Greetings, and welcome to the Advanced Energy Fourth 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. [Operator Instructions] As a reminder, this conference is being recorded. It is now my pleasure to introduce your host, Edwin Mok, Vice President of Strategic Marketing and Investor Relations. Thank you, Edwin. You may begin.

Thank you, operator. Good afternoon, everyone. Welcome to Advanced Energy's fourth 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 them 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, February 8, 2023, and the company assumes 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. Excludes our non-GAAP results are stock compensation, amortization, acquisition-related costs, facility expansion and related costs, restructuring charges and unrealized foreign exchange gain or loss. 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. Good afternoon, everyone, and thanks for joining the call. We delivered strong results in the fourth quarter, taking advantage of healthy demand, improved component availability and solid manufacturing execution. For the full year, we achieved record revenue of $1.85 billion and record earnings per share of $6.49, thanks to robust demand across all of our markets and improved execution across the company. Sales into each of our markets grew 20% or more in 2022. Overall, our operational performance improved throughout the year due to better component availability, successful qualifications of alternative parts and redesigns and good manufacturing execution. We doubled the number of new product launches in 2022. By and large, these new products employ leading-edge technology and are proprietary in nature. These products led to additional design wins in 2022, particularly in the industrial, medical and semiconductor markets. Moving forward, we expect design win activity to accelerate in 2023 as customers shift their focus from supply chain issues to product differentiation. We believe our leading-edge power delivery solutions enable our customers' new products and will fuel our profitable growth for years to come. In 2022, we successfully integrated SL Power into Advanced Energy. SL expanded our position in the medical power market where we are now one of the top players. In addition, we are adding capacity and capability at the former SL Power factory in Mexico to accommodate customers who prefer a North American manufacturing site. Now I'd like to provide some color on the current supply chain environment. Scarce components are still gaining revenue in the industrial, computing, telecom and networking markets. Power ICs and FETs are the two most significant constraints. These trailing etch products are widely used across the electronics industry, particularly in automotive and industrial applications. In semiconductor equipment, we are seeing…

Thank you, Steve, and good afternoon, everyone. We delivered strong financial results in the fourth quarter and a record 2022 as we secured additional supply of scarce components and began to leverage our backlog and low channel inventory to perform better than the market. Fourth quarter revenue of $491 million, an EPS of $1.70, both reached the second highest levels ever for the company. Overall, revenue grew 24% year-over-year and 18% organically. In the fourth quarter, backlog declined to $875 million, down from $1.1 billion at the end of the third quarter. Approximately 40% of the sequential decline came from the China-based semiconductor customer orders which we moved out of our reported backlog but were not canceled. The rest of the reduction in backlog reflected lower demand and changes in ordering patterns from our semiconductor customers as we improved our lead times. Backlog for non-semi markets remain unchanged quarter-on-quarter despite robust shipments. As we further resolve critical part issues, we expect to work down our total backlog over the next several quarters to a more normalized level of $400 million to $500 million. Now let me go over our financial results in more detail. Revenue in the semiconductor market was $232 million, up 30% year-over-year, but down 13% from a record Q3. Roughly half of the decline was a direct result of the China-based export control regulations announced in the quarter. In addition, our customers lowered their build plans in response to the current environment, which was partially offset by our ability to largely restock customer inventories back towards normalized levels. Revenue in the industrial and medical market was $119 million, up 21% year-over-year and flat with last quarter's record level. We continue to be parts constrained in this market and believe we have upside as component availability improves. Data…

Thank you. We will now be conducting a question-and-answer session. [Operator Instructions] Our first question is from Quinn Bolton with Needham & Company. Please proceed with your question.

Hey, guys. Congratulations on the strong finish to 2022. I guess, maybe Paul or Steve, I guess, kind of a big picture question. It sounds like margins are going to stay fairly flattish in the low 36% range in the first half of the year with only modest improvement expected in the second half of the year. I guess, what do you think it takes to get back to the 40%, 41% gross margins envisioned by the aspirational model?

Yeah. It's a good question. I'll take that one, Quinn. So clearly, in the near term, we continue to be impacted by higher material costs. And we expect those to begin to abate largely in the second half. We'll still see those through the first half, just given the timing of these costs rolling through our inventories. Now we do expect to see them to start to pick up in the -- later in the year, which will give us some improvement certainly as we have an exit rate to 2023. But the offset to that is we're not anticipating any pickup in volumes from these levels. In fact, our second quarter may even be down a little bit from this quarter as we won't get some of the restocking shipments we expect in the first quarter. So based on that, we'll see headwinds from volumes. But as volumes begin to recover and as the actions that we are taking over the course of the year to optimize our footprint take hold, then we expect that we'll be back on that track to get back to 40% or greater.

Got it. And then I guess, I think you kind of hinted at the answer to my next question, but just give us a sense where you are in terms of the jet bins (ph). It sounds like you had an opportunity to begin restocking those in the fourth quarter and you expect to restock perhaps more in the first quarter, but it sounds like am I right to assume that by the end of the March quarter, you're probably back to normal levels in terms of jet bins or inventory levels at your semiconductor customers?

Yeah. That's right. We definitely saw some benefit of that in the fourth quarter. And as I said, in my comments, we've been able to largely restock those. Now there's a little more to go, so we'll get a little more benefit in the first quarter. But we anticipate that, that will be -- customers will have the inventories they would like on their shelves by the end of the first quarter.

Got it. Okay. Thank you.

Thank you. Our next question is from Scott Graham with Loop Capital Markets. Please proceed with your question.

Hi. I'm here. I'm sorry, a little technical…

Hey, Scott.

Hey, same thing. Congrats on a good finish to the year. Couple of questions, so you're looking -- the backlog where it is, you're looking to bring that to -- I think you said -- you either said $400 million to $500 million or down -- I think you meant maybe I misunderstood down by $400 million to $500 million. Could you -- how does that -- how does that play out? I'm sorry, I just missed that when you said it.

Yeah, no worries. We expect that backlog, we'd like to bring it to about $400 million to $500 million. We think that's a reasonable target level. That would actually be probably a little more than historical levels. But just given the nature of the markets, these days, we think that's a more normalized levels. And as we said, we expect that to happen over the next several quarters. We continue to have a very healthy backlog. As we mentioned, our non-semiconductor backlog actually increased for Industrial and Medical and was about flat for the others. So it's actually continues to be an opportunity for us as we get some of the critical or scarce parts in to be able to bring in our lead times, bring that backlog into more normalized levels, and we expect that will happen over the next several quarters.

Thank you, Paul. And then can you just remind me the -- or maybe just tell us the $875 million, how does that split by business?

Yeah. We haven't historically broken that out. But as I mentioned, the backlog reduction this time was largely concentrated or entirely concentrated in semiconductor, in part because we removed some backlog out of our reported backlog, the China orders, that was about 40%. And the rest was really a rebalancing in our semiconductor markets. We were able to fill in some of the bins, as I mentioned in my earlier question, we've been able to bring our lead times down. And of course, our customers have reacted to the lower demand environment and brought their orders down. So if you look outside of semi, our backlog was about flat from last quarter, reflecting really stronger demand across those markets and continues to represent an opportunity for us to bring that more in line and either buffer lower demand if that happens in the future or deliver some upside if we can get additional parts as we go forward. But our goal would clearly be to try to bring that backlog and therefore, our lead times more in line with that $400 million to $500 million target.

I got you. And then last one for me, just a quickie. The gross margin guide for the first quarter, low 36s. I'm surprised you didn't mention mix as one of the key components of the delta. Where does mix fall in that?

Yeah. I think mix does have some impact, certainly, as we go from the second -- from the fourth quarter to the first quarter. But if you look at overall sort of the combination of the actions we're taking a little bit fewer of the PPV recoveries, we still expect to have higher material costs but less recoveries. Those things tend to -- are kind of tending -- and the actions, like I said, we're taking are kind of offsetting the impact of the lower volumes overall. So net-net, we expect to be down a little bit. It's actually, we think, pretty good from a delever perspective to hold margins, I'll say, down a little bit or down to flat. And it's a function of the actions we're taking and some improvement in material costs offsetting the other items. As we think as we look forward, we think we can probably hold gross margins and trough margins around 36%, I'll say, plus or minus, depending on volumes and where the markets go. But that's kind of how we're thinking about it. And as was asked earlier by Quinn, particularly in the second half as these material costs subside, the impact -- full impact of the actions we're taking to optimize our factory footprint. Those should help to see a little margin improvement in the back half of the year, but really position us in 2024 to see either continued margin improvements at sort of the similar lower levels or if we see revenues pick up a little bit, be able to kind of accelerate back towards our 40% target.

That’s great. Thanks.

Thank you. Our next question is from Krish Sankar with Cowen and Company. Please proceed with your question.

Yeah. Hi. Thanks for taking my question. I had a couple of them, too, Paul, just to follow up on your earlier comments. You mentioned second half gross margins should improve and some of these cost reduction and other factors should offset volume declines. I'm kind of curious, what is your visibility today? Because if I try to triangulate your answers, it seems to me that the brunt of the revenue decline happens in the first half and it kind of starts bottoming Q2 or Q3 on a sequential basis and improve into Q4. Is that the way to think about linearity of revenues this year?

Yeah. We have to -- obviously, we're operating in this market where semi is down this coming year. But as we look at overall, we expect semi to be down and we expect our other markets to be generally about flat or relatively stable overall. And so from an operating perspective, the way we're planning is -- you're right, we expect most of the brunt to be here in the first quarter, perhaps a little more in the second quarter, particularly as we won't have the benefit of the inventory stocking on the semiconductor side. And to kind of bounce around those levels for the balance of the year. I think that's generally consistent with how people see the market right now. Obviously, it's hard to look out that far and know for sure. But that's our operating assumption. And the gross margin color I give sort of reflects that type of a revenue projection.

Got it. Then I had two other questions. One is obviously, last year, you guys did really well outperforming WFE. Typically, component company center underperformed WFE during down year. So I'm just kind of curious if you think WFE is down, pick a number, 20% or 25%. How to think about your semi revenues relative to where WFE ends up this year? Would you be in line, worse, better than that? And then I had a quick follow-up.

Yeah, Krish, I'll jump in here. I think the first thing we should talk about is the fact that AE now is 50% non-semi as well as 50% semiconductor revenue. As we said before, we think the non-semiconductor revenue we could hold that flattish year-on-year. So that's quite a cushion for us compared to past semiconductor downturns. And within semiconductor, we think -- we do have pockets of strength in our service business is much larger and stronger than it's been in past downturns. We've got a very good position in ion implant. And as you know, there's still a lot of demand for ion implanters out there as people try to address the power IC shortage. And then we've got a number of new product ramps that are happening across the application set in semiconductors, which serve to offset to a certain extent, some of the downdraft in semiconductor.

Got it. Thanks, Steve. And then just a final follow-up on the backlog. I think, Paul, you mentioned normalized backlog of $400 million to $500 million. Is it fair to assume you probably get to those levels in a couple of quarters if revenues continue to decline? And at that level, is it roughly a 50-50 mix of semi and non-semi?

I don't know how long it takes. It kind of depends on the demand environment, but we've already seen sort of I'll say, a pretty good reset of the semi backlog this quarter. We took out the China demand, and we've normal-- we've adjusted that basically to our customers' outlook at this point. So the balance, if you think about where most of the rest of the backlog is in our industrial and medical areas, which I said, despite kind of, again, near record shipments, that I&M backlog was up again this quarter. So it depends a bit of a function on the demand, how well the demand for these other markets continues. We think that looks relatively stable, all things considered. And then our ability to solve critical parts and actually eat into that backlog and bring our lead times down. So that's a little bit how we think of it. My sense is, it will take a few quarters to roll that down. I doubt that, that's going to get to our target range in a quarter or two.

Got it. Thanks a lot, Paul. Thanks, Steve.

Thank you. Our next question is from Atif Malik with Citi. Please proceed you’re your question.

Hi. Thanks for taking my questions and nice execution. First, Steve, if you can talk about what you're seeing on the data center market and maybe if you have color enterprise versus cloud, we have been hearing about moderation in that market. Your comments on backlog indicate that you're seeing stability in that market. So what are you seeing in the data center market?

Yeah, it's interesting. We obviously have strong participation in that market. I could say that we have not seen major changes in demand. In fact, we're still supply constrained in that market. And our customers in the hyperscale market are constrained by power supply manufacturers like us, quite frankly. So what we're seeing is continued pull from the customers but we're also seeing a transition happening. And it's moving in our favor basically. We see the move to 48 volts. It's starting to accelerate. We are the leader there. We were the first and we're still the best technology for 48-volt type hyperscale applications. We see a strong move to higher efficiency as the cost of electricity go up and the environmental concerns become more prominent, we're in a good position because we have the most efficient solutions. And finally, we see a strong move to artificial intelligence which increases GPU and memory intensity. And it really places a premium on power density, and that's also an area where we excel. So I think over the medium to long term, we're well positioned to gain share because of these technology advantages we have. In the short term, we see demand still being pretty strong, but gated by component availability.

Great. And a follow-up for Paul. If you can touch on restructuring and are there opportunities for fixed asset optimization as you guys head into a downturn and eventually come out? Are there areas where you can prune some products or businesses to lift up to those gross margins? Thank you.

Sure. So as we announced a plan for restructuring, this is largely around optimizing our footprint and a few targeted reductions around the company. We do think that our goal as part of this isn't just to try to match headcount to some level of production or output but is actually to improve our footprint. So we want to move products from some of our smaller factories and leverage those around our larger factories. There's areas where we're going to make some investments. As Steve mentioned, we'll expand our newly acquired footprint in Mexico because we think that's an attractive place and gives us some strategic benefit in North America. And our larger factories will continue to optimize those around efficiency and capabilities. So we would expect to come out of this with, I'll say, maybe a little bit smaller footprint, certainly from a headcount perspective, but a more efficient one and an ability to scale better as we move into the next upturn.

And just to address your question about exiting businesses, we have no intention of exiting any business. And we had some concerns about the computing and networking businesses a couple of years ago. And I could say we've done a really good job improving the bottom line performance there. So I'm much less concerned than I was two years ago. We've also done a good job refocusing our resources on proprietary opportunities within those market spaces. And so between a better job managing our pricing tactically and a better job focusing on higher-value opportunities, I think that business is looking much better.

Thanks, Steve.

You’re welcome.

Thank you. Our next question is from Steve Barger with KeyBanc Capital Markets. Please proceed with your question.

Thanks. For the expected acceleration of new product wins and design wins this year, do you expect more traction from modified standards or full custom solutions? And can you talk about how those compare just from a time to market and margin perspective?

Yeah, Steve. I think it's a combination of both, quite frankly. The important thing is that we're introducing a lot more new platforms. That's across semiconductor, industrial and medical as well as in the high-volume areas like data center. And what happens with those new platforms, it goes one or two ways. The customer will say, hey, this meets our needs, but I need a few changes, and that's a modified standard or the customer will say, you're pretty close, but I need some significant changes. And I'll leverage what you have but I need this other feature as well. And that's more of a custom product. But either way, we're happy with it because at the end of the day, it ends up being a sole-source product and a source of revenue for many years to come.

Is there a big difference in dollars and margin between the two?

Not really. So the full custom products tend to go to large customers, so they're higher volume, typically. So they require more engineering investment upfront, but then the volumes and the dollars will be higher with those types of products. The modified standards tend to be more towards small and medium-sized customers. The engineering effort is much less. But the gross margin percentage for both of those products is similar.

Got it. And you said there's a strong network of distributors and value-added resellers. Are you fully covered in those channels, especially in the newer markets, medical and industrial, in terms of geographies? And can you talk about the mix impact of having more product go through those channels versus direct sales?

Yeah. If I look at our position relative to our competitors, I think we have more of a worldwide footprint than most. So we have strong organizations in Asia, Europe and North America. That said, there's a lot of improvements we can make, and we're doing that. And so we've held sales conferences in the past year in all regions and really tried to align our internal sales teams with our external partners and make a much more concerted effort trained to penetrate industrial medical customers. So I have high hopes that we could do a lot better this year and in 2024.

Understood. Thanks.

[Operator Instructions] Our next question is from Pavel Molchanov with Raymond James. Please proceed with your question.

Thanks for taking the question. Given the macro headwinds on the demand side that you've outlined today, I'm curious if the M&A landscape in terms of kind of prospective target-rich environment is perhaps offering better opportunities now than it was in happier times 12 or 18 months ago.

Yeah. I'll take that one, Pavel. We think the environment today for strategic buyers is better than it was last year or in 2021. So that's a positive. I think many of the companies that operate in our space, have been handicapped from the past two years due to the part shortages. And so I think some of those shortages are starting to go away. And I think they're probably going to realize this is about as good as it's going to get, right? So there's some demand challenges, but the financial performance they come up with in 2022 will lead to I think, more reasonable valuations as we engage with those targets. So yes, the bottom line answer to your question is, I think it's a more favorable environment, and we'll take advantage of that.

And from a balance sheet perspective, I think the last two quarters, you had kind of de minimis share buyback and not much M&A recently. So you'll be pretty soon in a sizable net cash position. What are your thoughts on kind of openness to lever off the balance sheet if needed for the right opportunity?

Yeah. You're right, Pavel. We have a good balance sheet. We have net cash, again, after a brief time when we were about cash and debt equal. And we should generate cash during the downturn here. And we're fortunate that we have a very good credit agreement in place that's relatively low cost that we can extend either through a line of credit or through some accordion features that are within it. So I think we have capacity if we saw the right opportunity to be able to use both our balance sheet and our credit position to make that acquisition. At the same time, we're going to balance to make sure that's the right return. Money cost more these days and also ensure that we don't over lever the company. So we, in general, have a target of not going beyond 3 times a leverage ratio. And so you would manage all those things to make sure that we add value through any M&A that we did.

And then just lastly, a quick point of clarification. With the shutdown of Shenzhen, what is the manufacturing footprint of the company right now?

Yeah. It's really three main areas where we have large factories. We still have one in China. We now have a large and very good factory in Malaysia, and we have footprint in the Philippines. We also have a handful of, we call them, kind of boutique factories in different places aligned with local engineering teams for some of the acquisitions we've done over time.

Very clear. Thank you, guys.

[Operator Instructions] There are no further questions at this time. This concludes today's conference. You may disconnect your lines at this time. Thank you for your participation.