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MagnaChip Semiconductor (NYSE:MX)
Q1 2020 Earnings Call
May 06, 2020, 5:00 p.m. ET

Contents:

  • Prepared Remarks
  • Questions and Answers
  • Call Participants

Prepared Remarks:


Operator

Ladies and gentlemen, thank you for standing by and welcome to Q1 2020 MagnaChip Semiconductor Corporate earnings conference call.[Operator instructions] I would now like to hand the conference over to your speaker today, Mr. Bruce Entin, head of investor relations. Thank you. Please go ahead, sir.

Bruce Entin -- Head of Investor Relations

OK. Thank you for joining us to discuss MagnaChip's financial results for the first quarter ended March 31, 2020. The first-quarter earnings release we filed today after the stock market closed and other releases can be found on the company's investor relations website. A telephone replay of today's call will be available shortly after the completion of the call and the webcast will be archived on our website for one year.

Access information is provided in the earnings press release. Joining me today are YJ Kim, Magnachip's chief executive officer; and Shin Young Park, our chief accounting officer. YJ will discuss the company's recent operating performance and market outlook for our product categories, and Shin Young will provide an overview of the accounting treatment of continuing and discontinued operations. There will be a Q&A session following today's prepared remarks.

During the course of this conference call, we may make forward-looking statements about MagnaChip's business outlook and expectations. Our forward-looking statements and all other statements that are not historical facts reflect our beliefs and predictions as of today and, therefore, are subject to risks and uncertainties as described in the safe harbor discussion found in our SEC filings. During the call, we will also discuss non-GAAP financial measures. The non-GAAP measures are not prepared in accordance with generally accounting principles, but are intended to illustrate an alternative measure of MagnaChip's operating performance that may be useful.

A reconciliation of the non-GAAP financial measures to the most directly comparable GAAP measures can be found in our first-quarter earnings release available on our website under the investor relations tab at www.magnachip.com. I'll now turn the call over to YJ Kim. YJ?

YJ Kim -- Chief Executive Officer

Thanks Bruce, and welcome to everyone on the Q1 2020 conference call. First of all, our hearts go out to all those people whose lives have been impacted by the global pandemic. At MagnaChip, we are fortunate that Korea seems to have handled the COVID-19 breakout in a manner that minimized its spread. MagnaChip started 2020 on a high note.

We executed well and delivered solid results in Q1 despite typical seasonal softness and market disruptions caused by the COVID-19 global pandemic. If you recall, on our Q4 earnings call on February 19, we guided Q1 revenue between $180 million to $195 million and gross profit margin between 23% to 25%. We updated our guidance on March 10 and raised the low end of revenue guidance to $187 million and the high end to $197 million due to stronger-than-expected revenue in our OLED and foundry businesses and despite weakness in our power business. We kept the gross profit margin range the same.

The financial statements we released today look different than in previous quarters because beginning in Q1, we now account for the foundry business as a discontinued operation on the accounting rules. The continuing business includes the display business, power business and fab 3 operations. The change in our reporting came about when we signed a definitive agreement on March 30 to sell the foundry business and fab 4. Shin Young, chief accounting officer, will soon provide a more detailed overview of the accounting rules that govern how we now present our financial statements.

Meantime, we are pleased that the combined Q1 revenue from standard products and foundry services hit $197 million on a non-GAAP basis. That was our highest revenue level for first quarter in 12 years and met the high end of our updated guidance. We currently do not detect excess inventories in our sales channels, and our own inventories are at levels to meet near-term demand. The non-GAAP combined gross profit margin from continuing and discontinued operations was 25.3% which exceeded the high end of the guidance range.

Revenue from standard products was $110.7 million, up 10.4% year over year, and gross profit margin was 26.3%. Revenue from the foundry business was $86 million and gross profit margin was 23%. Now, I'd like to give you an update on the definitive agreement to sell the foundry business and fab 4. If you recall, the transaction value was $435 million which includes $344.7 million in cash and approximately $90 million in accrued severance liabilities that will be transferred along with approximately 1,500 employees to the buyer.

The transaction remains on track to close on schedule in the September, October time frame. It's worth noting that there is no closing condition tied to any regulatory approval. Also worth noting is that the definitive agreement contains an explicit condition that COVID-19 cannot be a cause to delay or cancel the transaction. I'll comment further about the strategic rationale for selling the foundry business and fab 4 when we discuss Q1 foundry results in a few minutes.

Now let's take a closer look at the continuing businesses, starting with OLED which accounted for about 90% of our total display business in Q1. OLED DDIC revenue was $69.7 million, up 43.6% year over year and 3.5% sequentially. On our Q4 earnings call in February, we said we expected nine new OLED smartphones with our display drivers would be launched in the first half 2020. Now we are doubling our estimate to 18 new smartphones in first half.

Of these 18 models, eight were launched in Q1 and a ninth just went into pilot production. This helps explain the 3.5% increase in OLED revenue from Q4 '19 to Q4 2020 in a period that is typically seasonally soft. We achieved 14 new OLED DDIC design wins for smartphones in Q1 or more than 2x the total from the same period a year ago. Design wins on -- always a direct indicator of future revenue, but definitely a good indicator of the market appeal of our low power driver portfolio.

We now have 16 OLED display drivers which is nearly twice the size of our portfolio in Q1 of 2019. Lastly, serving the needs of smartphone makers in multiple geography was a benefit to us in Q1. We saw a drop-off from smartphone brands in China in Q1 due to the COVID-19 outbreak, but the decline was offset by a Korean smartphone maker that launched multiple new models with our OLED DDICs. This diversification effort will benefit us again in Q2 as the China smartphone market is beginning to show signs of recovery.

Many new models with our OLED display drivers will launch in Q2. We see the following trends in 2020 for our OLED business, 5G of our 14 design wins in Q1, 10 were for 5G phones, and we expect this design activity to heat up throughout 2020. 28-nanometer drives will gain momentum. Our six 28-nanometer OLED drivers represent nearly 40% of our display driver portfolio and accounted for over 40% of design wins in Q1.

Our 28-nanometer devices are the lowest powered devices on market which is why we see design momentum continuing to be strong for this growing product family. Gaming smartphones are gaining popularity, and we are well positioned to capitalize on this trend. We see more design win activity this year for 120-hertz smartphones targeted for game users. We have four display drivers with 120-hertz refresh rate, and we also have capability to reach 144 hertz.

Higher refresh rates are important to gamers because of faster display response times which make the game play appear smoother on the screen. We recently take out another 28-nanometer product with a 144-hertz rate aimed at high-end smartphones. Our OLED solutions are also behind some of these smartphones with world's best cameras, an increasing important smartphone feature. Flexible OLED design wins are on the way up.

We are seeing more design wins with our flexible DDICs. Of those, chip on plastic packaging is becoming more prevalent. This is good for us because package cost is lower, thus the profit margin can be higher. Design wins in Q1 using COP packaging nearly tripled from the number of design wins in all of 2019.

OLED for auto. We have now kicked up development OLED for automotive products which we expect to go into production in first half 2021. We believe the auto market represents a promising long-term OLED opportunity. Micro LED, we have released an enhanced version of a micro LED TV DDIC for targeted production in first half 2021.

Micro LED represents an untapped market opportunity for growth. Now let's turn to power. The COVID-19 outbreak in China impacted our power business. power revenue of $33.1 million declined 12.3% sequentially and 21.2% year over year primarily due to market softness in China as offices and factories were shut down for an extended period in Q1.

Super Junction MOSFETs and power IC performed well in Q1, but we saw a sharp decline in other products due to softness in wireless communications and e-bikes. power product mix improves. Despite the decline in Q1 power revenue, premium products represented more than 55% of power products in Q1 as compared to the mid-40% level in Q4 2019. The good news is that China appears to be on the road to recovery from COVID-19, and we now expect power revenue to grow by a double-digit percentage sequentially in Q2.

Under the new bright spot for power in Q2 is that demand is ramping for our battery FETs in the rapidly growing wireless earphone market, especially for Korean OEMs. EV and hybrid auto segment opportunity. Two new projects for hybrid electric vehicle kicked off in Q1, adding to a growing portfolio of design wins for the EV segment. As you may recall, we are involved in several 10,000-hour qualification testing stages with auto suppliers.

We expect the EV auto segment will represent a meaningful growth opportunity for our power business in the years ahead. Now turning to the foundry services group. foundry services group revenue was 51.1% year over year and flattish from Q1 '19, while certain markets like wireless communication and consumer was soft due to seasonal macroeconomic trends, the declines were offset by -- in part by demand for medical devices including respirators and digital thermometers. Demand also came from the computing and tablet segments as working from home has increased due to the pandemic.

Foundry turned in a good quarter, but our decision to sell that business and fab 4 was strategic and aimed at maximizing shareholder value over the long term. The foundry business is capital intensive, highly cyclical, requires a separate sales force, continuous R&D and scalability. Hence, we believe this business could grow with a dedicated focus which is now will have with new owners. Given our size and financial resources, our Management and board both believe it made more sense to focus on either foundry or standard products, but not both.

From an operational point of view, the sale of the foundry business and fab 4 allow us to transform into a streamlined pure-play products company focus exclusive on the growth opportunities in the display and power businesses. The sale also allow us to set near-term and longer-term financial goals to improve overall profitability and maximize shareholder value. Putting aside the near-term impact of COVID-19, here are key priorities and financial metrics we are focused on over the next few years. It all starts with achieving profitable revenue growth.

Our No. 1 goal is to achieve robust, sustainable and profitable revenue growth through focused R&D and continued product innovation. We'll aim for higher gross margin and focus on increasing gross margin dollars to contribute to cash flow, generating net operating cash flow as we've done for the past four quarters is our key goal. We'll run lean and mean.

As a streamlined standard product company, we will rightsize opex and exercise financial discipline. Operating income targeted to double from current levels. Our longer-term goal is for adjusted operating income which excludes stock-based comp to double to above 10% in the next few years. We will delever and strengthen the balance sheet.

By this time next year, we should be largely freed of approximately $21 million in interest expenses which will improve net income by $21 million excluding the impact from noncash foreign currency gains or losses. Adjusted EBITDA margin percentage to increase. This goal will be made more achievable without the foundry business and fab 4. We plan to provide more detailed information on our pro forma financial models as we go forward and hold an analyst day after we close the sale of the foundry business and fab 4.

Now let me make a few comments about COVID-19 and how we are dealing with it at MagnaChip. Many investors have asked us how we are managing our workforce in view of the pandemic. We began in February to take serious steps to help protect our employees, the vast majority of whom work in Korea. Each day, we disinfect all areas in our fabs where workers held together, and we require that office and fab employees use separate entrances to avoid cross contamination.

We've also installed plexiglass partitions in the employee cafeteria to create protected spaces for employees. Forehead temperatures are taken and hands are sanitized each time an employee enters any of our offices or fabs, and employees wear a face mask and practice social distancing. In our Seoul office, we've operated to the semi-HEPA air filter system, capable filtering ultrafine particles. And we've implemented alternating work-at-home days for those in critical function to avoid sidelining whole teams or management.

We've provided paid leave for five employees that were in a severely affected area and sent them the care package to their home. I thank all our employees for their ongoing dedication to serve our customers during this extraordinary period. Turning now to our supply chain. Our assembly and test subcontract in China now are fully operational.

We used two external 12 foundries outside Korea and China in a separate location to manufacture our new generation OLED display drivers. Both foundries have been operating at normal levels. Likewise, our displays have contracted in Korea are operating at normal levels and now also hold an extra two months of inventory to prepare for unexpected events. To date, our fab 3 and fab 4 manufacturing facilities in Korea have been operating at normal levels.

The supply chain is only as strong as its weakest link, so we will continue to monitor it closely to mitigate potential vulnerabilities. Turning now to our business outlook. Please refer to the press release we've issued today for Q2 financial guidance. COVID-19 has reduced our visibility and created significant business challenges, but we are better prepared now than ever before to confront them.

To sum up, I'd like to emphasize that the business transformation we are undertaking will better position us to deliver sustainable and profitable growth. I shared with you earlier our priorities over the next few years and look forward to report our progress as we continue to execute our business plan. Now, I'll turn the call over to Shin Young and come back for Q&A. Shin Young?

Shin Young Park -- Chief Accounting Officer

Thank you, YJ. Let's review the accounting treatment for the continuing and discontinued operations. As you can see in our first-quarter earnings release, the financial statements look very different from what we've reported in the past. Until we close the sale of foundry business and fab 4, the prudent way to calculate our non-GAAP EPS is that you need to look at it on a combined non-GAAP basis.

The foundry services group is accounted for as a discontinued operation beginning in this quarter, and the assets and liabilities relating to the foundry business and fab 4 are shown separately as those held for sale on our balance sheet. What this essentially does is that we are carving out the foundry services group from our operational results and the assets and liabilities that belong to the foundry business and fab 4. To do this carve-out, we've applied certain assumptions mainly for the allocation of opex between the foundry business and the standard products business. For instance, we used a list of approximately 1,500 employees as a basis for the allocation of payroll cost.

If there is any change to the list of employees to be transferred through to the closing, we'll make an adjustment as applicable. Following the consummation of the sale of foundry business in fab 4 and for a certain period of time thereafter, we'll provide a transitional foundry services to the buyer for foundry products manufactured in fab 3 which is our fabrication facility located in Kumi, Korea. For the period prior to closing, revenue we derived by providing transitional foundry services from fab 3 to the foundry services group are recorded at cost in both of the continuing and discontinued businesses resulting in no margin. As such, sales and costs are eliminated when reserves from the two businesses are combined together.

Because of this accounting treatment, you will see new lines on the statements operations called net sales transition of fab 3 foundry services and cost of sales transitional fab 3 foundry services. Keep in mind that accounting rules dictate the general corporate overhead shared between continuing and discontinued operations get lumped 100% into the continuing operations bucket. This is why it would not be accurate to extrapolate this level of shared services expenses as part of continuing operations into the future. I'd like to note the expenses that qualify for inclusion in discontinued operations are direct operating expenses incurred by the foundry services group that are reasonably segregated from cost of the ongoing reporting entity.

Indirect expenses, such as general corporate overhead, are not including discontinued operations under the accounting rules. Generally, costs and expenses that are expected to continue in the ongoing reporting entity after the disclosure date should not be allocated to discontinued operations and instead should be included in the results of ongoing entity. For instance, professional fees for audit concerting legal services for the overall company cannot be allocated to the foundry services group. These types of expenses will be rightsized.

Interest expenses cannot be allocated to the foundry services group as we do not transfer our third-party debt obligations. As none of our intercompany long-term loans are transferred either, continuing operations absorbed the related foreign currency gain or loss in our P&L. As a reminder, a substantial portion of our net foreign currency gain or loss is associated with the intercompany long-term loans to our Korean subsidiary by our Dutch subsidiary which are denominated in U.S. dollars and is affected by changes in the exchange rate between Korean won and the U.S.

dollar. Therefore, the net loss for Q1 of 2020 on a GAAP basis from continuing operations, otherwise known as the standard products business plus fab 3, appear to have dipped compared with a year ago as the Korean won depreciated relative to U.S. dollar. But this financial yardstick is not necessarily a relevant measure of our business performance because the aforementioned net foreign currency gain or loss is a noncash item.

With that, I'll turn the call back to Bruce. Bruce?

Bruce Entin -- Head of Investor Relations

Thank you, YJ and Shin Young. So Kristal, this concludes our prepared remarks. With that, we now like to open the call for questions.

Questions & Answers:


Operator

[Operator instructions] The first question comes from the line of Suji Desilva from ROTH Capital. Your line is open. Please ask your question.

Suji Desilva -- ROTH Capital Partners -- Analyst

Hello YJ, Shin Young. Congratulations on the execution in a challenging environment.

YJ Kim -- Chief Executive Officer

Thank you.

Suji Desilva -- ROTH Capital Partners -- Analyst

Yeah, there's a little static. Let me know if you can hear me well. So the China smartphone market, maybe YJ, what are you seeing in terms of demand, the late March, April, early May, since the quarter closed, week-to-week trends? Anything -- any color there would be helpful.

YJ Kim -- Chief Executive Officer

As you heard today, I mean we are expecting nine product launch in the first half. We doubled to 18. Part of reason is that there are uptick activities in the new design wins. So we are very pleased to report our design win in Q1.

We continue to win more design win. And we're excited about some of the new phones that we launched in Q2. So we'll have a nine new product to be expected to launch in Q2. So we think that the market is recovering.

And one way to recover the revenue is also through product innovation, and I think that's what we are seeing in the market.

Suji Desilva -- ROTH Capital Partners -- Analyst

OK. And with the impact of COVID, perhaps the overall market -- smartphone market maybe being weaker, are you seeing any increase in the OLED mix? Are the smartphone OEMs and service providers emphasizing 5G OLED upgrades in this environment? Are you seeing any of that benefit?

YJ Kim -- Chief Executive Officer

I mean even today, if you look what we just said, out of 14 design win in the Q1, 10 were targeted for 5G smartphones. So we definitely see an uptick on the 5G momentum. And because product portfolio has increased from nine to 16, if we -- in fact, if you include, the legacy is 18. So we have doubled the number of the portfolio.

So I think that the momentum is there going to the OLED.

Suji Desilva -- ROTH Capital Partners -- Analyst

OK. And then the power segment, you say you're seeing recovery here. Would the premium mix continue to stay high and increase further here? Is that going to be how the power segment plays out the rest of the year? And would inorganic growth here makes sense to grow the portfolio and improve the premium product effort even more.

YJ Kim -- Chief Executive Officer

Yes. Our laser focus is improving the portfolio and the product margins. But as the market also recovers, there will be more demand on the non-premium as well. So we expect both segments to grow in terms of revenue.

Suji Desilva -- ROTH Capital Partners -- Analyst

OK. Well that makes sense. Maybe last question perhaps for Shin Young. The opex, I'm trying to understand, going forward, what portion will be allocated to standard products versus the overall sort of non-GAAP that you've given in terms of opex? So we can understand the go-forward run rate of the opex.

Shin Young Park -- Chief Accounting Officer

Right. Understood. We don't actually forecast like opex for the whole year, but I can repeat the comment that we gave last quarter earnings call. The first half of -- the opex for the first half of 2020 would be flattish with the second half of last year's.

So that would -- that should stay hold true. And also, I would not really object if you are going to use the Q1 of 2020 as your proxy to kind of see the split between discontinued and the standard products business.

Suji Desilva -- ROTH Capital Partners -- Analyst

So that run rate makes sense, Shin Young, is that right?

Shin Young Park -- Chief Accounting Officer

Yes. I mean, yeah. I have no object if you use that ratio, yes.

Suji Desilva -- ROTH Capital Partners -- Analyst

Understood. Appreciate that. Thanks for the color and again, congratulations on the progress. Thanks.

YJ Kim -- Chief Executive Officer

Thank you.

Operator

[Operator instructions] Your next question comes from the line of Raji Gill from Needham. Your line is open.

Raji Gill -- Needham and Company -- Analyst

Yeah. Thanks. You might have touched on this, but there is a lot of issues on this call, getting on the call in terms of logistics. So you talked about, YJ, I think in this part of it, the adjusted operating income will double 10% the next few years.

Can you talk about what the -- can you just repeat the operating income, the gross margin, the interest expense reduction, the time frame? What are those numbers? If you can repeat all of that.

YJ Kim -- Chief Executive Officer

Sure. Sorry, I had some hearing issues. So on the operating income. So operating income, we target to double from current levels.

Our long-term goal is for adjusted operating income which excludes the stock-based comp to double to about 10% in the next few years. So that's what we said exactly.

Raji Gill -- Needham and Company -- Analyst

What is it now? You said double from current years. I mean it's apples and oranges. What's the operating income now ex the foundry and [Inaudible]

YJ Kim -- Chief Executive Officer

It's about 5% on apple-to-apple base.

Raji Gill -- Needham and Company -- Analyst

OK. And what about the gross margin on a go-forward basis? Is this going to be kind of 28% gross margin for -- well, yeah, until you guided to 27% gross margin for...

YJ Kim -- Chief Executive Officer

For a combined base.

Raji Gill -- Needham and Company -- Analyst

For a combined which implies about 28% for display and power. Is that the gross margin for OLED and power? What is the gross margin for OLED and power on a go-forward basis?

YJ Kim -- Chief Executive Officer

We haven't provided those details today on the pro forma.

Raji Gill -- Needham and Company -- Analyst

OK. And then this-- so this opex of $22.6 million for Q1, and the revenue was $120.5 million excluding the foundry. The -- in terms of the revenue of $9.8 million for the fab 3 transitional service, how long is that going to be? And how do I model that going forward? And what -- should we be modeling $120 million as the stand-alone business for the two segments and whatever our growth rates on top of that?

YJ Kim -- Chief Executive Officer

Yes. So as you know, we don't give more than a quarter up, but -- because a special situation. I think for this year, you could have a similar model, but going -- ongoing more than a couple of years, we will give more depth on the analyst day on the model. But the -- we expect the transition on service to be there next few years, but how the curve plays out will give you more forecast for next few years on the analyst day on that portion.

Raji Gill -- Needham and Company -- Analyst

And when is the analyst day going to be? Have you set a date for it?

YJ Kim -- Chief Executive Officer

Yeah. We said that we will have it after close of the fab 4 transaction. And the fab 4 transaction, we said it's going to be September, October time frame.

Raji Gill -- Needham and Company -- Analyst

And then you mentioned also -- I missed -- I'm sorry, go ahead. Finish your thought.

YJ Kim -- Chief Executive Officer

And the other thing -- important thing we gave you is that the -- we will delever and strengthen the balance sheet. So by this time next year, we should be largely freed of approximately $21 million in interest expenses which will improve net income by $21 million excluding the impact from the noncash foreign currency gains or losses. And as you know, this interest expense is on top of the operating income that we're going to generate.

Raji Gill -- Needham and Company -- Analyst

Right. So when you're doing the operating income of -- or you're projecting about I guess 10% over the next few years, ex the stock-based comp, is that essentially the transfer of all -- the majority of the 1,500 employees to the special purpose company? Does it also include any additional savings that's factored into this kind of number?

YJ Kim -- Chief Executive Officer

This is after the company -- the transaction is completed and additional saving and improvement that we're going to execute in the next few years. So that's all baked in, because as I said before, that even today, on an adjusted basis, apple-to-apple, we are about 5%. So there is going to be a lot of other improvement we are going to perform to maximize shareholder value.

Operator

[Operator instructions] I am showing no further questions at this time sir. I would like to turn the conference back to the speaker.

Bruce Entin -- Head of Investor Relations

OK. So thank you Kristal. This concludes our first-quarter 2020 earnings conference Call. Please look for details of future events on MagnaChip's investor relations website.

Before we end, I would like to welcome Ms. So Young Zhang, a 20-year IR veteran in Silicon Valley, who replaces me as head of investor relations. She's an IR pro in Silicon Valley, and she looks forward to meeting all of you. As for me, thanks to everyone for a great ride over the past five years.

I've enjoyed my time, had the honor of working side-by-side with YJ, his team and the board. I'll be spending less time on airplanes and more time at home and cheering on MagnaChip from the sidelines. Thank you for joining us today. Operator, thank you.

Operator

[Operator signoff]

Duration: 39 minutes

Call participants:

Bruce Entin -- Head of Investor Relations

YJ Kim -- Chief Executive Officer

Shin Young Park -- Chief Accounting Officer

Suji Desilva -- ROTH Capital Partners -- Analyst

Raji Gill -- Needham and Company -- Analyst

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