Greetings and welcome to the Advanced Energy Second Quarter 2022 Earnings Call. At this time, all participants are in a listen-only mode. A brief question-and-answer session will follow the formal presentation. . As a reminder, this conference is being recorded. It is now my pleasure to introduce your host, Edwin Mok, VP of Strategic Marketing and IR. Thank you. You may begin.

Thank you, operator. Good afternoon, everyone. Welcome to Advanced Energy's second quarter 2022 earnings conference call. With me today are Steve Kelley, our President and CEO, and Paul Oldham, our Executive Vice President and CFO. Before I begin, I'd like to mention that we will be participating at several investor conferences in the coming months. If you have not seen our earnings press release and presentation, you can find it on our website at ir.advancedenergy.com. Let me remind you that today's call contains forward-looking statements that are subject to risks and uncertainties that could cause actual results to differ materially and are not guarantees of future performance. Information concerning these risks can be found in our SEC filings. All forward-looking statements are based on management's estimates as of today, August 3, 2022, and the company assume no obligation to update them. Medium-term targets and long-term aspirational goals presented today should not be interpreted as guidance. On today's call, our financial results are presented on a non-GAAP financial basis, unless otherwise specified. Excluded from non-GAAP results are stock compensation, amortization, acquisition-related costs, restructuring expenses and unrealized foreign exchange gains or losses. A detailed reconciliation between GAAP and non-GAAP measures can be found in today's press release. With that, let me pass the call to our President and CEO, Steve Kelley.

Thanks, Edwin. Hello, everyone, and thanks for joining the call. Second quarter revenue and earnings per share surpassed our expectations largely due to improved supply of key components and good execution by our operations team. While delivering record breaking revenue, we also significantly grew our backlog. This is evidence of the strong demand across our target markets. In the near term, the primary constraint on our financial performance will continue to be the availability of scarce components, particularly integrated circuits. While the procurement of scarce ICs is key to our short term performance, new products and technologies are key to our long-term growth. To that end, our development teams are highly focused on launching innovative products into our target markets. Within those markets, we are focusing on applications which need highly engineered solutions, allowing us to deliver more value to our customers. In addition, we are accelerating the cadence of new product introductions across a wide range of applications. In the second quarter, we expanded our reach in the medical power market by acquiring SL Power. We are now a top player in medical and aspire to become the number one player within the next five years. Customer reaction to the acquisition has been positive. They recognize that Advanced Energy's engineering capabilities, manufacturing footprint and strong balance sheet complement the innovative strength of SL Power. Now, let me provide some further color regarding the current operating environment. As I mentioned earlier, the supply environment remains dynamic. The availability of key ICs, all of which are built on older process nodes, is the primary issue. To partially mitigate the shortages, we buy certain components through dealer and broker channels. Our customers support this effort by absorbing some of the price premiums associated with these broker buys. While there are pockets of…

Thank you, Steve. And good afternoon, everyone. In the second quarter, we delivered record revenue of $441 million and earnings per share of $1.44, surpassing our guidance ranges. Demand for our products remain strong, and our backlog grew 15% sequentially to $1.17 billion. We believe this backlog, which is comprised of predominantly proprietary products, provides a runway to solid financial performance as we look over the next several quarters. Our operations focus remains on securing critical parts and getting products to customers as quickly as possible. Our redesign efforts, ability to move quickly to secure parts even at a premium, and other mitigating actions are having a positive impact. At the same time, the overall supply environment remains very challenging, and we continue to see higher material costs and premium recoveries. As a result, we will remain prudent in our planning, but believe our second quarter results are indicative of our ability to achieve our target earnings of over $1.50 per share by the end of the year. Now let me go over our financial results. Revenue of $441 million grew 22% from last year and 11% from last quarter. Excluding the contribution of the SL Power acquisition, organic revenue growth was 18% year-over-year and 8% sequentially. Revenue from the semiconductor market was $229 million, up 30% from last year and up 13% from last quarter. Demand was strong, and our backlog grew despite the record revenues. We are working closely with our customers to prioritize critical parts and deliveries and expect our semiconductor revenue to grow sequentially again in both the third quarter and the second half. Revenue in the industrial medical market was $105 million, growing 26% from last year and 27% from last quarter. Excluding SL Power, organic growth was 12% both year-over-year and sequentially, driven by…

. Our first question comes from Scott Graham with Loop Capital Markets.

Congratulations on a nice quarter, guys. I was hoping you could unpack the semiconductor growth up 30% year-over-year. Just give us a little bit more color on maybe some product lines that were maybe outsized strength and the like.

Scott, let me make a few comments there. Like the rest of our markets, our semiconductor market was really constrained by parts. It has been for the better part of the last year. So, what happened in the second quarter was we were able to procure more parts and turn those parts into revenue. There's really no meaningful change in the demand pattern. We're seeing demand exceed supply throughout our semiconductor business. I should mention, though, that some of the work we started last year on qualifying alternative ICs and requalifying circuit boards is starting to pay off in a big way for us starting Q2 and going into the second half of this year. So a big thank you to our customers for working closely with us to make those calls happen.

So, there are no particular areas of semi where you were maybe a little bit stronger by product line. It was pretty broad based in semi?

Yeah, it's very broad based. Again, it's supply limited, and customers are taking just about everything we could show.

On the data center side, you have a really good business there. That's a market, however, that half a dozen companies are saying that it's fine and maybe other half say it's weakening or will potentially weaken, tying things back sometimes even to the smartphone market. What are your customers saying in data centers? Are your customers, in particular, still have plans to have continue to build in the second half of the year and on into next year. Give us an idea of what's going on in that market?

Scott, we see a lot of strength in that market. And again, it's still a supply constrained market. So, they're taking everything we can build. I think the only thing we see in that market is that some customers are waiting for other components to complete their rack. in the market, we were able to quickly ship those products to a different customer. So, so far, we have had no constraints in the hyperscale market and we're just being expedited on a daily basis from these customers.

And if I could just sneak one last question in here, if you don't mind. Your chart on page 6 is pretty telling, the growth of the backlog has been like a weed. I guess the concern that I would have there is, is there a percentage of that you think might be double ordering, first available, getting into slots, and what have you. How much of that backlog do you think is real OEM order versus maybe some double ordering in there? And what is the potential that – closing in on $1.2 billion, that if demand weakens in the semiconductor markets, as I think most people believe it is in a lot of pockets, that there's some cancellations there?

Yeah, that's a good question, Scott. Can we take a look at that backlog very closely because it is at an all-time high. So let me just give you some more data to support the integrity of that backlog. First of all, two-thirds of that backlog that we have currently is shippable in the next six months, so it's got customer request dates within the next six months, which is important to know because that means it's demand that's right in front of us. If I take a look at our backlog in – addressing specifically your question about perishability. 80% of our backlog is for the semiconductor, industrial and medical markets. So, nearly all that is sole source. And we believe that all that is earmarked for specific slots. So, we don't think there's much that's perishable there. The part that is perishable is the hyperscale backlog, right? Because that's a business where there's more than one supplier for every one of those boxes. And so, we track that very closely. It's the riskiest part of our backlog, but it only represents 10% of the dollar value of our backlog. So, that's where we take a very conscious approach on buying piece parts and integrated circuits for the hyperscalers. So, we make sure that we're covered so that we don't get left with unsold inventory.

Our next question comes from Krish Sankar with Cowen.

First one, Steve, I'm just kind of curious, people do worry about next year and the macro and everything, but your number is obviously very impressive and good. But at the same time, your customers like Lam who reported last week are growing their inventory. So I'm just kind of curious, if and when a slowdown happens, is it fair to assume you might see it before your semi cap customers because they would rather drawdown from your own inventory versus buying from you?

I recently spent a lot of time with our major customers in semiconductor, almost all of them in the past month. And the message was very clear. Ship us more in the second half. So they see demand that's solid through 2023 and into 2024. And their biggest issues are basically parts issues. Typically, it's not Advanced Energy anymore. It's other suppliers. And so, the nice part about that market is with our biggest customers, we work off of hub inventories. And so, even if there's no specific need for a product today, we can still ship the product into the customer they'll put into inventory, and then they could turn that when they need it. So in addition to filling real demand today, we're also replenishing the hubs at our major semiconductor equipment customers. So, we feel very good about our ability to keep shipping at a high rate into those customers well into 2023.

And then a quick follow-up for Paul. Just a hypothetical question just on operating leverage. If for some reason, revenues are down next year, let's say, 5% or 10%, or whatever it might be, I'm just kind of curious how to think about the leverage in the model now that you also have SL Power added on to your portfolio?

I think our operating leverage is in the 40% to 50% range. On the downside, it would probably run a little bit higher than that. But remembering our gross margins, the majority of our costs are variable costs. And so, yeah, it may not have as big an impact on us as companies who have a large fixed cost base. Clearly, there are some things that we could do to manage our expenses, if, in fact, we saw revenues lower, including one of those is that every year – most every person in the company is on variable pay type program. And there's certainly variable expenses that we can manage down. At the same time, as I mentioned before, we do think that the nature of this cycle is a little different, in that it's a supply constrained cycle. And if you look at our inventories, our inventories are up, too. But they're up because we're waiting on critical parts. And we found that – we see a lot of that at our customers who have higher inventories, but they have the higher inventories . So we do think our backlog provides us some runway as we look forward, even in a softening demand environment where we believe customers will take the equipment to either replenish their own or hub inventories or areas where they've had to borrow from places to just meet their own their own demand today.

Our next question comes from Amanda Scarnati with Citi.

I've just got a quick clarification question. In terms of the impact of the new designs and sort of restructuring of some of the components versus sort of general supply easing, where did you see sort of the biggest benefit in the quarter in terms of outperformance?

Amanda, I would say that there's probably the biggest benefit in the semiconductor area. That's where we saw the biggest hit as far as the ability to turn more revenue due to these alternative IC quals and the board redesigns within semiconductor.

Just in terms of your CapEx plan going forward, I know there's plans to sort of shrink some of the capacity in Asia. But with the CHIPS Act passing and including equipment suppliers, does that change how you look at capacity in the US or through your general capacity footprint? Or are you still more concerned about just sort of right-sizing the business at this point?

We're going to expand capacity, Amanda. There's going to be puts and takes where we close some factories and open new ones because we're modernizing our operations. But I think you'll see us significantly expand capacity in the coming years, particularly in Asia. With regards to the CHIPS Act, we don't see any direct benefit. We don't expect to get any grant money or investment tax credits as a result of that bill. However, we believe that our customers will benefit significantly from that. So, anything that's good for our customers is good for Advanced Energy.

Our next question comes from Quinn Bolton with Needham.

Congratulations on the results and the outlook. I guess I've got a question about the broker channel. As I've heard more about it, it sounds like in order to win business in that channel, you often have to commit to not only the higher prices they're asking, but also minimum commitments which might fulfill your needs for multiple quarters. And so, as you guys look at the supply constraint, can you just sort of talk to us about, when you go into the broker channel, are you sort of committed to buy at these higher prices for several quarters which will keep that premium costs or that drag on gross margin high through early next year? And if that's the case, do you also see sort of just a kind of game of whac-a-mole where the components shortages, one quarter it's MOSFETs, next quarter it's PLDs, next quarter it's something else. And so even though you might have these supplies from the broker channel one quarter, a critical need comes up the next quarter and you've got to go back for a different type of component.

I'd say, first, the nature of our buys from the broker channel tend to be driven by immediate needs, not trying to fill material slots for out multiple quarters. And frankly, you can't get that many parts from these channels. It's a much more of an optimistic buy than that. And they usually might tie us anywhere from a month to a handful of months. So, I don't think there's a long risk that we bought parts that we're going to be consuming for a long period of time. They tend to be consumed pretty quickly. They kind of come in the door and right out because they're the critical parts that we're looking for. But your second comment is right. It is a little bit of a game of whac-a-mole. And there's certainly some components where supply has gotten better or we've been able to get a longer visibility of supply. And other parts that show up that hadn't been a problem, but now are a problem because there was a yield issue or there was some other issue in the supply chain and now we're not able to get parts. So I do think that the nature of these broker buys being sort of both necessary and opportunistic, is that this activity will abate as the general supply chain improves. We haven't seen that yet. And particularly on our comments, we talked about, we expect that to persist into the third quarter. But we don't see this being a long-term pattern over time. It will improve if the supply chain normalizes.

This sort of relates to my second question. Did you expect the broker or the premium buys to have that same relative 160 basis point impact in the third quarters as it did in sort of Q1 and Q2? And then a second question, I think you've mentioned you're keeping the Shenzhen facility open for longer to maintain that surge capacity. Can you give us any update on your thoughts about when you may be shutting down that line as things get back to more normal conditions?

In general, as we said, we're seeing the higher material costs persist into Q3. So, while we didn't say specifically on the broker buys, which can vary a little bit, but broadly speaking, I'd say in the same range probably makes sense. It's obviously something that's dynamic. It could increase or we could see it improve depending on how the broader economy environment goes. With respect to Shenzhen, we do expect to close that by the end of the year. And we'll keep that capacity. And as Steve said, we are adding capacity. And part of that rebalance is to ensure that we've got adequate capacity across our sites as Shenzhen closes to ensure visibility to not only maintain, but grow our semiconductor revenue

Paul, is that about 50 basis point drag for Shenzhen, is that the right ballpark?

Yeah, I think that's in the right range.

Our next question comes from Steve Barger with KeyBanc.

Sounds like you're expecting continued strong growth. When you think about what you're seeing in end markets and just the mix that you have in backlog, do you expect semi equipment continues to show higher organic growth rates than industrial and medical as you go into next year or do tougher semi comps make that slip?

We do expect to see semi continue to be strong through 2023. But we think I&M has actually got more potential because I&M has been really restrained by lack of parts. And it tends to be more of a higher mix, low volume business for us. And so, I think as we are able to get more parts for the industrial and medical business, you're going to see quite an uptick in the industrial medical space.

Really good to see your confidence in more than $6 in run rate earnings in 4Q. Given that strong demand environment and your comments on backlog, is that 150 per quarter plus kind of a minimum base case going into next year as you think about the first half, assuming you can get all the parts you need to ship?

Yeah, I think assuming we can get the parts to ship, there's upside to that number. So it all comes down to those constraints in the supply environment. And as we commented, we've seen demand remain strong. And given the proprietary or sole source nature of the backlog, we still continue to operate in a supply constrained environment, even if we saw demand soften a little bit. Ironically, some softening in macro demand might actually help the part situation, which would benefit us as we go into next year. So, we're keeping a close eye on it. But we do believe that the combination of strong markets and our backlog profile give us continued upside, all based on where we're at from a parts perspective.

And if I can just add one kind of related question, to your comment about – if things were to slow, you mentioned that you're pushing to accelerate the cadence of new product introduction, is that a function of increasing R&D spend? Or is there some internal processes you're streamlining to get things to market faster?

It's a combination. We are certainly spending more money in R&D to accelerate our technology development. But from a product standpoint, it's really how we're going to market. So, we've organized into business units, which are highly focused on our target markets on semiconductor, industrial and medical. And I think between the two, that's what's causing us to get our new product output up. And it's very important for us to continue that improved cadence as we go into 2023.

Our next question comes from Hans Chung with D.A. Davidson.

Congratulations on the strong result. So, first, can you kind of give me some color around the industrial and medical segments during the second quarter. I know that there are contributions from the SL Power. We also see very strong organic growth. I'm just kind of curious about what the driver and any color around that?

A couple of comments. I noted in my remarks sort of the organic and inorganic growth. So, we did have a strong quarter in industrial and medical. And that's driven by strength across a number of verticals. Steve mentioned several of those in his commentary around lighting, indoor farming, and more broadly. In general, industrial and medical, the demand has been strong. And it's all about the parts. So, we grew backlog, again, in industrial and medical products, and it's across multiple areas. We did add SL Power this quarter. As I mentioned, it added just under $13 million of revenue and was clearly accretive for us for the quarter. And we do think the combination of the SL Power products and the people that joined us as part of that acquisition, as well as the expansion of channel, combined with our existing footprint in medical, does give us a significant opportunity to grow in the medical market.

Regarding the target for $6 EPS run rate by end of this year, contribute from – let's say, for 4Q, assume we may see the sequential growth in top line and also probably you will see some gross margin benefit from maybe more moderate – the cost premium from the third party, the IC. And so, my question is that, what will be a major driver for you to achieve the $6 plus run rate EPS in the fourth quarter? Will that be more driven by top line or gross margin or kind of equally on both sides?

I think earlier in the year, we felt that the supply chain would be improving and we would see some of these cost premiums abate and we would get some uplift for gross margin by the end of the year, which would contribute to our gain of $6 annualized earnings per share. So, I think a couple points as we become current in that is, first of all, I think we've done a pretty good job of getting parts because our focus has been on getting product to customers. That's come at a higher cost, but we've been able to get revenue out. And so, if you look where we are today in Q2, we're actually nearing into that $1.50 per share and gross margins are sort of in the 37% range. So, I guess our comments today try to indicate that, as we get parts and are able to ship more, we'll see the volume that will support that. And also, we'll see some improvements in gross margin. But I think we're tempering our view a little bit on gross margin improvement by the end of the year based on how persistent the higher parts cost is going to be. So, we believe we can get to the $1.50 without a significant uptick in gross margin. And as that increase in gross margin comes, as the supply environment improves, that will just be additional tailwind to our financial performance.

Maybe last one quick. So can you elaborate on the new design win in the data center segment? I think you comment on that. I'm just curious what's – any color around the geography or the product line and any color? And how long it could take to convert to kind of volume order? And is that potentially is first half or second half, any color will be helpful.

We've been going through a transition in the data center market for the past year-and-a-half. So what we've been doing is focusing on more higher value-added designs. So, we could either be sole sourced or the lead source in a two source situation. And that's actually progressing quite nicely. I can't give you a lot of color as to exactly where we're playing and who we're playing with. But I could tell you that I'm pleased with the progress. At the same time, given the dynamics in the hyperscale market, which is supply constrained, we're also doing a bit better there because we're able to pass on some of the increased parts cost to the hyperscale customers. So, I'm seeing improvement in the hyperscale business, both the current business, the gross margin performance, as well as the future business we're winning today. So I'm happy with it.

Our next question comes from Patrick Ho with Stifel.

Congrats on a nice quarter. Steve, maybe first off, you've obviously shown that the production levels have increased with the last few quarters. You've talked about your Malaysian facility ramp in the past, can you give us an update on some of the efficiencies and the optimizations that are occurring there that are allowing more output to come from it, which is obviously helping your financial results?

What we've been doing there for the past nine months is basically growing our output. We're also expanding our floor space. So that's a three floor factory, and we are going to finish building up the third floor here in the next couple of months. So what we've seen is a steady increase in output out of the Malaysian factory. We've brought a new chief operating officer in September, who's made a big impact on our operations there. We also brought a new plant manager in. And so, I think one thing that I've noticed is our attrition rate has come down to below the average in Malaysia. And a year ago was much higher than average. So when you have that situation when you have a constant pool of employees, your quality goes up and your output goes up. And we've seen that in the Malaysia factory.

Maybe as my follow-up question, I know, Steve, you've been in this industry a long time. Whenever costs go up, they don't tend to go down over time. But this is obviously a very different environment. How are you passing along some of the cost increases that could be permanent on your end towards your customers? Because, obviously, everyone is trying to figure that aspect out across the ecosystem.

We actually had a major price increase that happened last fall. And those actions are never easy, right? Because nobody wants to pay more. But the way we approach that is, we basically catalog all of the increases that we were seeing across the board, not just ICs, but almost everything we buy has gone up in price. And so, we basically laid it out to our customers, this is what we're experiencing, we need some help absorbing these increased costs. And that's how we sold it. And that's basically how we'll continue to play it, very transparently with our customers. We're not adding margin to the increased costs. We're just saying, hey, we need we need to be compensated for the increased prices we're paying, particularly brokers and dealers, as well as to the manufacturers. So, it's a heavy lift. It was a heavy lift last fall, but I think the team has gotten better at it. And if we need to raise prices again this year, we know how to do it.

When we think about costs and passing them on to the customer, there's really two categories of those. One are these broker dealer costs that we think are transitory. They're very transactional. In those cases, oftentimes, we'll talk to our customers before we buy the parts about whether they're willing to help support that. And again, on those, we're just passing the cost along, they're reimbursing us, and we've had a pretty good track record. We don't recover everything, but we've recovered a lot of it. That's the premium buys. That will go away over time in our view. It's transitory. The most structural increases in price where we're seeing actually our OEMs and our other suppliers raise prices, our goal is to largely either recover those through price increases of our own or through efficiencies and other things that we can do over time. So as we think about inflation as something that's more structural, we believe that we will be able to cover that over time because it's in our entire ecosystem. We'll always be able to pass those costs along or make improvements to offset them.

Our next question comes from Paretosh Misra with Berenberg

In your semiconductor business, is there a way to think about your exposure to memory versus logic as to which of these you have a higher exposure?

Paretosh, in general, I would say we have higher exposure to logic. So the memory ups and downs affect us a little bit less than some others. If you take a look at the total WFE, just a few years ago, that memory was what roughly two-thirds of the market. Today, it's more like 40%. While it's significant, I think the logic market is bigger, both leading edge and even trailing edge. And so, we're participating in all the spaces, but we have more of our revenue weighted towards the foundry space than we do to the memory space.

With regard to your operations in China, are they now running normally? Is it still impacted by any COVID related lockdowns? And I guess, quantify the impact, COVID in Q2? Will that normalize in Q3?

Yeah, we were very fortunate that we had no lockdowns in Q2 at our Chinese factories. The only shutdown we've had this year was in March. We shut down for a week in Shenzhen, but we recovered very quickly. But Q2, remarkably, no shutdowns.

There are no further questions in queue. At this time, I would like to turn the call back over to Steve Kelley for closing comments.

Thank you much for joining the call today. Really appreciate your interest. Just some takeaways. I think Q2 was a good quarter. We were able to find more parts than we expected and turn those parts into revenue quickly. We're working hard behind the scenes, designing new products and bringing new technologies to market. And finally, we have great confidence in our ability to deliver superior, profitable growth over the long term. So, again, thank you for joining the call today. Bye-bye.

This concludes today's teleconference. You may disconnect your lines at this time. And thank you for your participation and have a great day.