Greetings, ladies and gentlemen, and welcome to the Ichor Third Quarter 2021 Earnings Conference Call. [Operator Instructions] As a reminder, this call is being recorded. I would now like to introduce your host for today's conference, Claire McAdams, Investor Relations for Ichor. Please go ahead.

Thank you, operator. Good afternoon, and thank you for joining today's third quarter 2021 conference call. As you read our earnings press release and as you listen to this conference call, please recognize that both contain forward-looking statements within the meaning of the federal securities laws. These forward-looking statements are subject to a number of risks and uncertainties, many of which are beyond our control and which could cause actual results to differ materially from such statements. These risks and uncertainties include those spelled out in our earnings release, those described in our annual report on Form 10-K for fiscal 2020 and those described in subsequent filings with the SEC. You should consider all forward-looking statements in light of those and other risks and uncertainties. Additionally, we will be providing certain non-GAAP financial measures during this call. Our earnings press release and the financial supplement posted to our IR website, each provide a reconciliation of these non-GAAP financial measures to their most comparable GAAP financial measures. On the call with me today are Jeff Andreson, our CEO; and Larry Sparks, our CFO. Jeff will begin with an update on our business and a review of our results and outlook, and then Larry will provide additional details of our third quarter results and fourth quarter guidance. After the prepared remarks, we will open the line for questions. I'll now turn over the call to Jeff Andreson. Jeff?

Thank you, Claire, and welcome to our Q3 earnings call. Q3 revenues were $263 million, which is $27 million below the low end of guidance provided on August 3. While the low end of our guidance had factored in the impact of the reduced workforce and the 2-week factory shutdown in Malaysia, our plans to adjust to continued limitations in Malaysia also included shifting supply to our other sites that manufacture weldment. Unfortunately, the plan to fully recover the lost capacity took longer than anticipated. The combination of these had a direct impact on our gas panel integration business and our ability to ship gas panels at the forecasted run rate in September. In simple terms, the $27 million below the low end of guidance equates to approximately 1.5 weeks of gas panel output. As for the mid- to high end of our revenue guidance range, those had assumed a more aggressive ramp and recovery of the lost capacity. I'd like to take a step back to review a bit more in detail the issues that affected our Malaysian factory over the past several months. In June, the Malaysian government issued an enhanced movement control order that initially limited our workforce to 60%. We saw the COVID cases increasing in early Q2 and built inventory ahead, which enabled us to offset some of the impact for early July. We operate in the Southern portion of the country, near Kuala Lumpur, which had a much higher rate of COVID cases, and this led the government -- to the government's decision to shut down most businesses in the region in July. We manufacture about 50% of our weldments in this facility. And between the 2-week shutdown and prolonged output constraints, we lost about 40% of our output through mid-August. The majority of…

Thanks, Jeff. First, I would like to remind you that the P&L metrics discussed today are non-GAAP measures. These measures exclude the impact of share-based compensation expense, amortization of acquired intangible assets, nonrecurring charges and discrete tax items and adjustments. There is a very helpful schedule summarizing our GAAP and non-GAAP financial results, including the individual line items for non-GAAP operating expenses, such as R&D and SG&A, in the Investors section of our website for reference during this conference call. Third quarter revenues were $263 million, up 15% year-over-year with a 7% decline from Q2, due to the limitations in Malaysia and supply chain challenges Jeff discussed and the resulting impact these had on our overall gas delivery subsystem output. Given the challenging operating environment, we are pleased with our gross margin and profitability performance in the quarter. Gross margin of 16.7% was similar to last quarter as continued cost-reduction programs and favorable product mix were offset by labor inefficiencies due to the lower factory volume. Compared to the third quarter of 2020, gross margin increased 210 basis points, and the flow-through on the incremental revenue volumes year-over-year was above 30%. COVID-related impacts on our gross margin continue and are primarily related to higher freight and logistics costs. The impact of these higher costs on our gross margin remains around 50 basis points and are expected to persist for the foreseeable future. Q3 operating expenses were $16.3 million, slightly below forecast due to the timing of new product engineering materials purchases. Operating margin of 10.5% was 65 basis points below Q2 and 220 basis points above Q3 of last year. For the 9 months of 2021, operating margin has increased 300 basis points over the same period last year. Interest expense for Q3 was $1.5 million, down slightly from Q2,…

[Operator Instructions] Our first question comes from the line of Craig Ellis with B. Riley.

And thanks for the detailed discussion on the operating items affecting the quarter. Jeff, I wanted to follow up on that. One of the questions I've gotten from clients is regarding market share implications for what happened operationally and with an impact to both weldments and gas panels. What's the company's view on whether or not there was any market share implication from what occurred?

Well, Craig, thanks. Thanks for those comments on our Malaysia update. I appreciate that. I think as you think about share shifts, we don't see any real change in our customer strategies. If there's any share shifts, I would say they're temporary in nature, and I would say they would be largely around our weldment business. And so if I looked at Q3 and Q4, if I was just to put a number on it, I'd say it would be no more than $10 million or $15 million that our customers would have had to reposition to support their business, in lieu of some of the constraints we had coming out of our weldment factory. So I hope that kind of helps put a frame around it.

Yes. That's great, Jeff. And then nice to hear the very constructive calendar '22 color. The question is just given the nice growth that we're seeing in the fourth quarter, although some of that is facilities just getting ramped back up to normal, how should we think about what's possible as you move through calendar '22? Not looking for specific guidance, but the company has been investing to build its capacity to $400 million, which is 33% above the level that we'll exit this year. So any color on how things could proceed would be quite helpful.

Yes. I think our view of next year is going to be revenue -- or market growth of -- in the 10% range. So we're certainly going to see growth year-over-year. I think as we kind of look at our early part of next year, we see steady growth from Q4 into Q1. Some of that may be muted by the supply chain constraints that we're all seeing. But I -- you would hope that those will begin to lessen. So I think we'll see steady growth into next year. Now I couldn't actually predict the quarter-to-quarter and the size. But one question that probably comes up is, as you recover a lot of this shortfall this year of -- does it fall into next year? The answer is yes. I would say a large portion of this will continue into next year, but I don't expect a huge step function in the first quarter, but hopefully, we see steady improvements throughout the year after that.

Got it. And if I could just -- yes, yes. And if I could throw one in for Larry. Larry, we're -- despite mix, we're staying at high levels on gross margin. We'll get volume help as we go through next year. But is it going to be volume help that really is averse to gross margin? Or how should we think about gross margin potential as the business continues to grow sequentially?

I think we’re modeling and expectations to continue on 10 to 20 basis points improvement as we kind of go into 2022. You will have an increase in gas panel absolute business. But I think our plan is to continue to push on the component side of the business as a higher percentage of our overall revenue, which, as you know, between the precision machining businesses and kind of recapturing some of the weldment business, I think those will help us and be very margin accretive as we go through the year. So we did it this year, and I think the expectation is we will do that next year. So we’re expecting to continue this kind of march up in gross margin as we go into 2022.

Our next question comes from the line of Tom Diffely with D.A. Davidson.

So Larry, just to follow up on that. It sounds like over the last year, you had a 30% incremental gross margin, which is obviously quite impressive. But what would you say the natural incremental -- transient margin is on the incremental dollar of revenue on a go-forward basis?

We've been around 20%, I think, when you look at the mix -- combination of mix and the cost improvements.

Okay. So what was the big difference over the past year that drove it up to 30%?

I think there was a few things. One is the -- we did some cost-reduction activities. We talked about closing the Union City business and changing our cost profile there. But I'd say one of the biggest components is really around precision machining and growing that piece of the business as a percentage of our overall revenue profile. I'd say if you take that, combine with a few of the other cost initiatives we had around materials and a few things, that's really what's driving us a little bit better.

Okay. Great. And then, Jeff, when you look at your both next-generation gas panel and your liquid delivery system, which do you think is going to be the bigger driver in 2022? And which one is the bigger driver ultimately?

I think next year, the bigger driver will probably be some of the success in the liquid delivery module, the chemical delivery systems that we have. If those evaluations complete and ramp up, those are fairly large wins for us. And they're -- you're going to be designed in on a new generation of a tool. I think longer term, obviously, the next-generation gas panel will have the biggest effect on the company and its profitability profile as we add more and more content onto the gas panel that we manufacture and design.

Okay. Great. And then just finally, when you look at the hiccups over the last quarter or so with manufacturing, has that changed your long-term process at all? Are you doing anything on a more permanent basis, like keeping a higher inventory level going forward? Or any changes that might be more permanent?

Yes. I think – I hate to use the term 2020 hindsight, but I think you’d learned from these events. I think that there are some inventory positionings that we could beef up and even in respect to some of the other supply constraints. So I do think we will look at things differently. We’re also looking at things geographically differently as well. We haven’t solidified any of those plans as we’re kind of managing through this phase, but they’ll definitely be considered going forward. And the industry is only getting bigger. So it’s kind of why we’ve had a few hiccups this quarter in challenges. It’s a pretty exciting place to be right now.

Our next question comes from the line of Quinn Bolton with Needham & Company.

Jeff and Larry, I wanted to ask about the lower fourth quarter revenue guidance relative to 90 days ago. Can you sort of walk us through what the impact there is? Did you still see some impact in early October from the lower weldment shipments coming out of Malaysia that affected gas panel integration? Or could it be some of that $10 million to $15 million potential share-shift that you had mentioned in response to Craig's question?

Yes. Good question. What I would tell you is our factory in Malaysia is fully operating, and maybe there was very little effect on early October. I mean, as we look at October versus, for example, last quarter, we're seeing a kind of a higher run rate of revenue already, which gives us some confidence that we're seeing some improvements along other supply chain challenges. But I would say, as you look at it, I'd really say it's the other supply chain challenges that are muting it. I think we have some recovery to do in weldments, but the vast majority of that is related to other issues within the supply chain that you've heard. These are very persuasive -- pervasive across the industry and the sub-tier suppliers as well.

Got it. That's helpful. And then I guess the second question is just as you go through this period of disruption in weldments and gas panel integration, is that prompting any audits or sort of OEM customers coming in to kind of do a review of the supply chain? Or do you think they understand sort of that this was a kind of COVID effect in Malaysia? It wasn't specific to the company. It's pretty broad-based across the country, and it hasn't prompted any new reviews or audits or anything like that?

No. I think the simple answer is no, but I'll expand on it. I mean, we work extremely close with our customers all the time. And there's always a review of your continuity of supply and working with our customers. So there's nothing new that would happen. That's a normal course of business. I think I wouldn't say we're 100% unique, but the Southern portion of Malaysia was hit really hard with COVID cases. And so it was unique to a very few number of suppliers, whereas a lot of the suppliers you here that in Malaysia are out in the Penang area, which is in Northern Malaysia. So a bit unique to those of us that operate in the Southern portion.

Got it. And then just last quick one for Larry. The $400 million of annual revenue capacity, when would you think you hit that? Is that something you achieve in calendar 2022? Or is that a longer-term capital investment plan?

Well, it's a longer-term plan. I think, for us, we have to be -- plan our capacity well ahead of the requirement. Our customers want to see that, especially we're talking about brick-and-mortar and some of the longer lead-time capacity investments. So that's -- we have to put that in place. I mean we talk about 10% growth year-over-year, and we'll continue to fill that up as we go through '22 and into '23, I think.

Yes, I think the way you can think about it, Quinn, is that at $400 million or so of run rate, that’s, say it’s $1.6 billion versus what we’re estimating now. And that’s quite a large increase in WFE. So this will support us for several years, if not 3 or 4. We’ll have pockets of investment in machining and things like that, that will continue. We want them to continue to outgrow WFE. But I think largely brick-and-mortar and integration side, we’re in pretty good shape with the plans we have today for several years out.

Our next question comes from the line of Krish Sankar with Cowen.

This is Steven calling on behalf of Krish. Jeff, maybe first question for you on your gas delivery products. Historically, I think the gas liquid products have had very low inventory since their customized products. I was curious like what are your cycle times today for those products compared to the typical average of like 4 to 6 weeks?

That's a good question. I mean, I think what you're saying is, I mean, our lead times are definitely expanded with our customers given some of the supply constraints. But I mean, typically, if we are operating in a normal environment, they would be under a month, and they're probably longer than that by a week or 2.

Got it. Got it. And then just sort of one other longer-term question related to, I guess, your expectations to outgrow WFE next year. I know you're not providing any long-term forecast right now, but just given the sort of the urgency to add headcount sort of in the near term here as you're recovering from the issue last quarter, I was curious like sort of your headcount growth plans going into early next year? If you could provide a little color on that, that would be helpful, like in terms of the growth rates will be significantly greater than what has been growing the last couple of years? Or will it be more in line?

I’m not sure I understand the question, so I’ll start to answer it. You tell me if I’m on the right track. First, I don’t think that our biggest issue is getting people. It’s a little tougher now, but we’re – we are adding heads fairly consistent. And so most of it is the effect of some of the supply chain that keeps your factories less efficient. So that’s actually – once the efficiency level comes up, that’s going to help reduce the need to add kind of rate-per-rate people in the next year. Our labor content, generally in the gas delivery area is pretty low. I won’t give you a specific number, but it’s below kind of 5% of total costs. So we’ll continue to focus on hiring in advance of the revenue outlook that we have. Today, I don’t – we would like to see it faster, but it’s not like it said it’s standstill. People are coming back to work.

Our next question comes from the line of Patrick Ho with Stifel.

This is Brian calling in for Patrick. A few questions. Maybe first -- yes, maybe conceptually, maybe directionally and if you want to, you can quantify. But from a gross margin standpoint, thinking about sort of the 16.7-ish level here in 4Q, roughly in terms of gross margins, and thinking about the initiatives you talked about, Jeff, and kind of the beta tools that you're going to get higher gross margins on and sort of the 6-month qual times, you may start to dip into some of that favorable mix second half of next year. Can you talk about relative to sort of the 4Q this year? Where you think your gross margins -- assuming we're kind of in that growth mode year-over-year still relative to this year, what those gross margins could kind of look like? Could we be at 17% year-end? Any sort of commentary would be helpful.

I'll start, and Larry can add if I missed something. But you're talking about 17% at the end of 2022. Because I think Larry basically said, given where we're at today, we see relatively flat Q4 gross margins. But he also indicated that kind of the area of gross margin improvement will be between 10 and 20 basis points on a quarterly basis. So certainly, we would be unhappy if we didn't have a 17 on the gross margin by the end of next year.

Okay. Got it. I was talking about just like the year-end, not necessarily the full year, right?

Okay. Yes.

That's helpful. And then maybe in terms of -- you talked about sort of the refi and the additional flexibility it gives to the company here moving forward. Obviously, we're hitting levels on the house that people don't expect to in terms of the WFE number, and it's expected to go higher next year. And obviously, it's hard for a lot of suppliers to keep pace in this kind of a growth environment and this quickly. So I mean, are you seeing that in terms of sort of the landscape out there, of the vast supplier landscape? It's pretty ripe maybe for further kind of consolidation at the moment. And does that kind of play into some of the moves you've made recently?

Well, what I would tell you is we’ve been pretty consistent that the kind of the M&A landscape is pretty active right now. And beyond that, I wouldn’t comment about anything specific, but you do know that we’re looking for a higher IP content, higher margin type acquisition. So obviously, when we did the refinancing, part of it was just the rate environment was really good. We’re coming up on getting within a year of our last 5-year debt, and we wanted to refinance it between now and say, I don’t know, February of next year. So – but in doing that, the company has grown. This added some flexibility going to $400 million from $300 million. And so it does give us better flexibility to do M&A, and it gives us more capacity to do a larger-scale M&A should the opportunities be out there that fit for us.

Thank you. Ladies and gentlemen, this concludes today's question-and-answer session. I would now like to turn the floor back to Jeff Andreson for closing comments.

Thank you for joining us on our call this quarter. I’d like to thank our employees, suppliers and customers for their support and strong execution in this historic demand environment for the semiconductor industry. We look forward to updating you on our next earnings call in early February. In the meantime, we hope to see you at one of our Q4 investor conferences, such as the CEO Summit at SEMICON and those being hosted by D.A. Davidson, UBS and Stifel. Operator, that concludes our call.

Thank you. Ladies and gentlemen, thank you for your participation. You may disconnect your lines at this time.