Keysight Technologies, Inc. (KEYS) Q3 2015 Earnings Report, Transcript and Summary

Ladies and gentlemen, and welcome to the Keysight Technologies Fiscal Third Quarter 2015 Earnings Conference Call. My name is Mike and I will be your lead operator today. After the presentation, we will conduct a question-and-answer session. Please note that this call is being recorded today, Wednesday, August 19, 2015 at 1:30 P.M. Pacific Time. I would now like to hand the conference over to Jason Kary, Vice President, Treasurer and Investor Relations. Please go ahead Mr. Kary. Jason A. Kary - Treasurer, Investor Relations & Vice President: Thank you, Mike, and welcome everyone to Keysight's third quarter earnings conference call for fiscal year 2015. With me are Ron Nersesian, Keysight President and CEO and Neil Dougherty, Keysight Senior Vice President and CFO. Joining in the Q&A after Neil's comments will be Guy Séné, Senior Vice President of Measurement Solutions and Worldwide Sales and Mike Gasparian, Senior Vice President of Customer Support Services and Marketing. You can find the press release and information to supplement today's discussion on our website at investor.keysight.com. While there, please click on the link for Quarterly Reports under the Financial Information tab. There you'll find an investor presentation along with Keysight's segment results. We will also post a copy of the prepared remarks following this call. As usual, today's comments by Ron and Neil will refer to non-GAAP financial measures. You will find the most directly comparable GAAP financial metrics and reconciliations on our website. We will make forward-looking statements about the financial performance of the company. These statements are subject to risks and uncertainties and are only valid as of today. The company assumes no obligation to update them. Please review the company's recent SEC filings for a more complete picture of our risks and other factors. And now, I'd like to turn the call over to Ron. Ronald S. Nersesian - President, Chief Executive Officer & Director: Thank you very much, Jason and hello, everyone. To start, I have three headlines to share with you regarding Keysight's Q3 results and our recent acquisition. First, despite challenging market conditions, Keysight delivered solid profit and cash flow. This was the sixth quarter in a row that we delivered financial results at or above the midpoint of our revenue and EPS guidance. Second, our strategy to grow in wireless communications and software businesses took a major step forward this quarter when we announced the Anite acquisition and closed it two months ahead of schedule. Third, our fiscal year 2015 guidance reflects our revenue and operating profit overperformance in Q3 and a slightly improved outlook for Q4. Now, let's move to the specifics of Keysight's performance. We had a strong profit performance despite a challenging market environment. Our operating discipline enabled us to perform better than expected in orders, revenue and profit. Q3 orders were down 5%, primarily due to two factors: Greater China and currency. Core orders, without currency and acquisitions, were down 1%, largely due to weakness in Greater China. While this is not desirable, it is a noticeable improvement from the Q2 core order decline of 8%. Q3 revenue, driven by weak orders in the previous quarter, was down 12% or 9% on a core basis. As we anticipated this result, we used our flexible operating model to generate non-GAAP EPS of $0.55, which was $0.11 above the midpoint of our guidance. Neil will discuss the balance between flexible spending and one-time benefits for future modeling. As this is the sixth quarter in a row that we delivered results above the midpoint of guidance, we feel very good about our operational capabilities as an independent company. Strategically, our focus remains on addressing the customer needs of the faster growing market segments in electronic design and test. Our first area of focus that we outlined over one year ago are realizing solid gains. Wireless communications, modular instrumentation and software solutions. In fact, we accelerated our efforts in both wireless communications and software by announcing in Q3 our intention to acquire Anite. We closed the transaction just last week, two months ahead of schedule. Anite is the leading supplier of test and measurement solutions to help customers develop software and optimize performance in the wireless communications market. This acquisition expands our solutions offering in wireless R&D design and test specifically into the software layer for design and validation. Coupling Keysight's expertise in helping customers design and test hardware, with Anite's leadership in helping the same customers design and test software, we can now provide customers with the most comprehensive wireless solutions for both the hardware and software layers. Anite also has a Network Test business that brings innovative solutions that help deliver an outstanding experience for mobile users in the network. The Network Test business expands Keysight into an adjacent market and increases our overall served addressable market by about $500 million. We are excited to have the talented Anite team join us as they bring a new set of skills, capabilities and opportunities to Keysight. Anite will provide $0.14 to $0.17 of accretion in FY 2016. It will also deliver at least 15% return on invested capital by year five. In addition to Anite's contributions, we continue to make progress on our growth initiatives. In wireless communications, we recently announced 5G collaborations with NTT DOCOMO in Japan, and KT in South Korea, and we joined the mmMAGIC project, a European Commission 5G effort. These early 5G collaborations add to our growing list of engagements with market-making customers, consortia and universities. In modular, Keysight's PXI and AXIe modular business continues to generate very strong growth year-over-year, driven by new products and our success in the Wireless segment. In summary, despite a down revenue quarter, Keysight delivered better profitability than expected in Q3, and we see a slightly improved outlook for Q4. This contributes directly to our full year guidance in which revenues are expected to be in the range of $2.84 billion to $2.88 billion and non-GAAP earnings per share are expected to be in the range of $2.38 to $2.52. At this point, I will turn the call over to Neil to provide details of Keysight's financials. Neil P. Dougherty - Chief Financial Officer & Senior Vice President: Thank you, Ron, and hello, everyone. Keysight had solid profit performance in a quarter where seasonally soft revenue was compounded by the impact of our weak Q2 orders. The order picture improved in Q3 with orders down 1% on a core basis versus a core decline of 8% last quarter. We actually saw core order growth in all regions with the exception of Greater China and had a book-to-bill ratio above 1. Third quarter revenues of $665 million were down 12% year-over-year, or down 9% on a core basis, which excludes the impact of currency and acquisitions. The regional breakdown of revenue was in line with prior periods, with 37% of revenues coming from the Americas, 18% from Europe and 45% from Asia. On a core basis, revenue was down 11% in the Americas, down 5% in Europe, down 14% in Asia excluding Japan, and up 14% in Japan. China revenues were down double-digits in Q3 versus a particularly strong compare. Despite the softer top-line, profit performance for the quarter was solid with Q3 operating margin of 18.6%. After applying our 17% non-GAAP tax rate, we generated non-GAAP net income of $94 million or $0.55 per share. We did benefit from $5 million in one-time items this quarter, which improved our operating margin by 75 basis points and our EPS by $0.03. Even after adjusting for these favorable benefits, our profit performance illustrates the strength and flexibility of our operating model. Gross margins improved 110 basis points versus last year on much lower revenue. Among the drivers of this improvement was a higher mix of sales to R&D versus manufacturing customers and disciplined pricing management. Expenses were well controlled during the quarter as our flexible business model enabled us to manage our cost structure in response to business conditions. Currency continued to provide a significant revenue headwind in the third quarter, reducing the top-line by four percentage points. Despite this impact, exchange rate movements had no material impact on our Q3 earnings, as the unfavorable impact on revenue was offset by a favorable impact on expenses. Now, turning to cash flow, in Q3 Keysight generated cash from operations of $135 million and had $35 million of capital expenditures. This resulted in $100 million of free cash flow. We finished Q3 with cash and cash equivalents of $1 billion and total debt of $1.1 billion, for a net debt position of approximately $100 million. However, as Ron mentioned, after quarter end, we closed the all-cash acquisition of Anite for a purchase price of approximately $600 million, materially reducing our cash balance. Moving to the results of our two operating segments. Measurement Solutions generated third quarter revenue of $564 million, down 11% on a core basis, with an operating margin of 18.4%. The Customer Support and Services segment generated revenue of $101 million, up 4% on a core basis, with an operating margin of 19.4%. Now, turning to our outlook for the fourth quarter. End markets appear to have stabilized, and we expect Q4 to be seasonally stronger than Q3, in line with historical norms. Including the impact of the Anite acquisition, we expect Q4 revenues to be in the range of $735 million to $775 million, and non-GAAP EPS to be in the range of $0.57 to $0.71. At the midpoint, this reflects a core year-over-year revenue decline of 2%, which excludes a four percentage point unfavorable impact from currency and five points of inorganic growth from the Anite acquisition. Now, looking at our expectations for the full fiscal year, the midpoint of our Q4 guidance implies FY 2015 revenue of $2.86 billion, which is flat on a core basis; and FY 2015 non-GAAP earnings per share of $2.45. In summary, our operating profit performance in our first year as an independent company has been strong. We launched Keysight, completed the separation and stabilized our operations. We accomplished all this without disrupting our customer relationships, while generating strong profit, increasing our investments to drive future growth and initiating our post-separation optimization efforts. Looking forward to FY 2016, we currently expect the electronic design and test market to grow at a rate of approximately 2%. We're excited to have closed the acquisition of Anite as the addition of their product portfolio and the expansion of our markets supports our strategy to grow in wireless communications and software. We expect Anite to be accretive to our FY 2016 non-GAAP earnings by $0.14 to $0.17 and have already begun to implement our integration plan. This plan will result in $20 million of run rate cost synergies by the end of year two and enable us to generate a 15% return on invested capital within five years. It is important to note that Anite's revenue and profit are highly seasonal. In Anite's fiscal year ended April 30, 2015, 60% of their annual revenue and 77% of their annual profit was generated in their second half. Keysight's business also follows a seasonal pattern with our first and third quarters typically having lower revenue and our second and fourth quarters being seasonally stronger. As you look beyond the coming quarter, recall that in addition to this revenue seasonality, expenses are typically higher in our fiscal first quarter impacting Q1 profitability. Finally, you will notice a new line item on our income statement this quarter, other operating income and expense. We have determined that certain income and expense items, primarily rental income, are more appropriately classified within our operating results. We have, therefore, moved them from other income and expense to the new line, other operating income and expense. This is purely a reclassification and has no net impact on our business. As a final note, we will be discussing our longer-term strategy at our upcoming Investor Day which is planned for September 1 in New York City. With that, I will now turn it back to Jason for the Q&A. Jason A. Kary - Treasurer, Investor Relations & Vice President: Thank you, Neil. Mike, will you please give the instructions for the Q&A?

And the first question is from the line of Patrick Newton from Stifel. Patrick M. Newton - Stifel, Nicolaus & Co., Inc.: I have couple questions on Anite, if I may. One is did I hear you correctly that there's four points of growth embedded in the outlook for the acquisition in your fiscal fourth quarter? Neil P. Dougherty - Chief Financial Officer & Senior Vice President: Sorry, in the fourth quarter, it's five points of growth. Patrick M. Newton - Stifel, Nicolaus & Co., Inc.: Five points of growth. Okay. Neil P. Dougherty - Chief Financial Officer & Senior Vice President: Yes. Patrick M. Newton - Stifel, Nicolaus & Co., Inc.: And then how should we think about the $20 million in cost savings? You talked about it layering in over the next 24 months, but when you provided your $0.14 to $0.17 of accretion, how much of that $20 million is built into fiscal year 2016? Neil P. Dougherty - Chief Financial Officer & Senior Vice President: Yeah, the – as we look at our integration plan, not surprisingly, there are a few things that kind of you get quick wins, but then a large portion of the integration plan takes time. Our focus with the integration is really on making sure that we continue to generate the growth that Anite has generated over the past year and we want to continue that trend. So there's a relatively small portion of those synergies will be realized within FY 2016. That $20 million will be really the run rate that we will achieve two years from now. Patrick M. Newton - Stifel, Nicolaus & Co., Inc.: Okay. That's helpful. And then I guess where exactly are those cost savings going to be coming from, Neil? Neil P. Dougherty - Chief Financial Officer & Senior Vice President: Not surprisingly there are opportunities kind of up and down the P&L. Typically, we will do our best to eliminate duplicate costs, but you will see cost savings in the admin functions as well as in gross margins as well. Patrick M. Newton - Stifel, Nicolaus & Co., Inc.: Okay. And then can you talk a little bit about your appetite for M&A post this acquisition, I think you said in your prepared remarks that this was obviously a $600 million purchase, so quite substantial, but you did generate $100 million of free cash flow in the quarter. So if you could touch on the appetite for M&A and then also, Neil, if you could remind us the mix of domestic and international cash post the transaction. Ronald S. Nersesian - President, Chief Executive Officer & Director: I'll let Neil talk about the cash position, but our appetite is strong. We're looking to grow and have the absolute strongest portfolio in the wireless communications market, the aerospace and defense market and the industrial markets. So we're looking and we will continue to look for strategic acquisitions. The one thing that I want to make sure is that we integrate any acquisition effectively. We deliver on the synergies and deliver on the return on invested capital. So that's our first priority and after that and once we are convinced that we could do that and take on another significant acquisition, we will follow up. But at this point, we're not willing to give a timeframe until we see progress on the Anite acquisition. Neil P. Dougherty - Chief Financial Officer & Senior Vice President: And then with regard to the split of our onshore and offshore cash generation, I think the important things to note there is the $600 million purchase of Anite was entirely with offshore cash so that would be a reduction from our offshore cash balance. And then going forward, we generate cash – our cash is generated approximately 75% offshore and 25% onshore. Patrick M. Newton - Stifel, Nicolaus & Co., Inc.: So that mix is heavier onshore then, currently post the $600 million purchase? Neil P. Dougherty - Chief Financial Officer & Senior Vice President: Yeah. The ratio, obviously, shifts significantly towards the U.S. but we don't have a large U.S. cash balance. I don't have the number in front of me right now, but it's between $100 million and $200 million is the rough number. Patrick M. Newton - Stifel, Nicolaus & Co., Inc.: Great. Thank you. I'll jump back in queue. Ronald S. Nersesian - President, Chief Executive Officer & Director: Thank you, Patrick.

We have time for one last question and the question comes from the line of Richard Eastman with Robert W. Baird. Richard C. Eastman - Robert W. Baird & Co., Inc. (Broker): Yeah. So let me ask a couple of questions here. One, Ron, can you just talk to orders the seasonal or sequential strength in orders. Where did that come from? I mean it looks quite good and there was some reference to the fourth quarter looking slightly better, so maybe you could just kind of dive into that order number and why seasonally where the strength was. Ronald S. Nersesian - President, Chief Executive Officer & Director: Sure. I'll let Guy give you some color commentary, but as we mentioned, our core orders were down only 1%. All regions were up with the exception of Greater China. So that gives us a very good perspective and that's a substantial improvement from what we had seen in Q2. And Guy, I think you may want to give some more comments. Guy Séné - SVP-Measurement Solutions & Worldwide Sales: Yes, of course. Richard, when you look at the adjusted for currency in orders, mainly this was driven by a stronger wireless R&D, we also had some good business in the components and the semiconductor. We had, for instance, won some large design deals mainly with our high-speed digital solutions there. Europe was up also on strong semiconductor and manufacturing test. We had some good aerospace defense deals, and obviously, we have easier compare now for Russia. And Japan continues to see steady investments in device component manufacturing and we also had some nice investments for 4G wireless in R&D for them. So again, as Ron was saying, all regions except Greater China were positive in all of those. Richard C. Eastman - Robert W. Baird & Co., Inc. (Broker): And China, and just continue on China, is that all reflected in this communications decline of 20%? And are we still kind of held up on or paused on 4G deployment? What's – why is – yeah? Ronald S. Nersesian - President, Chief Executive Officer & Director: Sure. China has been roughly flat for us for the last four quarters with very strong compares versus the four quarters below that. But what we've seen is that business level out roughly in the $130 million per quarter range with regard to orders and revenues. So the declines, we haven't seen them much since then in the last four quarters, as we've been pretty flat. Most of that is in wireless communications, but they also do have an Aerospace Defense business that we sell into. We do not sell the highest-performance products which are basically only allowed to be sold to certain countries, but for the generalized Aerospace Defense business, that also plays into China. Richard C. Eastman - Robert W. Baird & Co., Inc. (Broker): And then – and your reference to down or flat the last four quarters, this would be the last quarter then of being "down 20%" against the tough comps? Is that what you're implying so the next quarter becomes an easier comp? Neil P. Dougherty - Chief Financial Officer & Senior Vice President: That's correct. Richard C. Eastman - Robert W. Baird & Co., Inc. (Broker): Okay. Okay. And then also, Ron, you have made a comment about – just trying to find it here, but electronic design being up 2% next year. I think the reference was to 2016. Yeah, electronic design would grow 2%. Was that reference to Anite's growth rate specifically? Neil P. Dougherty - Chief Financial Officer & Senior Vice President: No. No. Ronald S. Nersesian - President, Chief Executive Officer & Director: Neil had made that comment, and that's for the electronic design and test market that we play in. We've seen that market grow typically 3% to 4% when we look on a longer-term basis, but given where it is now, we see the market growing roughly 2% next year. Richard C. Eastman - Robert W. Baird & Co., Inc. (Broker): And that leaves out the portion of your business that would be more production test? Ronald S. Nersesian - President, Chief Executive Officer & Director: No, that's the overall market that we're talking about which is roughly the $12.5 billion for the addressable market that we have. Richard C. Eastman - Robert W. Baird & Co., Inc. (Broker): Okay. I understand. So that's the benchmark for your core growth rate and we plan to do better than that? Yeah. We... Ronald S. Nersesian - President, Chief Executive Officer & Director: Absolutely. Richard C. Eastman - Robert W. Baird & Co., Inc. (Broker): Okay. Ronald S. Nersesian - President, Chief Executive Officer & Director: No doubt. And for our growth rate, obviously, we have been doing pretty well in keeping up on a core basis during this last year and even at the end of the year before and then we have Anite on top of that on an inorganic basis. Richard C. Eastman - Robert W. Baird & Co., Inc. (Broker): Okay. Okay. And then just a last question. I just – one of the things that I think that you had mentioned, Ron, coming out of the fiscal second quarter, was just some concern around currency, had not seen any pricing pressure related to currency, related to the dollar and the competition. Obviously, nothing is showing up in your gross margins. But how do you feel about that situation, especially with the – potentially some devaluations of the renminbi? Ronald S. Nersesian - President, Chief Executive Officer & Director: Well, the biggest issue is Rohde & Schwarz is a competitor that is based out of Germany and they may have a little bit more ability to price more competitively, but we've had a very active program during the last year to reduce our discounts and that has paid off well and that has been a contributing factor to our gross margin improvement, that continued through last quarter. So we will keep an eye on it, make sure that we're competitive with our non-U.S. competitors, but so far so good and that's why we really have gone to work on discounts, on cost improvements, on product models and as well as moving our mix, less from manufacturing to more into R&D which as we reported before, the last time we reported publicly is over 50%. And as we move Anite into our numbers, that will increase that percentage even further as they are more strongly biased towards research and development. Richard C. Eastman - Robert W. Baird & Co., Inc. (Broker): Okay. I understand. And congrats on Anite, it looks like a good fit. Thank you. Ronald S. Nersesian - President, Chief Executive Officer & Director: Thank you very much, Rick.

Our next question comes from the line of Brandon Couillard with Jefferies.

Thanks. Good afternoon. Neil, just back to that last question on the market growth, do you have an estimate for what your $12 billion TAM, what the market did or will do in 2015? Ronald S. Nersesian - President, Chief Executive Officer & Director: Yeah. I'll take that question. This year I mean you can look at all the competitors and seeing what's happened during the last 12 months. We see it roughly flat, now again, when you look at the public numbers that exist for the public competitors, we look at the test and measurement portion of Danaher, we look at the test and measurement portion, for instance, of Anritsu, don't look at their total numbers, but look at the markets that we play in. And then we use a third-party source when available to try to fill in some of the smaller competitors. But during the last 12 months, it's been roughly flat.

Super. Then, Neil, you alluded to some one-time benefits on the margins in the third quarter, what were those attributable to? And as far as the Anite accretion goes for next year, are you absorbing any – are there any upfront one-time costs or expenses that are embedded in that accretion expectation? Neil P. Dougherty - Chief Financial Officer & Senior Vice President: Yeah. So first of all, with regard to the one-time benefits that we saw here in the third quarter, we do an annual true-up of our U.S. benefit costs. It's essentially we accrue expenses based on actuarial estimates, as there were things like workman's comp, disability and medical and then we do a true-up once a year to essentially reconcile between the rate at which we were accruing and actual experience – and our actual experience over the course of the last 12 months was favorable relative to the rate at which we had been accruing. That's not something that you can count on going forward. It only takes one or two events to flip that the other way. So we believe we accrue over the long-term at the right rate, we just had a little bit of good luck over the course of the last 12 months. And then with regard to your question about the costs associated with Anite and delivering those synergies, if you review the 2.7 document, we do talk about kind of integration cost – total integration costs including both the costs necessary to generate those cost synergies as well as some potential IP transactions totaling $100 million. That was what was shared in the original transaction documents. We now believe that, that number would max out at $80 million again and that would be really over the course of the first couple of years you'd see those things – that, that money's spent.

Super. And then last one, Ron, you alluded to a slightly improved 4Q outlook. What changed relative to your initial expectation? What are you more optimistic about in particular? Ronald S. Nersesian - President, Chief Executive Officer & Director: It's really the forecast, we do a bottoms-up forecast in our sales organization; we do a bottoms-up forecast in each of the divisions that are out working with customers on big deals. We look at the size of our funnel and we look at our direct channel as well as the funnels from some of the business that we've converted from indirect in the U.S. to direct, and all of those come together in a forecast and where we're glad that we've seen an increase in that forecast going forward. As you know, we also build backlog in Q3, which was very nice.

Super. Thank you. Ronald S. Nersesian - President, Chief Executive Officer & Director: Thank you.

Thank you. That concludes our question-and-answer session for today. I would like to turn the conference back to Jason Kary. Jason A. Kary - Treasurer, Investor Relations & Vice President: Thank you, Mike. I'm actually going to turn it over to Ron for your final comments. Ronald S. Nersesian - President, Chief Executive Officer & Director: Thank you, everyone, for joining the call. While market conditions remain relatively soft, we've delivered to our operating model as well as focused on transforming our company to grow. We will continue to leverage our unique formula of technology-leading hardware and software and our large global network of experts to create value for customers and shareholders. In closing, I remind you that our inaugural Keysight Investor and Analyst Meeting is on September 1 in New York City. We look forward to sharing more details of our long-term plan for value creation and providing you a better understanding of Keysight's strengths and market opportunities. I hope you can join us. Thank you very much, and have a nice day.

This concludes our conference call. You may now disconnect.