBO Max and discovery+ as stand-alone products, we probably underpriced the ad-free tier a little bit so that the ARPU on the ad lite version was actually sometimes higher than — in some markets, higher than the ad-free version. And I think there is room for upside.

Again, pricing overall, my view is in the industry needs to continue to show an upward trend. We’ve talked about that a couple of times, collapsing all windows into one and then giving it all away for $9.99, it doesn’t sound like a very smart business model. And I think we’re continuing to see that trend. And with the Max product, we’ve now increased the content that’s available on the platform in an amazing way, and we’re still selling it for essentially the same price point as before.

So I think we’re very, very competitively priced. But over time, I would see some more steps. We’ve taken some price hikes in Latin America in the first quarter. Internationally, I believe that we’re still too low. That was still part of that initial HBO Max rollout of just land-grabbing as many subscribers as possible. So I think there are opportunities.

And the advertising-funded opportunity, either as an ad lite tier on an SVOD platform or in the VaaS pace, I think, has a lot of growth opportunity.

And specifically for the former, with the Max product, HBO is such an amazing and such a powerful brand and has never been exposed to advertising for decades. The view in the market is coming around, and I think advertising is accepted today as a legitimate form of monetization even for a very, very premium content.

And we’ve only just started. We’ve had some sponsorship deals. Mercedes is a brand that wants to be tied to that premium…

Philip Cusick

Succession.

Gunnar Wiedenfels

HBO brand in Succession, right. And we’ve started opening up some pre-rolleds, but there’s a lot more opportunity. It’s nothing we push right now because of where the market is. But we’re in the very early innings when it comes to advertising growth on the D2C platform.

And by the way, also in linear with finally the Nielsen monopoly falling apart and different alternative currencies coming to a level where they’re actually transaction-ready, there’s a lot of opportunity for just better measurement, but better data-driven linear selling.

So I think that — again, don’t want to take — I don’t want anyone to take away linear as a big revenue growth driver here. But with data-driven linear advertising, dynamic ad insertion on some of the virtual MVPD platforms, there is a lot of upside still to manage some of the declines in viewership.

Philip Cusick

My kids always get mad at me because I sign up for all the ad tier versions of streaming services. I say it’s because I want to see the ads, it’s really because I’m cheap. But 90 seconds of advertising, those kids have never lived in a world where there was 20 minutes an hour of advertising. And 90 seconds feels painful when you’ve lived without it for a while, but it’s really not that much. Where do you think the optimal level is for advertising on — as these things become fully loaded over time?

Gunnar Wiedenfels

Definitely not 20 minutes.

Philip Cusick

One hopes.

Gunnar Wiedenfels

Probably a little more than today. And I think if I look at what my kids say about advertising, they actually know most of the Liberty Mutual ads by heart.

Philip Cusick

All of them. Progressive. All the insurance ads, we know really well.

Gunnar Wiedenfels

Right, right. And so I think it’s an important point. To your point, it’s not a foregone conclusion that advertising is accepted, but that’s why the environment, the brand-safe environment is so important. The quality of advertising, and the dovetailing of the ad and the content is super important.

But I do think there is room for more, and I think people understand that nothing is for free. And there is a tiered structure and so many different products in the world. And I do think we have a lot more room on the advertising side. It’s never going to go back to the level on linear, but…

Philip Cusick

I will hold you to that. So I think what investors struggle with in the streaming world is we all started off paying $10 a month for streaming and now HBO’s, let’s call it, $20.

Gunnar Wiedenfels

For the top tier.

Philip Cusick

For the top tier of Max, it’s $20. And prices are certainly headed higher because every streaming service is going higher. And I think what people struggle with is are we really going to be in a world where people pay for 4, 5, 6, 7 of these things? Or does there need to be consolidation and sort of a rationalization in the space? How do you think about this? Having gone through a big deal, I know.

Gunnar Wiedenfels

Well, if I should — if I just look at it from a consumer perspective, from my consumer perspective, I agree with you. I find it annoying, you want to watch something and you got to figure out, wait a minute, what platform is it on? Do we — do I have that subscription or not? Do I remember the log-in? And you’re on your remote typing in your e-mail address on the TV screen, et cetera.

It’s certainly the unbundling comes at a price from the perspective of the user experience or the viewer experience. So I do think consumers would benefit from some form of rebundling. And I think a lot of people are thinking about that, and there are a lot of different models how that could be set up.

I think it’s going to be — that’s not an easy thing to pull off. There are so many questions on how exactly you would structure a product like that, how exactly you would structure the economics. It’s very hard to get perfectly aligned interests in a setup like that.

So I do think it’s compelling to think about some form of rebundling, but I don’t think it’s an easy thing to pull off, and I certainly don’t expect anything to happen short term here.

Philip Cusick

No, I think that’s right. I think…

Gunnar Wiedenfels

And then since you mentioned the deal. From a consolidation perspective, again, same thing. I think there is a clear rationale for more consolidation in the space. I don’t think that we need anything. We put together Discovery and WarnerMedia to form Warner Bros. Discovery because we are convinced that we have 100% of what it takes. We’re covering all genres. We’re in every territory in the world. We have an incredibly powerful content engine. We’ve got a 100 million-subscriber D2C platform and a cash machine in the linear world, which allows us to fund the growth opportunities in consumer products, games, making more films, again, expanding the D2C footprint. So I think we have all it takes to get that out of the way. And I do think there’s a lot of talk about consolidation.

It’s interesting once you start looking at the regulatory environment. I don’t think a lot of the combinations are slam dunks from that perspective.

Philip Cusick

Right. Spending 1.5 years and not getting something done doesn’t sound like fun.

Gunnar Wiedenfels

Right.

Philip Cusick

Yes. But in terms of D2C, so we talked about churn coming down, ARPU probably going up, advertising coming in. You have a $1 billion EBITDA goal, I think, in 2025 from D2C. The trends look like that is pretty reasonable. Why is that not a pretty conservative number?

Gunnar Wiedenfels

I don’t disagree with that logic. And as I said on the earnings call, we could have probably done a full replanning of the D2C trajectory and come up with more specific or updated guidance. It would have been a weird time, to be honest, because we’re just launching the product. So many drivers of that $1 billion are assumptions, and so many of those assumptions are going to be back-tested over the next 3, 4 months with actual data.

But you’re 100% right. If you just look at the trajectory, we pull forward the U.S. breakeven and U.S. profitability by a year. We’re trending much better than what we had in the plan when we put out that guidance about 7 or 8 months ago. So it’s going very well. But we also acknowledge that there is still a lot we don’t know, where we have strong hypotheses, a lot of reason to believe, and data evidence, but just not hard facts. And we’re going to gather those facts over the next 3, 4 months, and then we’ll come back to inform the market.

What I will say is I have a lot more confidence in our ability to profitably grow subscribers than maybe 12 months ago. I have a lot more confidence in our ability to continue driving down churn just because we’ve seen it happen with just margin — this are evolutionary, not revolutionary steps. And we’ve seen engagement come up, we’ve seen churn come down. It’s small things, and — but we’re consistently and continuously chipping away at some of the key metrics. And again, some of the really powerful impact of this combined content portfolio and a much, much better user experience in the sense of a technical functionality and reliability is only going to start kicking in now.

Philip Cusick

Yes. I mean, discovery+ typically had fairly low churn, a very reasonable price and a lot of engagement. HBO had that just hamster wheel of new content and people coming in and leaving in 2021. And sort of ’22, we’re kind of getting away from that. How much have you compressed churn between those 2 in the last year?

Gunnar Wiedenfels

Well, discovery+ has always had industry-leading churn rates really out of the gate. A lot of that is driven by the nature of the content. It’s daily engagement. People love their show brands and they’re coming back and they’re staying on for hours on end.

The HBO Max churn, I think, is a function of 2 things. One is that we’ve said that publicly a couple of times, the user experience has just not been great. If you look at App Store ratings, we had a 3.3-star rating on the Apple iPhone iTune store. But there were no 3-star ratings, there were only 1-star ratings complaining about technical issues with the app and there are 5-star ratings praising Casey’s content.

And we’re eliminating the left side of this, the 1 star, just the technical difficulties. The fact that, in 2023, you’re unable to download a show reliably, that’s just not acceptable and this is history now. So that will make a big difference, I believe. And we have already seen, with other tweaks, that we’re able to bring churn rates down.

The second point, though, is I want to make sure that’s understood as well, HBO content, by the nature of it’s — by its tentpole, lighthouse, talk of town nature, will always bring in hundreds of thousands of subscribers in individual days when they — when a new show drops, and then the second and third episode all of a sudden benefit from the word of mouth. So you bring in massive amounts of subscribers who really come for that one show. So it’s not inconceivable to assume, and that’s what we’re seeing when the show ends, that a certain percentage of those subscribers leaves again because the show is over.

That’s where we want — but to some extent, it’s the nature of the content. And that’s where we want to combine the 2 portfolios and serve those subscribers some other content that engages them on a daily basis. That’s the thesis, and we’ll be able to report back a few months from now how well that’s working. But I have a high level of confidence.

Philip Cusick

All right. We’ll be watching. Let’s talk about the theatrical side a little bit. You said you’ve got Barbie coming, and the other is — I’m blanking. Flash coming very soon. There’s been successful movies and not successful movies in the last year. What do you think is the common denominator? And where is the theatrical sort of world right now versus a year or 2 ago and then pre-COVID?

Gunnar Wiedenfels

Well, starting with the latter, theatrical world is up versus prior year. Significantly still, year-to-date, I think 26% below the pre-COVID levels. But it’s continuing to recover. I think there is this disturbance of the COVID output, the direct to Max shift, which I think for the market, obviously, was a weird time, but much more so for Warner Bros. And that’s still in the system.

We’re firing up the production, as we’ve said many times, 14 films this year. Where Mike and Pam are starting to develop, James and Peter are starting to develop for DC. What’s coming to the market now in ’23 and to a large extent ’24 is still a part of the old slate, but they’re putting their hands on it.

And I think what’s going to be helpful is a clear mission of what we’re trying to do here. And I think that was missing in the COVID years and then ’21 to some extent, with this idea of just spending enormous amounts of money for films that are going to end up on Max. But then there’s also inevitably a little bit of a, okay, well, this might not be a theatrical release, let’s put it on Max, right?

So I think there is — in essence, there were probably a couple of films greenlit that, in a steady-state, normal environment, you would have probably not done. But with this idea of, okay, it could be on the streaming platform, maybe people were a little more generous greenlighting content.

That’s behind us. There’s a very clear mission now. We are 100% committed to the theatrical window. What’s different is the theatrical window is not a fixed mold anymore. Every title has a different number of days in the theater depending — and that’s the flexibility we didn’t have years ago. But it’s now a great partnership with the theaters, and we’re jointly looking at what makes sense, what doesn’t make sense. One benefit is the marketing investment gets much greater leverage over the initial theatrical window, home entertainment…

Philip Cusick

Sort of overlapping windows rather than segment.

Gunnar Wiedenfels

Yes, exactly. And then even the streaming segment still gets a little bit of the initial buzz.

So I think it’s actually — it’s a productive environment. We’re firing up the production engine, and it’s going to take a little while before Mike’s and Pam’s output and Peter’s and James’ output is coming online. And these are also obviously enormous downstream opportunities because the international licensing, again, home entertainment, et cetera, are all going to benefit from greater volume again. And I think this should be a built-in tailwind for the next 3 to 5 years until we get back to a steady state.

But we’re very excited about the films that are coming out in the summer. The Flash, a lot of people who really know what they’re talking about have said this is the best superhero film ever.

Philip Cusick

Including your boss.

Gunnar Wiedenfels

I’ve watched it. I liked it. I don’t know if it matters. And again, Barbie certainly has the potential for a cultural phenomenon. Got a couple of other films later in the year, Wonka, Dune 2. So it’s a good second half of the year.

The first half of this year was obviously characterized by difficult prior year comps with The Batman in the first quarter of last year. Shazam 2, that we had hoped would do a little better than it ended up doing. So lots of positive things coming in the second half and beyond.

Philip Cusick

Okay. I want to hit gaming really quick. Hogwarts was such a success, certainly in my house.

Gunnar Wiedenfels

And mine.

Philip Cusick

And yours? We just need 1 that — 2 people can do it at the same time, that would be helpful. But how does that change your view on the gaming business overall? What’s your — what’s the future of that?

Gunnar Wiedenfels

Well, it hasn’t changed our view. I think it has reinforced our view. Because remember, when we first announced the deal, I don’t know how many — how much talk there was publicly and how many bankers called Bruce or David or myself. Is this is an easy one to delever? And we’ve just been very clear, no.

The whole idea here is this is not a conveyor belt of content into a streaming service, as everybody was looking at media at the time. But we’re deploying $20 billion in content spend and we’re monetizing that across as many platforms as possible. And to us, an interactive element in gaming was always part of that portfolio approach. We did say we’re going to give ourselves a year, 1.5 years to look at whether that’s right, better understand what the opportunity is. And Hogwarts Legacy, I think, is a great testament to the value in having that interactive element to monetize one of the greatest IP libraries in the world.

And I do love the fact that — I think it’s 12 years since the last — 11 years since the last Harry Potter film, and we’re coming out with the greatest game in Warner Bros. game’s history on the basis of that IP. We’re opening up a Harry Potter tour in Tokyo in June. Again, it’s small in the greater scheme of things, but the presales — we’re already sold out for the first 2 or 3 months. There’s so much power in that IP. And I think the success of this game goes to show how important it is to be able to use all those different platforms and cash registers to keep monetizing.

And interestingly, The Last of Us shows that it also works the other way around. Unfortunately, we don’t own The Last of Us games IP. But the fact that we were able — that Casey and the team were able to make a TV adaptation of that game and create such an enormous success goes to show that it’s really — it’s a cross-pollinating opportunity.

And we’re incredibly happy about how this game has gone. We got the Switch launch later in the year. That’s going to be, hopefully, another big bite at the apple because it’s a large installed base, very family-focused, and I think that’s going to be a good fit for this game specifically. And we’ve got Mortal Kombat coming out in September, Suicide Squad next year. So there’s a pipeline as well with a lot of investment and lots of at-bats in that space. So it’s one of the exciting growth opportunities that I see.

Philip Cusick

That’s great, and a good place to leave it. Thanks, everybody. Thanks, Gunnar. Nice to see you.

ON Semiconductor Corporation (NASDAQ:ON) 51st Annual J.P. Morgan Global Technology, Media and Communications Conference Call May 23, 2023 3:55 PM ET

Company Participants

Hassane El-Khoury – President and Chief Executive Officer

Thad Trent – Executive Vice President and Chief Financial Officer

Conference Call Participants

Harlan Sur – JPMorgan Chase & Co.

Harlan Sur

All right. Good afternoon, and welcome to the second day of JPMorgan’s 51st Annual Technology, Media and Communications Conference. My name is Harlan Sur. I’m the semiconductor and semiconductor capital equipment analyst for the firm. Very pleased to have the team from ON Semi here with us. We have Hassane El-Khoury, Chief Executive Officer; Thad Trent, Chief Financial Officer. The team held their Analyst Day a week ago. It was a great event. It’s really been incredible to watch the team execute to its strategy of growth, margin, earnings, free cash flow power expansion over the past few years. So what I’ve asked Hassane to do is to sort of just kick it off with just a brief few minutes summary of last week’s Analyst Day.

Hassane El-Khoury

Yes. I mean, like you said, it was a great day for a few reasons. I would say primarily, it was a testament of a solid strategy that would continue and expand beyond what we’ve been doing in the last couple of years. Like you said, we’ve embarked on a transformation. That has been going exactly according to plan. Our strategy is solid. Our strategy has been stressed with the macro environment, and it’s sustainable. Our results are proof of that. Our investments in the right areas, what I call the sustainable ecosystem of electrification of the infrastructure, electrification of mobility have shown the results already.

And the way I judge was at a good Analyst Day is we didn’t do a reset. We actually did a continuation about what’s next, what’s the journey ahead. That’s what made it a great day for – not just for our employees, but our shareholders and really more importantly, our customers who have been on that journey with us the last couple of years. And based on the long-term agreements we have with them, they’ll be on the journey with us for the next 10 years.

Question-and-Answer Session

Q – Harlan Sur

Perfect. I’m going to start off with – I’m going to go – I typically start off with near- to mid-term. I’m going to go backwards now because I do want to focus on some of the aspects of the Analyst Day and sort of the mid- to longer-term strategy. First question is going to be on your silicon carbide strategy, right? You guys have done a phenomenal job on ramping internal silicon carbide, sort of end-to-end manufacturing infrastructure, right? In fact, you are ahead of your ramp plan and looking at your internal capabilities to help drive your 70% per year sort of silicon carbide revenue growth profile with the gross margin profile is accretive, right, to your current gross margins.

You still have some cost and efficiency tailwinds over the next few years. I do think that the move from 150-millimeter 6-inch to 200-millimeter 8-inch diameter wafers is part of that further optimization and efficiency unlock. What’s the status of the development efforts here? And what’s the timing of the team’s transition to 200-millimeter?

Hassane El-Khoury

Like you said, we’ve been exactly where we are as far as what we’ve outlined on the silicon carbide ramp. We’ve 5x the capacity on the substrate. Our yield since the time of the acquisition are only embarked on the silicon carbide journey have been up 1.7x. We’re basically doing exactly what we said we were going to do. And actually, we’re ahead of our own internal plans, which showed the results of we doubled our revenue quarter-on-quarter, and we’re on track to deliver the $1 billion. That’s what you need as a baseline in order to start talking about a transition. So we have a very solid baseline. We have a solid technology. And more importantly, we have a solid LTSA or revenue committed by customer that we talked last week in Analyst Day is at a $9 billion lifetime revenue for silicon carbide.

So all of these put us in a very good position to build upon. And building upon, one of the aspects we build upon is on the going – the migration from 150 to 200-millimeter. Where we are – and our plan has always been, we will enter the market in 2024, and we will generate revenue in 2025. We’re still executing to that plan. We already have it today. Now people ask, well, why don’t you accelerate it? Because we don’t have a reason to accelerate it. And I’ll tell you where the balance needs to be. Our 150-millimeter is scaling. It’s yielding. It’s highly effective. And we’re on track to absorb the start-up costs for it, which puts us on that margin trajectory in order for us to establish a very solid baseline upon which to build the 200-millimeter.

Some of our peers have had struggles when they need to ramp very quickly. We’ve been able to 5x because we had a very solid baseline on the 150-millimeter. We are establishing that same baseline right now on the 200-millimeter. So when it’s time to ramp, we are able to ramp very quickly and effectively.

Harlan Sur

And I think you did mention a number of years out, right? You will be – your next brownfield expansion for your silicon carbide manufacturing capabilities, you’ll be committing $2 billion of investments, right? Do you expect that, that brownfield will be 200-millimeter?

Hassane El-Khoury

Yes. So look, as you look out in time, all of our investment are going to 200 millimeters because of, again, the transition is inevitable. Now one thing I do want to make sure everybody understands is our 150-millimeter capacity today is 200-millimeter capable. So when I say we’ve been running 200-millimeter already to establish the baseline, we’re actually running it on the equipment that we have already in place. It’s not some new facility.

And that adds that baseline because you can expect when we convert to 200-millimeter, if you have been running that 200-millimeter on the existing line, then you have the yields, you have the outlook, you have all of that already established to be able to run. If we are adding – as we add the new capacity or the end-to-end manufacturing site, that will more likely be on the 200-millimeter just because it will be in that time when we start the 200-millimeter conversion.

Harlan Sur

And you did bring this up in terms of some of the challenges that some of your competitors have had. The ON team, you’ve been doing power for 30, 35 years. You’ve ramps. You’ve built a learning curve in all of the different flavors of power transistors, modules, packaging, right? I mean – and then, obviously, doing it in a very systematic fashion. In the same way that you just described, doing it in a systematic fashion and moving from 150-millimeter to 200-millimeter, right? How much of this 30-year learning curve across power, module capabilities, a lot of the special intellectual property and in-house expertise is responsible for where the team is today, the $9 billion of committed silicon carbide revenues, how much of that is this learning curve and systematic approach to process manufacturing improvement and cost reductions?

Hassane El-Khoury

I would say pretty much all of it. You have to have solid IP. You have to have competitive design. So all of that are what I call the baseline upon which, if you don’t have the competitive advantage on a technology, and I categorize technology as device and packaging in one. If you don’t have that, then it doesn’t matter how quickly or how effectively you build capacity. So we have that competitive moat that we have across all of our IP and capabilities. But to scale that very effectively and not just effectively, but at the speed by which we scaled it, then it’s all about the knowledge, the history and really, call it, scars on our back for the last 30 years of ramping fabs, ramping power semiconductors and ramping customer designs in the automotive industry that’s very demanding.

Harlan Sur

Yes. And I feel like that’s a pretty big competitive advantage, right? You can talk about figure of merit or transistor performance, all that kind of stuff, but I think people fail to realize one of the biggest barriers in this industry is learning curve, manufacturability, yield, cost improvement, intellectual property.

Hassane El-Khoury

That’s right. And the faster you can resolve these issues, the faster you can stay ahead of your learning curve and delivering and over-executing to your own plans then you’ll get the results. And if you look at our first quarter results, we came ahead because of exactly all of these improvements and all of that firepower we have within the company, where we have individuals running those initiatives that have done it before and know what to look for kind of around the corner.

Harlan Sur

And as some of your competitors have struggled because they’re still coming up their learning curve and cutting their teeth, as it relates to the $9 billion in committed revenues for silicon carbide, has there been an acceleration of customer engagements, new commitments just given what appears to be some issues with some of your competitors, start-up issues with your competitors?

Hassane El-Khoury

Yes. Look, it’s a natural state where we have customers that have come to us because they have plans to ramp, and any concerns that will jeopardize their ramps, they have to find a solution. So we’ve seen an uptick in interest. Obviously, in 2023, we’ve said we’ve sold out. So it’s not something that’s going to impact the short-term. But definitely, this is a long-term view. That is not yet reflected in our LTSA’s because that’s the engagement we’re doing now. So you’re going to start seeing more and more engagement that we make public.

But again, at the end of the day, what you have to always remember is it’s the technology and the superior technology that’s going to make the win or loss. I tell my team, we’re not going to win if somebody else doesn’t win. We need to win when everybody else is able to win because that’s the competitive advantage that is sustainable, and that’s what we focus on. That’s why I always start an anchor on technology, technology, technology, because without that, any win is short-lived.

Harlan Sur

Yes. You did a great job of giving us last week at the Analyst Day a deep dive into your automotive clearly, your industrial efforts, but often overlooked, you guys didn’t overlook it, but I don’t think focused a whole lot on it. But as you’re focused on 5G and cloud power, right? Because it’s a great way to leverage your entire power portfolio, high-margin, fast-growing market, right? And last week, you articulated a 20% growth outlook for your 5G and cloud power business. That’s 2x faster growth than you had anticipated the last time you guys updated us two years ago, right? So what’s driving the better growth outlook? Is it higher dollar content? Is it the data center move from 12-volt to 48-volt infrastructure power? Is it higher computing performance? What’s driving that?

Hassane El-Khoury

So it’s actually all of the above, which is a great market. So like you said, two years ago, when we talked about the cloud, we talked about 11% growth rate, now it’s 22%. So Sudhir in Analyst Day talked about the power tree that also applies to the cloud, the same as it applies in automotive and industrial. That is where our technology competitive advantage comes in. You mentioned 48 volts. We’re already in production with 48 volts. So we’re at the cusp of this 48-volt conversion, and we’re there to play. More content in per, call it, per server, therefore, per cloud infrastructure. That content has gone up, which is also driving our growth with it.

And really, more important – and the compute power is getting more and more. And that’s very important because it’s not just adding more content because it requires more power, but it requires more efficient power, which means when the power requirements increase, they can be proportional an increase of consumption to increase of power, therefore, efficiency starts to matter because that’s all CapEx. That’s all expenses that our customers are going to have to absorb.

So by us making the power conversion more efficient, they will monetize it on the back end in consumption reduction on electricity and cooling and so on. That’s why we’re winning. And we’re – but again, it goes back to the technology to anchor on technology. And when you have the right technology at the right time in a growth market, that’s how we end up outgrowing the market.

Harlan Sur

I think a metric that reflects all of the things that you’ve talked about, right, technology leadership, share gains, increasing complexity, portfolio breadth is cross-selling, right? And I think it’s the dynamics that have made the team so successful is the breadth of the portfolio and the ability to cross-sell. And I think last week, you guys mentioned that your top 20 largest customers purchase on average per customer 800 products, 800 ON Semi products. How does that compare to two to three years ago? And do you guys have a particular marketing and sales programs in place that incentivizes the team to as you’re going after this opportunity, let’s make sure that we maximize ON Semi content per board, per car, per whatever the case maybe.

Hassane El-Khoury

Yes. So it grew from the last two years. And a lot of it is we’ve gone through a very constrained market dynamic. And we have made a very strategic approach to prioritize some of our strategic customers in the automotive and industrial at the expense of the broader consumer compute market that is not strategic for us. And what that allowed us to do is be able to service a lot of our auto and industrial customers when some of our peers could not. And that created a much longer-term share gain that we’re benefiting from today.

So that’s kind of the catalyst that started this whole thing. Do we focus on cross-selling as an active sales and marketing or a go-to-market? Absolutely. So when – in Analyst Day, I talked about how the structural change, the go-to-market change that we do, that is definitely a pillar in it of sure, well, it’s always easier to sell to an existing customer a new product than to go and capture a new customer. And we have to be able to do both in order to have the best-in-class cost of sales. You do it by getting big wins, strategic wins, cross-selling, so lower customer capture and adopting new customers. That’s our go-broad strategy with our tools and the software.

All of those are part of that efficiency that Thad talked about in the new model of getting to that 13% OpEx. We’re going to keep investing in R&D, but SG&A is going to get, call it, subsidized by the growth on top and the efficiencies we do in the go-to-market.

Thad Trent

And Harlan, I would also add that the – our strategy with LTSA’s have elevated the engagement with our customers. And now we’re selling much more products to that same customer base because they have assurance of supply, right? So they’re co-investing with us. So the relationships are much deeper, and that’s allowing us to get more of their wallet at the same time.

Harlan Sur

I’d like to – on the financial targets that you put out last week, 10% to 12% revenue CAGR, 53% gross margins, 40% operating margins and 25% to 30% free cash flow margins. The team has been defocusing away from low gross margin businesses, right, over the past number of years.

You’re clearly richening the mix of your portfolio with new products. And so looking at that 53% gross margin target and looking at your current business today, what percentage of your current shipment mix is driving gross margins higher than that 53% range? And more importantly, of the design win funnel, what percentage of the design win funnel that you’re securing for the next few years carries gross margins that are higher than the midpoint of the target?

Thad Trent

Yes. So let me take that. So if you look at our design win funnel and you look at anything coming out of R&D, it’s at or accretive margins, right? So everything is accretive. So as we think about new investments, it’s at the target or above. So anything that we’re working on currently should drive incremental gross margin improvement. If you think about the improvement steps of where we are to get to that 53%, a big component of that is mix.

And it’s two components of mix. One is auto and industrial, as we flex more there, which we’ve been doing. Last year, we were roughly 73% auto and industrial. In Q1, we’re 79%. If you fast forward, we’re going to be 85% auto and industrial. But the other component is the mix to this higher-value product, proprietary products that drive higher gross margin. And that’s these products and these markets that we’ve talked about. We’re also exiting the low-margin business, kind of historically low margin, competitive. We’ll exit that. We’d get another $400 million that we’re going to exit this year. That helps with the gross margin over time as well.

Today, that’s good gross margin. But as supply comes online, we expect our competitors to actually take some of that product in that business. And that’s fine. We’re planning for that. So we’ll allocate that capacity into these high-margin products.

Hassane El-Khoury

Now to give you – we talked about a digital-first strategy as part of the Analyst Day. That, of course, is a big portion is the go-to-market with the tools and the efficiencies and so on. But internally, you mentioned on the funnel and the visibility we have over a longer term.

Both Thad and I review the funnel – before opportunities go into the funnels, they’re [indiscernible], and nothing goes into the funnel if it’s dilutive. We’re not into the fab filler. We don’t care about that. We’re not going to be going after that. We’re going to walk away from all that business and that culture in the company, now it’s less and less. So we’re done. That’s kind of Phase I of our transformation. Phase II now is ramping and growing those new products that are all accretive to margin.

Harlan Sur

You guys highlighted some interesting differentiators that – last week that we certainly don’t hear very often from power and mixed signal companies, right, and that is software analytics and simulation platforms. In the case of your power business, right, your software development kit for your image sensor customers and the move to digital control architecture for your power customers to optimize their – the power flow and their systems, right? Sounds like the playbook for a leading-edge semiconductor – leading-edge digital semiconductor company, right? So is the role of software, digital-based techniques, a strong differentiator for the team? And is the team spending higher proportions of its R&D investments in this area?

Hassane El-Khoury

Yes. At a high level, I agree with you. We are the, call it, the benchmark for what power should be. So I don’t aspire to be like other power companies. We aspire to be like the best companies out there in the world, which is not typically thought of for power, but our financial target is the best-in-class if you look at it, hands down and not just in the power domain, but in semiconductors.

Having said that, that requires a very different go-to-market and a different mindset of what you invest in. But we’ve always said the combination and the competitive advantage is not on a piece part. It is how can you make all pieces work together to solve the customer problem. One of the customer problem is it is expensive, and it takes time to iterate on power semiconductor because you have to build the unit and run it in order to get – you get the efficiency. So that was an anchor point on, okay, if that’s the biggest problem, how can we solve it?

We have the domain knowledge. We have all of the stuff because we’re vertically integrated. So we’re able to allow the customer with our tool sets to iterate in a few hours what they otherwise would have done in a year. And it doesn’t cost them anything because there’s no capital or they don’t have to build the samples or any of that or wait for equipment to get delivered.

And that started off as a few customers, lead customers. And it turn into a very broad approach that we have, and that have allowed us to get a very big competitive advantage because what the customer is able to do is simulate a lot of these architectures. Do I go with quad SiC? So I go with 2 SiC? Do I go with IGBT and SiC? Imagine those architectural decisions at an OEM level, how valuable they are with our tool set, number one.

Number two is when they actually get to the silicon and get the package and the performance is exactly the same as what they modeled, they now can proliferate it within the account. That is, again, a competitive advantage. The same thing applies with image sensing. How can we get the image sensor with software to be tailor-made for an application? That is a competitive advantage, not just from a go-to-market, but from differentiation of the customer. If they’re able to make things that are their own versus an off-the-shelf, they have a competitive edge against their peers. And we enable that, and that has value.

Harlan Sur

Let me shift to some of the near to midterm trends in the business. So demand trends remain strong in auto and industrial. As you mentioned, it’s 79% of your revenue mix. While it seems like your non-strategic end markets, right, which are primarily consumer-focused, are stabilizing. Some of your peers have been cautiously optimistic on growth for the second half of the year. What’s the team’s view on growth for the second half of the year, let’s say, versus the June quarter levels?

Thad Trent

Yes. I think look, a couple of things are happening here, right? When you think about consumer and compute that got soft mid last year, I think that’s remained soft, and it’s continued that way. Industrial got soft and then stabilized for us last quarter. And auto, obviously, has been robust for us and continues to be robust.

I think when we look into the second half of the year, we’re very optimistic, but we’re cautiously optimistic just given the uncertainty in the market. We have great visibility in what our customers’ demand is because of the LTSA’s. We’re building to the LTSA’s.

But when we look at where The Street is for 2023, it feels good. I think we’re in a good spot there. If you exclude the growth from silicon carbide and you exclude the exits, the $400 million of exit year-on-year, the second half should outgrow the first half.

And if you take that base business, excluding silicon carbide and the exits, it’s growth of like low single digit. I think that feels good right now kind of in this environment. We’ve been very proactive in managing wafer starts, managing inventory in the distribution channel, just being cautious in terms of the outlook here and supporting our customers. And I think we feel good about where consensus is and kind of the outlook for the rest of the year.

Harlan Sur

Does some of that confidence come from – I mean, I know it is the case during periods of macro uncertainty and end-market weakness, right? You go through these periods where customers are wanting to reschedule, move backlogs, very high levels of activity on that front. Then you go through a period of that activity sort of wanes and then things start to sort of stabilize. And then obviously, the next move would hopefully be the upward inflection.

The team has accommodated customers on shifting timing, helping customers move shipments around. But has that activity level in terms of push outs started to stabilize? And more importantly, is the team starting to see some improvements in like level of your global POS or sell-through?

Thad Trent

Yes. So let’s back up and talk about our business. Our LTSA’s or what we’re managing, right? And when customers are coming in, they need help with LTSA’s. We’re getting the call quarters in advance of something is going to get solved.

If we can create a win-win with that customer, we’ll try and help that customer. And there’s got to be a win for both companies. We saw a lot of that happening late last year. We’ve actually seen in the first quarter and even so far in the second quarter is that’s actually stabilized and actually coming down a little bit, which gives you some confidence in the [indiscernible] well.

Again, think about the visibility we have with the LTSA’s and the fact that we’re getting less of those requests. There’s pockets of them. But late last year, we saw a lot more uncertainty, and I think people remain cautious. So that allows us to really have a dialogue with our customers versus historically, they place a PO, and that PO would disappear 30 days before it shipped. Now we’re getting that call in advance, and we’re able to help those customers. But it is kind of slowing in terms of the rescheduled request.

Harlan Sur

Yes. Touch upon the LTSA’s. You’ve done a really good job on these long-term supply agreements. It gives you visibility, right? It helps your customers – well, helps you guys plan your production requirements, right? It gives your customers peace of mind and assurance of future supply. You guys have increased your LTSA’s by $1 billion, right, last quarter to $17.6 billion with $5.8 billion committed revenue from those LTSA’s being recognized over the next 12 months, right? So that’s approximately 70% coverage on consensus next four quarter revenue outlook.

Obviously, that’s great visibility. Some of the LTSA’s obviously are running their course as well. But given how beneficial it is for these customers, I would assume that the renewal rate is quite high and maybe encompasses more products versus the last LTA agreement. I think we talked about that. But does the team have any metrics to share with us, renewal rates and increasing part numbers?

Thad Trent

Yes. I mean, your key metric right there, you said it is $1 billion in Q1, right? Our LTSA value went up $1 billion in one quarter in a market that’s uncertain.

Harlan Sur

A lot of that was renewal? A lot of that $1 billion was renewal?

Thad Trent

It’s a couple of things. It’s customers extending their LTSA’s. So maybe they’re tacking on additional years. So on average, an LTSA is four to five years. So we’re a couple of years into this and maybe tacking on to the end. The other is they may be expanding it. So we’ve got hundreds of part numbers on these LTSA’s. As they [indiscernible], customers are wanting to put additional part numbers on LTSA’s.

And then the third element is customers that didn’t have an LTSA that have now come in and saying, that’s the new mode of operation. It’s working. We want to get on LTSA. But I would say that, that is the leading indicator of $1 billion in Q1 is a very favorable sign in a soft market.

Harlan Sur

I want to step back for a second on the image sensor business, strong market position, 68% market share in auto ADAS. Overall, strong number one position in auto and industrial markets. This business has been constrained over the past three years. I think it’s still somewhat constrained even now, I believe.

And so can you just give us an update, Hassane, on the efforts to bring in some of that image sensor mix in-house to your 300-millimeter fab. I mean, I know – I assume that in addition to better supply management, some in-sourcing will help drive an even better gross margin profile, right, due to the lower cost of your 300-millimeter facility. Is there – also, is there any way to kind of quantify that benefit as you bring some of that in-house?

Hassane El-Khoury

Yes. So just at a high level, that business just delivered over 50% gross margin from historically where it’s been.

Harlan Sur

The majority is outsourced, right?

Hassane El-Khoury

Majority is outsourced. So you can think about gross margin trajectory that is favorable. When you go even to 12-inch because some of it was still on 8, going to 12. Some of it is 12 to 12, but outside versus inside, which gives you a cost benefit. So where we are, we’ve already done a tape-out for that business. That tape-out is basically the first proof that we’re able to do it in East Fishkill, which is historically not an imaging fab. So from a technology perspective, we have the technology readiness, product sample and then the proliferation. Obviously, these are – go into the automotive market. So you have time for design in before you start seeing the revenue and therefore, mix. But what you said is absolutely – the vector is more supply assurance but also a margin expansion.

Harlan Sur

And as you think about your prior fab-lite strategy and now fab right strategy, right, what is the optimal mix of image sensors, in-sourced versus outsourced, you think?

Hassane El-Khoury

So we’re more focusing not on the optimal mix. We’re more focusing on – so fab right is, more importantly, it’s getting the right product in the right spot whether it’s inside or outside because there are products that would be more suited depending on the area that are outside versus inside. That’s fab right, not just on image sensing but across our whole chain.

So we have fabs that potentially are running six variants. They will end up running four variants and moving two out, so we can get more efficiency within the fab and therefore, more outs, which drop the cost. So there’s a lot of that benefit that’s going to get us to that 53% margin, I would say, not a destination but a milestone. But that’s all of the manufacturing efficiencies that we still have ahead of us. So there’s a lot of margin expansion opportunities that are baked in that we need to execute to.

Harlan Sur

Absolutely. On the – maybe again on some of the more near term. On the supply side, lead times remain stable, 41 to 43 weeks. I think though, traditionally, your historical average lead times were more in that sort of eight to 12-week range, right? And this does obviously reflect. The current 41 to 43 reflects continued supply tightness but strong demand profile, right? The team has mentioned that there’s still supply constrain. Can you just articulate some of the product categories where lead times are stretched beyond 41 to 43 weeks? And do you anticipate lead times coming back down to more normalized levels over the next few quarters?

Hassane El-Khoury

Yes. So some of the technologies, obviously, I think we’ve been consistent with that. Obviously, silicon carbide is fully constrained when we sold out. IGBT or other silicon power technologies are still constrained, mixed signal analog and image sensors. So a lot of our strategic is still constrained, and that’s where we’re adding capacity in order to support LTSA’s.

But we are adding capacity for LTSA’s, which makes really the lead time not really a relevant metric anymore for the bulk of our business. What I mean is I don’t think lead time are going to go back to where they used to be because you have fab cycle time, our new technology is longer cycle time than that crank commodity, and we’re not in a fab filler.

Therefore, we’re not going to keep building just to put inventory and reduce lead because there’s a cost associated with short lead time, which I don’t think is necessary anymore given the LTSA’s. So they may come down for some technologies, but we don’t see it come down to where it used to be because, again, it doesn’t need to. And there’s a better cost structure associated with a tight balance based on the LTSA versus just driving lead time to drive lead times down.

Harlan Sur

I mean, I guess that’s one of the benefits of the LTSA’s to give you exact timing on delivery, right? So in that – from that perspective, lead times doesn’t really sort of come into play.

Hassane El-Khoury

That’s right. Because, look, lead time drop if you don’t have an LTSA, so does cancellation. So it doesn’t really matter. LTSA is what gives the visibility. Everything else we do based on the LTSA is operational excellence.

Harlan Sur

On the distribution channel business, that remains lean at seven weeks and below the historical 10 to 12-week range because you guys continue to proactively manage your channel inventories. When the supply and demand environment does normalize at some point, does the team expect to remain – to maintain channel inventories above current levels, but maybe slightly below historical levels? I mean, I would think a linear profile is quite optimal for you guys, right, because I think it drives better responsiveness from the channel. I just wanted to get your views. Do you ever go back to those – that 10 to 12-week range?

Thad Trent

Yes. I don’t think so. I mean, historically, we’ve been 11 to 13 weeks. We’ve been running at seven weeks for several quarters now. That’s been proactive management by us. Our distributors would take much more inventory if we would ship it to them. We are on a FIFO basis, and it’s exactly what you said. It allows that channel to be more efficient for us to have better visibility in what’s selling through and where there’s inventory pockets as well. So I don’t know that seven is the end goal, but it’s probably somewhere in between.

But I don’t think we go back to 11 to 13 because I really don’t think we need that much inventory in there especially as we ship more of proprietary products, you just don’t need it sitting on the shelf, right? And with the LTSA visibility, we don’t need it. The distributors will support a long tail of customers. So we do have to have inventory there, but you just don’t need that 11 to 13. It’s just not efficient. And it doesn’t give us the visibility we need.

Harlan Sur

Great. Well, we are just about out of time. Hassane, Thad, great discussion. Appreciate you guys participating.

Hassane El-Khoury

Thank you.

Thad Trent

Thank you, Harlan.

Advanced Micro Devices, Inc. (NASDAQ:AMD) 51st Annual J.P. Morgan Global Technology, Media, and Communications Conference May 23, 2023 3:15 PM ET

Company Participants

Jean Hu – EVP, CFO & Treasurer

Ruth Cotter – SVP, Marketing, HR & IR

Conference Call Participants

Harlan Sur – JPMorgan Chase & Co.

Harlan Sur

Okay. Let’s go ahead and get started. Good afternoon. Welcome to JPMorgan’s 31st Annual Technology Media and Communications Conference. My name is Harlan Sur, semiconductor and semiconductor Capital Equipment analyst for the firm.

I’m very pleased to have Jean Hu, Executive Vice President and Chief Financial Officer. And Ruth Cotter, Senior VP of Marketing, HR, and Investor Relations at Advanced Micro Devices here with us today. Jean and Ruth, thank you very much for joining us this afternoon.

Jean Hu

Thank you, Harlan.

Question-and-Answer Session

Q – Harlan Sur

Let me start it off with you, Jean. You’ve been with the AMD team now for four months. Came to AMD with a great track record of execution. Just wanted to get your thoughts on what you’ve observed so far, the AMD team, the execution, and more importantly, the growth opportunities.

Jean Hu

First of all, thank you, Harlan, for inviting us, and good afternoon, everyone. Thanks for the question. I’ve been really fortunate to work at some of the best semiconductor companies. And I’m super thrilled to be part of the AMD team at this inflection point for high-performance computing. The last four months has been very exciting as part of the team. I continue to be very impressed by the whole team’s strong focus in developing innovative products and also execution. That’s just super impressive.

I would say one of the most exciting aspects during the last four months, actually is to see incredible market opportunities, especially the opportunities related to generative AI, a large language model. Literally, it’s just unfolding in front of us. That’s very exciting. I think AMD has a broad portfolio. The company has been investing in both the CPU, GPU for the last decade. And the last year, with the acquisition of Xilinx and Pensando, the business added not only CPU, GPU but DPU adaptive compute and adaptive SoC.

So, when you look at the portfolio, probably it’s one of the best positions of the company to address the future opportunities ahead of us. Financially, the company has built a strong business model with strong financial flexibility, so we can continue to invest to really aggressively double down on the AI front and address the opportunity ahead of us. So overall, really, really exciting, a lot of work to do.

Harlan Sur

Perfect. Well, I appreciate that, and very insightful. Let me — I’m going to start off with the first few questions, sort of near to midterm, get that out of the way, and then let’s focus — I really do want to focus on kind of the mid-to longer-term strategy and traction of the team. So, server shipment TAM forecasts for this year have continued to come down, right? The latest view is that server shipments probably down about mid-single digits this year.

The AMD team has clearly been under shipping this dynamic in the first half of the year. You’ve talked about weak enterprise, weak China, mixed trends in cloud, but you anticipate a better second half of the year.

In fact, you expect to grow 40%, 50%-plus second half versus first half implied within your full-year guidance. What dynamics are you tracking customer programs, ramp of your next-generation Genoa, Bergamo platforms? All of that, that gives you sort of confidence on a significantly better second half of the year?

Jean Hu

Yes. I think in the first half of the year, we do see a mixed-demand environment. Some of our cloud customers, they are going through inventory correction and optimization. And also, enterprise is seeing weakness just because of macro uncertainties. But if you look at our Q1, because of those factors, it does impact our Q1 revenue. We guided Q2 just up modestly quarter-over-quarter. Overall, the first half our revenue run rate is quite low.

We do think from that much lower run rate, the second half, we’ll see revenue growth and a step-up on the revenue side. There are a couple of drivers, and Ruth, you can add this. First, I think, is from Genoa, right? It was introduced last November. We have been working with not only cloud customers and enterprise customers to qualify a much broad set of workloads.

So, when you think about, Genoa has been ramping, but the second half, we do see broader workload adoption, which will help us. And also, we do add much more value with this generation for the product versus supply generation.

Secondly, Bergamo, you mentioned, we’re going to see the initial ramp of Bergamo because it’s actually tailored for cloud-native applications. We do think there’s a demand for that kind of workload and applications. And then Milan continued to see strong demand actually because we continue to have cost efficiency, total TCO. We do think Milan continue to be really a good product for us. And last, I guess, is MI300. We did say in Q4, we’re going to see the initial revenue ramp from a supercomputer side and some of the initial AI workload, too.

So, when you look at it all together, we think we have a very strong product portfolio in server market. And we have been gaining market this year for the last four years, so we do think it will continue to drive the leadership and continue to gain share.

Harlan Sur

Does the transition — Genoa, Bergamo, they’re pretty big inflection points for the team. During these periods of inflection, do you get better — is that partly what drives the confidence in the second half is because customers have been qualifying it, developing software, they really want to exploit the TCO benefits? They want these servers in their data centers. Is that partly — and so they’re giving you better, more clear visibility in terms of deployments? Is that also kind of what drives the confidence?

Jean Hu

I think in general, when you look at our EPYC server platform, we do work with our customers closely, especially cloud customers. You literally have to go through the qualification process. You will have a lot of discussion on which workload they use and their ramp plan. Of course, the macroeconomic condition always can change. But overall, we do have a lot of visibilities how customers think about the ramping. So, from that angle, the engagement of our team with customers are very deep.

Ruth Cotter

I think in addition, as we look at approaching 30% market share in server market, we have gained critical momentum, to your point, with customers. And because of that, we get deeper and more longevity into their road maps, which allows us to make sure that we approach our data center efforts in a very customer-centric way as we look to sort of solve their problems. And on the CPU side, that strategy has played off very well. And to Jean’s point, we look to replicate that now beginning with MI250, which is on the CPU side and market today, and MI300, which will be launched before the end of the year.

Harlan Sur

Perfect. And then on the client side, similar question that I just asked you but now more focused on the PC business. What metrics are you monitoring, tracking that gives the team confidence that PC client business bottomed in the March quarter and is set for growth through the remainder of this year?

Jean Hu

Yes. PC market, as many of you know, has been going through one of the worst down cycles since probably 1995. AMD, we have been undershipping the consumption for the last three quarters, actually very significantly. So, we do monitor the sell-through data carefully, and we do think there’s an inventory digestion continuously, but the stability of the sell-through definitely is there.

If you look at our own business, we continue to believe, for Q1, it will be the bottom of the business because of the inventory digestion because the second half, you do see some seasonality pickup. Given what I said, I do think right now, our planning scenario is a steady improvement, right, and the second half will get help from seasonality.

Harlan Sur

Lisa talked about seeing some positive signs out of the China. I believe it was enterprise markets, right? It’s been a slow demand recovery, right? China has emerged from the COVID lockdown. Is the team also seeing signs out of China, positive signs out of China in your PC client, and embedded businesses as well? And is any of your second-half growth assumptions dependent upon a meaningful recovery in China?

Jean Hu

We do see some stabilization. I would not say pickup, I would say, stabilization in the PC market and the server market. We probably have more engagement and discussion but not pick up yet. And our assumption for the second half really did not incorporate whether China is going to go through recovery.

Harlan Sur

Perfect. So, let’s talk a little bit more about sort of the medium to longer-term trends. I do want to start off with AI. Obviously, the big focus by the market has been on this AI arms race amongst the cloud and hyperscale titans. And what we do know is that all of them are spending on compute, networking, storage, infrastructure silicon, right? You have your data center and AI tech event, right, on June 13. So, I’m hoping that we’ll get more insights then.

But the team has a strong portfolio, as you mentioned, to take advantage of these opportunities, CPU, GPU, FPGA, ASIC capabilities, right? And as it relates to these new transformer base, large language models, right, that are driving things like OpenAI’s ChatGPT platform, you guys are focused on this opportunity with your instinct-based GPUs, right? Your MI300, very innovative, integrated CPU, GPU platform. What does the engagement and revenue opportunity with your cloud and hyperscalers look like for the MI300 or the instinct-based GPU platforms over the next, call it, 12 to 24 months?

Jean Hu

Yes. Ruth, maybe you want to kick off to talk about the June 13 events and the whole thing. I can definitely add.

Ruth Cotter

Sure. Thanks, Jean. So, to your point, Harlan, on the 13th of June, we’re hosting a data center and AI event. We’ll focus on our CPU product momentum with the next product in the family to come as Bergamo, as Jean talked about, which is sort of cloud-optimized high-performance, low power. So, we’ll give more details on that. And we’ll also frame our AI strategy and vision to make sure that expectations are clear.

And then all of that will be leading up to the MI300 product launch, which will be later in the year. We said that will be in the second half of the year. So, we just want to make sure the strategy and vision is appropriately set. And then we’ll also give some details on software side, software engagement. That’s obviously a topic of interest to complement the hardware work that we have been doing.

And then on the MI300 front, we’re very pleased with the customer engagement and momentum. And we had said that engagements are at 3x today, what they might have been even at the beginning of the year as you think about this AI inflection point in the market. And we’re also happy with how MI250 has been progressing with Microsoft, in particular, as the sort of publicly announced customer for that product. And that’s sort of setting things up very nicely for MI300.

Harlan Sur

Perfect. And then I had asked this question on the conference call because there is another segment of the market going after these AI processors and accelerators. And that’s the cloud and hyperscaler, your customers opting to, at some point in their portfolio, add some custom ASIC capabilities, right? And if you look at what it takes to be successful in the custom ASIC market, right, expertise in designing this huge system-on-a-chip, billions of transistor chips, strong compute, networking, IP, right, and a track record of execution, right?

And the AMD team has that with your semi-custom business. You’ve been a big player in the gaming market with your semi-custom solutions. You have all of the right building blocks. And so, has the team — does the team think about potentially entering the ASIC market and servicing your cloud customers?

Jean Hu

Yes. Harlan, thanks for the question. I think from an AMD perspective, the way we think about is we address high-performance compute across all different — either it’s x86 or ARM or customer silicon or potentially ASIC. I think the key thing for us is to think about what we can provide to customers with the best TCO. And if you look at the approach and the strategy we have been going after is on the x86 side. With the Genoa family, we actually broadened our offering from not just Genoa. We have Genoa-X focused on the technical workload.

We have Genoa focused on the low-cost telco market, and we have a Bergamo, we talked about which literally is tailored for native cloud applications. That actually offers better efficiency and performance than some of the ARM merchant product supposed to come to the market. But overall, we are very open. We have a deep engagement with the customers. If customers want to do customer silicon or wants to do ASIC, we actually have all the capability and IP. As you said, the team also has a strong track record to execute on customer programs. So, we are quite open for all the solutions and definitely just want to provide the customer best TCO.

Ruth Cotter

And the track record that we’ve built through our semi-custom business with game consoles to date and the complexity and precious IP that’s been involved in that has stood well to sort of continuing to engage with customers. But whether they decide to go with a custom offering or not, the building blocks of IP that we have amassed in the company and how we’ve put those to work is very attractive to our customer base, and it allows them a lot of flexibility. And as the company has scaled more recently over the last several years, it’s also proving to be a win in terms of our strategy as we look to continue to gain share pervasively.

Harlan Sur

Yes. Now you can add adaptive compute to the ASIC IP portfolio as well, right, add some programmable capabilities to any custom solutions that you do. On the data center and server markets, you guys continue to gain server CPU share from your competitor. I think by our estimates, you gained about 10 percentage points of share in 2022 to about 22%, 23%. You drove 25%, 27% share in Q1. And we think you’re on track to capture 5 percentage point to 7 percentage points of share, somewhere around 28% to 30% share for this year.

Obviously, technology performance lead over your competitor with your EPYC family has driven this strong share momentum. Clearly going to sustain that momentum this year. You’ve got 5th Gen EPYC CPUs slated for next year, which would ramp around the same time as your competitor’s next-gen CPUs, and they hope to reach competitive parity with the AMD team by 2025. So first, are you still on track with your Turin in architecture in 2024? And then how do you see the competitive dynamics potentially changing if your competitor is successful at executing to their 2024, 2025 road maps?

Jean Hu

Yes. First, Turin is absolutely on track, and we are actually very pleased with the initial results. I think maybe what we need to do is take a step back to look at AMD’s journey over the last six years to really build the leadership position in server market. If you look at the last six years, the company has consistently executed from Gen 1 to Gen 4. Each generation, literally, we delivered, as we said, with the regular cadence, right? And each generation, we increased the differentiation, increased the performance.

If you look at Milan, which we introduced more than two years ago, that actually helped us to gain tremendous market this year. And even today, Milan continue to perform extremely well against competitor’s newly introduced product. And then last November, we introduced the Genoa generation. Not only we learned from the prior three generation continue to improve the differentiation and performance. Frankly, it’s matched from the performance perspective, efficiency, security, every aspect of the Genoa product. And also, we expanded into the family, right, with the four different flavors of Genoa. So overall, we continue to drive the leadership.

I think to your question, when you think about the history over the last six years of our journey of technology leadership and the share gain, it’s not one thing or two things. It’s about architecture, design, IP, packaging technology. And working with a foundry partner, TSMC, closely not only to just use their foundry but optimize the process technology, optimize the packaging technology, co-design, co-optimization, and above all, it’s consistent execution. Of course, I was not here, but the team has executed, did exactly what they said six years ago with a regular cadence. So that combination of success formula, I think we’re going to continue, and that’s how we can continue to drive leadership. We always assume it’s a very competitive market.

Harlan Sur

Perfect. And then my next question, and Ruth, you touched upon this a little bit is as we move into this period of accelerated compute, we continue to hear that software, software framework is becoming a huge differentiator, right? And your competitors that compete with you in the more accelerated compute AI-focused markets tend to lead with their software frameworks. And so, I’m wondering, what is the AMD team doing here to close the gap on software, AI frameworks, and just overall accelerated compute ecosystem development?

Ruth Cotter

So, I think our history and history of innovation has been grounded in hardware traditionally. And we’ve also obviously done a lot on the GPU side as it relates to software. Now moving into the data center with GPUs, there’s been a lot of focus on software, to your question. We’ve done a nice job addressing the external workloads and frameworks that are required to be supported all the large ones such as TensorFlow, PyTorch, et cetera, and staying abreast of what may be next to come as part of that effort and focus.

We’ve been deploying incremental resources in that area consistently for the last several years to ensure that we can keep a pace with that development. And now the focus is, as it relates to internal workload, several of the hyperscalers’ own software capability, making sure that, that is running well on our hardware. MI250 has been very helpful there with several providers as we’ve looked to porting their in-house software onto our hardware in preparation then for MI300.

So, we feel well positioned. And there is some more work to do in the internal workload space. As we continue to add more customers to our portfolio, that work will continue. But we’ve had some good momentum. So, we feel well positioned now when we’re showing up in front of customers today as compared to how it might have been 18 months ago.

Harlan Sur

Let’s switch to talk about one of my favorite market segments for the AMD team, and that’s the embedded markets, right? And good to see the sort of strong near-term growth dynamics in the team’s embedded business. Very diverse end markets, industrial, auto, comms infrastructure, test, and measurement. And given their strong market position here, the Xilinx team is in a good position to catalyze EPYC, rising CPU attach rates to their FPGA, and adaptive solutions, right?

I think that embedded x86 CPU is about a $6 billion to $8 billion per year market opportunity. And the AMD team has fairly small CPU share here. So, given your year with Xilinx in the portfolio, can you just give us an update on the synergy unlock? And what is the AMD team doing to aggressively drive higher compute attached to Xilinx’s products?

Jean Hu

I’ll start, and Ruth can add since she actually led the integration of Xilinx and AMD. I think, first, Xilinx business has been performing extremely well. As you said, it’s industrial, it’s aerospace, defense and a lot of the drive come from the digitization and automation, especially in the industrial or aerospace vision. Those kinds of applications, we do see not only Xilinx FPGA gaining share, but they also incorporated the SoC, which have content gain. So, it’s a tremendous business right now.

And what we are seeing is when we combine with AMD, the embedded processing market is opening up to the whole company. And we never paid much attention in the embedded market, but you are absolutely right. It’s a large opportunity with more than 60,000 customers from Xilinx side. We actually see tremendous leverage.

We are getting design wins, some of them we announced. For instance, in security firewall, in networking side, we continue to really getting more and more market this year. It’s actually a very large opportunity for long term because the product life cycle in those markets tend to be very long. But we are really pleased with the initial design win opportunities. There are more, right?

Ruth Cotter

Yes. And I think we’re both engineering-led first companies, which meant that the teams came together very quickly and identified very commonality as it relates to how can we bring the IP of both companies together as we look to advance the long-term road map. More to come as we continue to work through that. And then I think rolling AI and all the cross-company AI efforts under Victor, Victor Peng, and making sure that he has oversights not only across all the different pieces of IP but also the 6,500 customers that Xilinx brought into our company as we look to fan that AI strategy from supercomputers to cloud to endpoints to PCs as we think about those multiple opportunities, it’s also quite exciting.

But the teams have come together well. The cross-sell opportunities are compelling, to Jean’s point, as we think about us offering what was Xilinx’s greater scale, the ability to bid for larger bids and opportunities. And likewise, the opportunity to sell AMD products into their — what was their former customer base is very attractive to us as we look to grow that CPU share, to your question.

Harlan Sur

Yes, absolutely. On the competitive front, we continue to see ARM-based servers continuing to take share from x86 at a very gradual pace, right? And most recent estimates, I think, show that ARM-based server CPUs make up about 4%, 5% of the total server CPU market. You have one start-up out there. Obviously, Amazon has been deploying ARM-based servers for several years now. We hear about some of the other cloud titans having some programs there.

Are these ARM programs mostly internal specialized programs or are they being targeted for broader data center footprint compute workloads? And how do you see the broader potential proliferation of ARM-based servers in the data center?

Jean Hu

I think in data center, the demand for compute overall just increasing significantly every year. From the angle we see, ARM largely is being deployed either in customer ASIC or semi-custom programs because they have a specific workload they really want to optimize. It’s all about the TCO in the end. So, from our side, we definitely — Bergamo was one for the programs. We really try to address the same TCO concern in cloud-native applications to really offer customers the best TCO so they don’t need to do their own customer programs.

At the same time, we have the ARM capability, both from Xilinx and from Pensando acquisition, and we have a really great semi-custom team. So, if really there’s true economics of doing some kind of customer chip or even ASIC for a particular workload, if it makes sense for us, definitely, we are open for that.

Harlan Sur

On the financial side, it looks like gross margin is bottoming here in the first half of the year at 50%. If the full-year growth profile plays out, you’ll see revenues growing in the second half quite strongly. You’ll be seeing your gross margins expanding as well. Understand the better mix dynamics, right, i.e., like stronger data center revenues in the second half. But Jean, you particularly mentioned PC improvements in the second half as a significant contributor to the gross margin expansion.

And that’s created, I think, a little bit of confusion amongst out there. So maybe — I think part of it was because knowing that your competitor may continue to be aggressive on PC client pricing. So maybe just walk us through the puts and takes on how do we think about the second half potential gross margin step-up.

Jean Hu

Yes. So, if you look at the first half of our business and the gross margin around 50%, as we mentioned, we are actually very pleased with the strong gross margin performance in both the data center and the Embedded segment. Both segments together accounted for more than 50% of revenue. So once the headwind we see is actually on the client side because we are undershipping the consumption significantly and going through the inventory digestion in the downstream supply chain. That really impacted our segment gross margin significantly.

Second half, we do believe the inventory digestion in the downstream supply chain will largely done. And then the client’s gross margin actually going to improve second half. Of course, we’re not talking about going back to last year’s level but to improve from a very lower level to second half actually is the major driver of our second half gross margin improvement. There are other puts and takes, but overall, this one is quite significant because of how low our gross margin currently is.

Harlan Sur

And there have been also some questions going back to sort of the Embedded business. But I think the team is anticipating maybe a slight step down in the Embedded business in the second half versus the first half. Auto, industrial, service provider trends are holding up still relatively well. So, what are the drivers of the slight deceleration in Embedded as we think about the second half revenue profile?

Jean Hu

Yes, you’re right. What we see is industrial, aerospace, and the defense as far as automotive have continued to be very strong and solid demand. Second half for communication, definitely, we see weakness. You do see the global CapEx in communications side is coming down and the 5G is — actually, deployment is slowing down globally. So those kind of things impacting our wireless business and the wireline communication business. So that’s one of the headwinds. And of course, consumer, we continue to expect headwinds on consumer side. But overall, I think if you look at the year-over-year, the Embedded business continue to perform extremely well.

Harlan Sur

You’ve had time to review the team’s product portfolio, right, competitive position, customer opportunities. What’s your view on the team’s longer-term financial targets that were laid out at last year’s Analyst Day, right? 20% revenue growth, gross margins, 57% or better, and mid-30s operating margins.

Jean Hu

Yes. I think if you look at our product portfolio and the strategic direction to focus on data center, CPU, GPU, adaptive compute, and also Embedded, a very diversified business. In the longer term, we do expect our gross margin continue to go up. The 57% target for Investor Day two years ago continue to be our target. We do feel pretty good about the trend going forward. And of course, with the gross margin going up and the top-line revenue growth, the operating margin, the cash flow generation of the company is tremendous.

Harlan Sur

As you, Jean, have looked at the technology, the IP portfolio, anything that you’re seeing that you feel like the AMD team needs to add a little bit more scale, a little bit more capability as you go after client and data center sort of compute trends?

Jean Hu

I do think we have a complete portfolio. Ruth, you can add your comment, is the company is very well positioned from IP portfolio technology perspective. We always look at the AI investment, software talent, those kind of small acquisitions. If they are a good fit, we definitely will invest to address the opportunities ahead of us. But overall, we feel pretty good about our portfolio.

Ruth Cotter

Yes.

Harlan Sur

With the last couple of minutes, Jean or Ruth, did you guys have anything — any closing comments that you want to add? Anything — your discussions with investors today with your meetings or over the past couple of weeks since earnings? Anything that you want to communicate to the market in terms of things that you feel are underappreciated or key focus areas for the team that we should be thinking about as moving forward here?

Ruth Cotter

I think we feel we’re very well positioned. Obviously, there’s this mixed demand environment everybody is working through, to Jean’s earlier point. But as we come out of that, we have an incredible product portfolio. We have really strong road maps that continue to advance in both hardware and software. And we continue to leverage the Xilinx IP portfolio as well as what we acquired with Pensando as we look to gain more share in a more diversified market opportunity, which is very exciting.

And then 2023 brought AI, which we’re very well positioned to capitalize on. The team is very focused on maintaining execution as we continue to scale and grow. And we’re delighted to have Jean on board with us for the next inflection point and leg of the journey.

Harlan Sur

Absolutely. Well, Jean and Ruth, thank you very much for your participation today. Looking forward to watching the great execution by the AMD team as we move through the second half of this year. Thank you.

Ruth Cotter

Thank you, Harlan.

Jean Hu

Yes, thank you.

ServiceNow, Inc. (NYSE:NOW) JPMorgan 51st Annual Global Technology, Media and Communications Conference May 23, 2023 3:55 PM ET

Company Participants

C.J. Desai – President & COO

Conference Call Participants

Mark Murphy – JPMorgan

Mark Murphy

Okay. Good afternoon, everyone. I am Mark Murphy, Software Analyst with JPMorgan. And it is a real pleasure to be here with C.J. Desai, who is President and COO of ServiceNow.

First of all, C.J., it was great seeing you on stage at your own conference.

C.J. Desai

Thank you.

Mark Murphy

Last week out of Las Vegas and, thank you, I know you’re a popular guy, there’s a lot of demand for you. So thank you for taking the time.

C.J. Desai

Of course, absolutely.

Mark Murphy

Maybe you can spend a moment just giving us a super brief introduction of yourself. And in case there’s anyone in the audience who is not aware of what ServiceNow does, just a super quick brief.

C.J. Desai

Of ServiceNow as well? Okay. I’ll start with ServiceNow. ServiceNow was created in 2004 in San Diego area by Fred Luddy, and he created this as a platform company for any type of workflow automation. So any task that can be automated digitally, he wanted to do that. ITSM, which is our largest product line, was actually the first demo that was created on top of ServiceNow, and became the first biggest use case to get to $1 billion in revenue. So that’s how Fred started the Company.

After that, Frank Slootman became the CEO. Frank hired me in 2016 and said, C.J., we need to hit $4 billion in revenue by 2020. That was Frank’s call with Mike Scarpelli, who is the CFO at the time. And then after Frank was John Donahoe. John stayed with us through 2019 October. And then Bill McDermott came from SAP to take ServiceNow to the next level, and Bill has been here now, 3.5 years. I’m C.J. Desai, and I’m responsible for products, engineering, our cloud, customer service, professional services and a few other things.

Question-and-Answer Session

Q – Mark Murphy

So thank you. That’s a wonderful overview. Thinking back again to last week on stage, Bill McDermott was there and he said, this is the quote, ServiceNow is the intelligent platform for digital transformation, but people still ask me what does ServiceNow do, and that a lot of people still don’t know.

So for this audience, we hear the term workflow often. We hear the term orchestration layer. Amazon and Microsoft would also say, right, that they can handle some workflows. They would also say that they’re a platform for digital transformation. So when you look out at this audience of non-IT professionals, how would you convey this differentiated role that ServiceNow has in the IT landscape?

C.J. Desai

Yes, absolutely. So many companies will claim that they are platform company, that’s okay. And they will say that we also do workflow. And then the term gets used fairly generically at times, Mark, like you said. Here is how I would describe it.

If we take just a simple example that an employee at your firm wants to move, we are in Boston, so let’s use Boston as an example, from Boston to San Francisco. If an employee moves at a bank from Boston to San Francisco, there are so many departments that get involved in making sure that transfer happens, the mobility team from relo, is the payroll going to be different from Boston to San Francisco, is the department changing, the cost center changing, is the employee’s role changing as she moves to, say, San Francisco.

When you think about all of that at a corporation, these are complex workflows that need to be executed digitally for that transfer to happen. And even once the employee is transferred, the first 30 days, 60 days, 90 days in the new role, what are the to-do list training that, that employee has to go through? These are very complex workflows that go across departments in an organization.

The employee doesn’t care. The employees sometimes don’t even know that that’s the name of the department that’s mobility, which will help the employee with the relocation. That’s just an example of an employee just moving from one city to the other. You can think now more complex scenarios in IT landscape that a payroll system is down.

Why did it go down? What was the root cause? How can we get it up and running? And all that storming and forming happens in ServiceNow from an incident management, major incident management perspective. These are extremely complex workflows, and workflow is nothing but a task orchestrated in a certain sequence across systems, across clouds, across people to get work there.

Mark Murphy

Okay. So you used this term storming and forming, and I like that one. ServiceNow has been storming its way into our CIO surveys now for really, if you look back since 2011, right, the Company was still private. ServiceNow would rank consistently near the top in our survey work on, we would look at the spending intentions, we would look at the linkage with digital transformation, we would look at who’s going to be used for cloud. How would you describe to this audience? What is it that has vaulted ServiceNow into that kind of a position? And then, how have you maintained that also for quite so long?

C.J. Desai

Yes. So one of the things is when the Company was created, and most people say but a very few do it, the focus on the end customer and end user for use cases was very special and continues to be special at ServiceNow. We do not sell to small enterprises as some of you, if not all of you know, we only sell to upper end of the mid-market to large to very large to governments. That’s our segment where we do business.

And we are very focused on making sure that our customers get value out of any use case, whether it’s ITSM or whether it’s HR service delivery or customer service management. And if you look at our renewal rates, which are best-in-class, the reason is we work very hard with our customers to make sure they get value out of the platform. And even if we decide to go after certain use cases, that use case is something that they can truly see that ServiceNow.

Like I want to, Mark, give an example, when we entered the HR space, they said the same thing, hey, you do IT, why HR? And we said, we are not system of record. We do not want to be a system of record that SAP, Oracle, Workday and others do, that’s great. We are the workflow or the system of action layer, so that when the actual work that needs to be get done for an employee that spans organizational boundary outside of HR, that’s what we do. And we proved that. And now it’s a decent-sized business with north of 1,000 customers for us.

Mark Murphy

Decent sized. So, we’re commonly hearing out there when we do our field work that once you win the hearts and the minds of central IT within these big organizations that you’re targeting, that then it becomes very easy to expand outward into the other business units. You just mentioned HR.

But people will mention legal, they mention customer support, finance and so on. Can you shed some light on the mechanics of that? In the trenches, how does that IT stamp of approval kind of help grease the skids for ServiceNow so you can spread out across the business units?

C.J. Desai

So a lot of you have been observing technology industry. Mark, I know you have done a lot of work, including the service you mentioned about intentional spend, security being one and a few others in the past on JP surveys.

But one thing I’ll tell you that over last 10-plus years, the number of times I have heard, which has not turned out to be true, that CIO is irrelevant. The — it is all about the developers. The spending is moving to developers. Yes, it is true that some technology spending does move to developers, developers need to be productive, I get it.

So to answer your question, CIO, where which was our first use case at scale, which is ITSM, beginning of the last decade and has continued to grow, that is our core buyer. We have won hearts and minds of CIO. And around 2016, 2017, CIO became aware that ServiceNow can be the ERP for IT.

And that’s not a small term, because a CIO’s job is pretty broad: keep systems up and running; create new digital services; serve lines of businesses, whether it’s HR or sales or whatever, or finance. And we very much focused on CIO being the core of the core, and we were selling to the CIO, versus somebody will sell to Chief Revenue Officer and the CIO has to run a CRM system.

Somebody will sell to the CFO, say, a financial system, that’s the buyer, and the CIO has to run and operate that, versus we had actually product selling to the CIO. So CIO, because we became the ERP for IT, and we have never lost sight of that core buyer and that core stakeholder. And so once you serve the CIO saying, “hey, we are here for you. We are not here, that we are trying to sell to HR or finance like the HCM system with our CFO,” that gave us permission to say, “hey, Ms. CIO, can you introduce us to the CHRO?”

And again, you are going to leverage the ServiceNow platform that you have been leveraging for HR use cases. You are going to leverage the ServiceNow platform for customer support, and that’s what allowed us to gain permission to go to other buying centers.

Mark Murphy

So another element to this that has caught our attention for a long time is the fact that you do have a very integrated platform. Out there at your event last week, I was speaking with one of your very largest partner firms. And he was actually describing what you were just referencing.

He said, many companies have done ITSM, right? And now his term as he said, they’re work-flowing out, right? They’re work-flowing out from there across the rest of the Company, right? HR, legal, finance, supply chain security, the quote was it’s exploding in so many areas, and they’re succeeding with it.

And I stepped back and I said, well, but how? How can this company succeed in so many different parts of the organization? And he basically just said, integrated platform. Integrated platform, people want that. So could you speak to that part of the philosophy? It’s kind of been guiding ServiceNow in a unique direction of integrated platform. And then what are the advantages that it affords you that might not be clear to people in the audience?

C.J. Desai

Yes. So for customers like this partner told you is workflow out, for us it’s platform out. So you start with the platform as the core and some of the mechanics that I shared because our ServiceNow platform has user experience built in, machine learning built-in, workflow built-in, RPA built-in, process mining built in, all of these are, think about building blocks that are part of the ServiceNow platform.

And now when we decide as a company or as an engineering team that we are going to go after a supply chain use case, what I shared is that with one or two scrum teams, somewhere between 7 to 14 to 15 engineers, because the platform provides all core services, we can create a version 1.0 of any use case for, say, a supply chain department.

And then from a customer perspective, customer says, we use you for ITSM, are you telling me it is the same mechanics when we roll it out in supply chain, your portals, your workflows and others? We say yes. And all the user access model that you have built in, security that you have built in will just extend, so you’re not installing yet another platform. And you don’t need to install yet another team to scale that platform.

Mark Murphy

So, this platform keeps broadening. I think at the last update, C.J., we were told there are 11 organic businesses with over $200 million in revenue. So, it’s becoming actually pretty diverse. If you had to pick one or two of those and say, do you work, keep an eye on this because there’s nascent potential here, and this is going to be a durable compounder, where would you tell us to look?

C.J. Desai

I would say the same thing I think I said in 2017, which was now six years ago, to start with. Customer service is an area. We are ServiceNow, customer service, ServiceNow service. That is a large TAM. And when you do industry-specific customer service like a telecommunications or financial services, we believe that the market is large enough and this can become a massive business or ServiceNow outside of IT. So that’s number one.

And number two is we just entered last year what you called out finance and supply chain workflows. Again, we are not trying to be a system of record. But specifically, workflows for procurement department or a supply chain department or a finance accounts payable department, we believe there is enough pain points that ServiceNow can solve. That’s another area that has — it’s an $11 billion TAM is what we disclosed last week, but it has potential to be a very large business.

Mark Murphy

Okay. So — well you gave us a couple of areas to focus on and do the work. I do want to ask you about HR in addition to this. So I recall C.J., this was several years ago, I traveled out to the HR Tech Conference. It was probably in Las Vegas. And it had been a long week.

I walked into the partner pavilion, and I immediately saw a ServiceNow booth, right? Big booth right in the front, very crowded. And I had a brief moment of figuring that I somehow went to the wrong conference, right? I didn’t know about it then. And last week, we were kind of milling about and talking to multiple partners at your event. And several of them called out HR as their number one growth vector.

And so — and they’re saying that they’re getting inbound requests on the HR side. Could you help us understand, then, why is HR a logical extension for you? And maybe which pieces of that are resonating?

C.J. Desai

Yes. So first of all, just at the highest level, the good news for us is we have divided our product lines in four big buckets: Technology workflow; employee workflow; customer workflow; and creative workflow, right? All four of us, four of those workflows are growing nicely for us. So we don’t have this challenge, oh, one has — is declining, and we need to move the R&D and other allocation to the other area. All four are growing nicely, all four of them, okay? So that’s number one.

Number two, HR, which pretty much in its earnest started in 2016, where customers said, hey, for HR case management, onboarding type of challenges or offboarding challenges, ServiceNow can do this thing. What has resonated the most is an employee, in trying to make that employee productive, is something that always has been our focus and take friction away.

To give a very simple example, think about a large bank. And if you want to get something done for — with the finance department, you go to somewhere else. With legal department, you go somewhere else. With your facilities, you want to go somewhere else that, hey, I became a manager, I need an office. We provide a single portal for employees, because employees at the end of the day do not care what the org structure looks like. Okay, there are four lines of businesses, and there is this HR function. They want to go to one place to get help, and they want one place to get things done. And that’s what we have done with HR products.

Mark Murphy

So you’re mentioning the employee portal or I think you call it employee center at times. You have onboarding, you have that piece and then you have this HR agent type of work space. Where do you think it would expand beyond that? Or is there enough to be done there for a while where it’s not necessarily going to be expanding?

C.J. Desai

So, we are expanding on making life easier for managers to manage their employees and what are the workflows required for managers to deal with. Skills is another area that we launched last week. On every job function has skills, career path, right? You need certain skills to be a manager, certain skills to be a director, certain skills to be a VP, whatever it is, or a software engineer. How do you do that skills mapping? How do you have the conversation with your manager in a meaningful way? And there’s another area of focus for us.

And then because of the pandemic, what has also happened as companies have tried to figure out this hybrid workplace where some will say, we allow our employees, or we mandate our employees two days a week, some will say four days, some will say all five days, it varies. How do you do facilities management, and how does employee get that experience that if I’m only coming two days, that means I don’t have a desk that is assigned to me because no corporation will not sign your desk if you’re coming two days. So can I book something? Can I book a conference room? Can I look at the maps? These are other areas within employee experience standpoint that allows us to expand.

Mark Murphy

Okay. So you just mentioned the pandemic. And when you think back on this — if you think back one year at this conference that was the time when we just started to have a few software companies that began calling out some challenges in the demand environment.

C.J. Desai

That’s correct.

Mark Murphy

And then over the summer, ServiceNow was also relatively soon in kind of identifying the change, right, and called out macro cross winds. That was last summer.

C.J. Desai

I think Bill went on CNBC.

Mark Murphy

Yes, that’s the one. That’s what I’m referring to. So most companies kind of recognize the environment was changing a little later, right, or admitted it later. But how do you connect the dots on the macro environment, if you kind of start with the last several quarters? And then how does business confidence feel to you right now today?

C.J. Desai

Yes. I would say 2022 and 2023 from my perspective are very different, right? So 2022, there were a lot of conversations, especially in the first half that we saw, what around supply chain and what does that do to fulfill demand when you talk to companies or corporations, potentially talent shortage and all that.

And then second half of 2022, including this 2023, it has become all about interest rate environment, the cost to serve, profitability focus. And there is not a single conversation, Mark, I have where there is not a conversation about efficiency and automation. And simply put, I’ll just do this pattern matching over 100-plus customers in, say, last month.

They say, we are solving for two things: We want to automate better, while at the same time, our digital agenda is still on because digital is still required, right? But it’s not at all cost, but that’s the efficiency gain that we are solving for. It’s the year of efficiency or a year of productivity and all of that. That pivot happened once the interest rate environment changed at a global scale.

So from our perspective, we are pretty distributed in terms of industry, public sector to financial services, to health care manufacturing, telco media and others. So, we see it all. And that is, I would say, United States of America continues to be resilient for ServiceNow. This is very ServiceNow-specific comment, for us very, very resilient, because we are a workflow automation platform.

So, we see that from a demand perspective, whether it’s IT automation or HR automation or customer service automation. We are seeing also similar things in Central Europe. We are seeing UK turnaround for us this year. And so, I feel, given what we do around digital and automation, we are still seeing demand for ServiceNow.

And customers take — I mean, last week, we had 15,000 in attendance, and there are so many companies that have cut travel budget for profitability and others. We had I would say, median number per customer, 12 to 13 folks being sent, which just tells you that they want to learn more about ServiceNow.

Mark Murphy

There was good energy there, and it was crowded and it was busy. How was the pipeline generation activity?

C.J. Desai

Pipeline, so far — so our sales and marketing team did a great job to make sure that, one, there are still customers who don’t understand that we are the end-to-end intelligent platform for digital transformation, not just IT service management or IT operations management. So, these customers coming in and sending this many folks from line of business and IT, it just opened up.

And I had so many conversations over three days there where customers are like, “I didn’t know you did supply chain, or I didn’t know you did, customers said, Oh, I didn’t know you had field service management product.” So one, our existing pipeline that we need to nurture and mature, a lot of those customers came, and then now it has allowed us to also expand the conversations to say, I didn’t know this.

Mark Murphy

Okay. So you felt pretty good about that.

C.J. Desai

Very good.

Mark Murphy

Okay. So now you do a lot of business in the financial services vertical. We learned when we were out there, some of the banks sent 30 people, 60 people to that event. So you know that’s a big commitment.

But we’re constantly getting questions from investors about whether this regional banking crisis could cause any issues. Maybe you have some deal deferrals, even if it’s not from the regional banks, right, even if it’s from other banks. What are you seeing so far?

C.J. Desai

So, our Q1 numbers when you see — when we reported them in April, we were not impacted while the crisis or, however you want to say it, the phenomena that was happening in the regional banks in Q1. And when I look at the pipeline for this year and out years, right, we look at four, five, six quarters out, there are certain product lines we have besides our core of the core, which is ITSM and ITOM, is still demand for our risk solution in banks specifically.

So, we will have a Chief Risk Officer level conversation or we have digital risk level conversation. Our security products are resonating well with both large and midsized banks. And then between banks and the insurance companies and others, we are also seeing demand for mid-office, back office workflows.

So, we can — and again, banks all of you understand, they are tough customers. You have to prove out the use case, you have to show the value before they make a purchase. The cycles with all the banks have always been long. But they understand ServiceNow really well now and allowing us to expand in other areas besides just IT.

Mark Murphy

So, there were — there was good energy out there. Obviously, it’s not a perfect environment. Obviously, the typical software company has been — growth has been slowing, right, across the entire industry. And nobody has been immune to it.

There were people out there, there were partners out there last week who would recognize that, but then they would also say, it would at least hypothesize that ServiceNow could be a bit recession resistant, they didn’t say recession proof. But we would say, well, why?

They would say because companies they’re consolidating legacy point products, right, onto a modern platform and their feeling is that they do continue to do that even during a slowdown. So is there an element of truth to that? Is there an element of truth to being a little bit recession resistant?

C.J. Desai

Yes. Listen, 2022 was the first year where the word R came out, right? It was in ’22 that, hey, there are parts of economy that may be slowing down despite the labor market being super resilient. And ServiceNow did pretty well. We did pretty well.

If you look at our proxy statements, the demand was there and we executed on that demand. And it exceeded even when we reported our Q4 and fiscal ’22 numbers, it exceeded what was happening compared to the other SaaS companies. It’s what I can compare us against with close to 29% subscription revenue growth in 2022.

And now when we look at 2023, we had a strong Q1. We reaffirmed our guidance. And we won’t do that unless we feel that we are given what we do still in the strike zone of the purchases that the companies are trying to make.

Mark Murphy

Yes. Okay. Well said, well said. So C.J., in the time that’s remaining, let’s switch gears a little bit and go into the topic that’s on everyone’s mind, which is generative AI, right? You spent quite a bit of time at the Analyst Day talking about ServiceNow’s vision.

I’ll tell you what actually stood out to me. When you were on stage in front of the main session, the loudest response from the audience, and it was by far, it was when you were showing this demo of, I guess, I would call it text to code. But basically, someone goes in and someone types in, right, create a workflow for notifying like certain teams if — if there’s a level one incident.

And then the system basically spits out the code right? So, it understands what you’re asking, it spits out the — but it’s in the proprietary ServiceNow…

C.J. Desai

Department, yes.

Mark Murphy

Scripting language, right? And so people kind of went crazy. And then you can — you hit copy, it goes on a clipboard, and you could drop it right into the app, and then it’s live. I mean so — I assume you noticed that response.

C.J. Desai

100%.

Mark Murphy

Yes. I mean how much of a productivity base do you think you can provide to the typical — the admin or a ServiceNow platform owner?

C.J. Desai

So I’ll go to the first principles, okay? And this is super important for all of you to understand. In 2016, when we ended the year, we were $1.3 billion in subscription revenue. Last quarter, we hit $8 billion run rate and will be $8 billion by end of this year, right?

So you think about 8x growth in seven years, that’s a very fast license subscription growth. That’s great because of the use case is this and so on. But our ecosystem has not kept up with it, meaning trained ServiceNow professional. Every large customer I speak to, they say, we cannot find people who understand ServiceNow and how to code in ServiceNow.

So when we showed that demo that you write in natural language something and it spits out ServiceNow code, that was a domain-specific LLM that we created in ServiceNow by feeding ServiceNow proprietary code that we know how to write, because we wanted an accurate code to show 15,000 live audiences because anybody can take picture.

And if that code is faulty, which was a rejects for e-mail address, number of incidents and this and that, that’s a game over. You don’t want that demo, and we did a live demo. The reason you got this really nice applause and people who were cheering and there was like a gasp and all of that, is because every customer is dealing with not having enough ServiceNow professionals, and this just creates more developers on ServiceNow, creates their learning curve faster and ability to modify rules in ServiceNow. That’s it.

And so this allows our ecosystem to expand. Our partners, you mentioned, Mark, have a massive backlog to implement many of our product lines that our customers have purchased and this allows them to scale faster. And we will be able to monetize that. We are providing offerings on the productivity enhancements that they will get.

Mark Murphy

So, and you’re using — you mentioned the domain-specific LLMs. The thought process was, for me was, you have OpenAI, that’s the general purpose LLM. The value-add is going to be the domain specific.

And at first, I heard it as that you’re using a hugging face for that a private company. And then I think later on, I started to realize it seems like that’s also going to include NVIDIA.

C.J. Desai

That’s correct. I could not on Financial Analyst Day, disclose NVIDIA, because Jensen came on Wednesday, and he wanted the press announcement to go after we have announced it for NVIDIA shareholders as well.

Mark Murphy

I see.

C.J. Desai

So we are working with NVIDIA team on IT service management, specific LLM. And Jensen was very proud of his team showed me this morning, the results we are getting with open source LLM that NVIDIA is helping us fine-tune. Because general-purpose LLM with 175 billion parameters, whatever the numbers are, it will continue to increase, that’s interesting, but it’s general purpose.

What our customers want is, “Hey, C.J., I’m a large telco. I use you for these five products. How can I enhance my productivity? And can you please take care of it using gen AI?” And because that’s what — for ServiceNow specific use cases, they don’t want to build a gen AI model, they want us to build the gen AI model, which is why I call it domain-specific. And NVIDIA and hugging face at our partners to be able to do that, where we don’t require 175 billion parameters, and we can still compute efficiently.

Mark Murphy

Okay. Let me finish on observability. At a super high level, so why is observability going to end up being a good fit for ServiceNow? I mean you have incumbents out there. We had Datadog here yesterday. You have other incumbents. They’re pretty modern, right? They’ve been working on metrics tracing, monitoring logs. They’ve been working on it for a long time. Why is it a good fit for you?

C.J. Desai

Here is what I would say: At the highest level, our customers said, you have a right to play here. Because things that come out of observability platform that this particular applications performance is slow, or something changed where this application went down, eventually makes a call to IT service management, where you have all incident repositories.

So our customers said, you should play in this field. And only when our customers say, you should play in this field, we play in that field. Our platform was designed for human workflows, digital workflows, not machine data. Hence, we did the Lightstep acquisition. Lightstep used to do tracing really well, then they added metrics. And now late summer, we are going to add logs. So we will have a full cloud observability solution that integrates with ITSM and ITOM.

That is our differentiation. And given there are multiple solutions out there that are, as you know, you talk to any bank or any manufacturing company or any government, they’ll say we have five of them. That’s totally fine. We are focused on observability at scale, at a cheaper cost that integrates really well with the backbone of IT, which is ERP for IT, which is ServiceNow.

Mark Murphy

Okay, wonderful message to hand on. C.J., I can’t thank you enough for hopping on a plane and flying across to be here with us.

C.J. Desai

Of course, absolutely.

Mark Murphy

Thank you very much.

C.J. Desai

Thank you.