Keysight Technologies, Inc. (KEYS) Q1 2016 Earnings Report, Transcript and Summary

Good day, ladies and gentlemen, and welcome to the Keysight Technologies Fiscal First Quarter 2016 Earnings Conference Call. My name is Tracy, 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, Thursday, February 18, 2016, 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, and welcome everyone to Keysight's first quarter earnings conference call for fiscal year 2016. With me are Ron Nersesian, Keysight's President and CEO; and Neil Dougherty, Keysight's Senior Vice President and CFO. Joining in the Q&A after Neil's comments will be Mike Gasparian, Senior Vice President of the Communications Solutions Group; Gooi Soon Chai, Senior Vice President of the Industrial Solutions Group; John Page, Senior Vice President of the Services Solutions Group; and Guy Sene, Senior Vice President of Worldwide Sales. 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. 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 today. 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, Jason, and thank you, all for joining us. Keysight delivered strong first quarter results, driven by our operational discipline. We continue to execute on our key initiatives as we transform our business and create value for our customers, partners, and shareholders. We will focus today discussing on three important headlines. First, our first quarter financial results were strong with earnings and revenue both above the midpoint of our guidance and we made solid progress on our four growth initiatives. Second, we remain committed to delivering solid profitability in line with our operating model despite macro headwinds. We are currently actions to exercise the cost flexibility of the model to delivery high-teens operating margin in this environment. At the same time, we are executing our strategy and making the R&D investments that should drive above market performance when markets stabilize. And third, consistent with our phased approach to return of capital, the board of directors has authorized a $200 million share repurchase program. This action demonstrates our confidence in our ability to achieve above market growth in the long-term and our commitment to delivering shareholder value. Now let's start with an overview of Keysight's first quarter performance. In Q1, revenue grew 4% year-over-year and we delivered $0.55 in earnings per share, which was $0.04 above the midpoint of our guidance. Revenue for the quarter grew to $726 million, including revenue from our recent acquisitions. On a core basis, which excludes revenue from acquisitions and the impact of currency, revenue declined 1%, consistent with our expectations. We continued to execute on our strategic growth initiatives and are building momentum in these areas with innovative solutions that help customers design leading edge technologies and bring their products to market faster. First, in wireless, we are making solid progress on affirming Keysight as the market leader in 5G, including forming long-term strategic partnerships. In the first quarter, while off a small base, orders for 5G solutions more than doubled year-over-year and grew over 50% sequentially, as customers invest in early 5G research. We continue to collaborate with consortiums, working to establish worldwide 5G standards. We are the first company to offer a commercial 5G channel sounding solution. Our solution includes our channel sounding reference solution, instrumentation to measure and interpret how signals behave at high frequencies, and our industry leading SystemVue design and simulation software to develop and validate new designs. We are proud to announce that in the first quarter a leading research center in China selected our 5G channel sounding solution as the foundation for their 5G channel modeling research. Our 5G channel sounding solution is now used in research centers in the U.K., Malaysia and China, and it has enabled us to secure several competitive wins. Early strategic relationships with research centers around the globe are critical to our 5G leadership in the longer term. We will showcase our 5G channel sounding solution along with our 5G beamforming and 802.11ad testing and design tools at Mobile World Congress, where I will be next week with the Keysight team. Outside of 5G, we are gaining momentum with our newly introduced LTE-Advanced RF conformance solutions. This combined software and hardware solution offers best-in-class coverage for 3GPP industry standards and the flexibility for future technology evolutions. In the first quarter, two major chipset vendors, two leading carriers and a major testing lab, each selected our LTE-Advanced solution for testing complex radios with multiple bands and carriers. Moving to our modular initiative, our PXI and AXIe modular products, again, delivered solid double-digit growth. New products in high-speed digital and optical solutions drove our modular growth this quarter. Introducing new modular solutions to market is a key component to expanding our share in this growing part of our market. In the quarter, we introduced our first PXI reference solution for military, public safety and avionics radio test. Additionally, for the automotive market, we introduced the Body and Safety Electronics reference solution that includes both instruments and software. Moving to our software growth initiative, we continue to realize strong year-over-year revenue growth for our market leading design and simulation software solutions. As an example of our continued success with this platform, we recently were awarded a $12 million multi-year software contract from a major wireless customer. Keysight's design and simulation software is used by two-thirds of the world's high-frequency designers. You can see from the wireless and modular products I just mentioned that software solutions play an important role in our strategy to expand our business. Furthermore, the addition of Anite broadens our software portfolio. Our integration efforts are going well and tracking to expectations. And, by leveraging the Keysight sales force, we have identified additional opportunities to sell Anite solutions into our Aerospace and Defense market. We plan to meet many of our joint Anite and Keysight customers at Mobile World Congress, where we will be also showcasing Anite's recently launched Virtual Drive Testing Toolset that was already selected by a major mobile operator in China to verify mobile device performance in high-speed train scenarios. And lastly, looking at our services initiative, we continue to secure new business in North America and Europe with our multi-vendor calibration and asset management capabilities. When adjusted to exclude the impact of the three-year warranty program and currency, our services revenue grew 11% year-over-year. We are partnering with our customers to create value and help them manage assets and costs. For example, we recently worked with an Aerospace and Defense customer to measurably improve the use of their assets, reduce test time and increase yields – all in an effort to reduce test and design engineering and capital equipment expense. Our services plan included test system integration, test flow consulting and instrument and system level software functionality. And while we provided great value in helping this customer reduce their overall design expenses, their spending with Keysight more than tripled year-over-year. Moving on to our markets, as we discussed in November, we expected macro factors to suppress first half market growth. While orders tracked to our expectations for the majority of the quarter, we saw a significant slowdown in January as weakening macro factors in the broader markets negatively impact sentiment towards capital expense purchases. This effected order patterns across our end markets with the most notable pullback in Communications where our wireless supply chain customers paused spending following lowered estimates for wireless component and smartphone shipments. As a result, first quarter orders were down 2% year-over-year, and this is reflected in our second quarter guidance, which Neil will discuss in more detail. While we continue to see continued market softness in the near term, we remain committed to delivering profit within our operating model and at the same time investing in our growth initiatives. We believe Keysight is well positioned to grow when the market stabilizes and customers reaccelerate capital investments. The progress we made on our growth initiatives in the first quarter demonstrates that we are investing in the right areas and are creating value for our customers and partners by bringing leading edge solutions and services to market. While strategic M&A remains our priority use of cash, the $200 million share repurchase program we announced today reflects our confidence in our strategy and our ability to achieve above market growth in the long-term. Now I will turn the call over to Neil to provide more details on our Q1 financial results, as well as our second-quarter guidance. Neil P. Dougherty - Chief Financial Officer & Senior Vice President: Thank you, Ron, and hello, everyone. Today we reported first quarter total non-GAAP revenue of $726 million that was above the midpoint of our guidance. On a year-over-year basis, this represents 4% growth. On a core basis, which excludes the impact of currency and acquisitions, revenue declined 1% year-over-year in line with our expectations. GAAP revenue for the quarter was $721 million, which excludes certain accounting adjustments associated with revaluing pre-acquisition deferred revenue from Anite. Looking at our top line performance by end market, Communications revenue grew 8% year-over-year including revenue from Anite. Excluding Anite, Communications revenue decreased in the low double-digit range year-over-year as restructuring and consolidation activities impacted spending patterns and softness from customers in the smartphone supply chain outweighed growth in LTE-Advanced and 5G technology. Revenue from Aerospace and Defense was $171 million, a decline of $3 million or 1% from last year's first quarter, which was the high point for 2015. Growth in the U.S. for our Aerospace and Defense solutions was offset by continued softness in Europe and Asia. First quarter Industrial, Computer and Semiconductor revenue grew 3% driven by strong sales from our instrument and parametric test products and next generation processor testing. Regionally, and on a core basis, revenue was flat in the Americas, up 1% in Europe and grew 16% in Japan. Revenue in Asia excluding Japan declined 7%. The regional mix of total revenue was 38% from the Americas, 20% from Europe, and 42% from Asia. Our first quarter operational results were strong with gross margin increasing to 56.6%, a 100 basis point improvement year-over-year as a result of a higher percentage of software and R&D revenue. Expenses were well-managed while we continued to invest in R&D programs in support of our growth initiatives. Operating expenses totaled $282 million, including the first full quarter of Anite spending. Operating margin was 17.8 %, in line with the prior year. Our industry-leading margins result from our continued operational discipline and the proactive management of our cost structure across the cycle. Non-GAAP net income after taxes was $95 million, or $0.55 per share, which was above the midpoint of our guidance range. Moving to the results of our two operating segments. Measurement Solutions generated first quarter revenue of $631 million, an increase of 4% including revenue from Anite. Operating margin for Measurement Solutions was 18.3%. The Customer Support and Services segment generated revenue of $95 million in Q1, up 2% on a core basis, with an operating margin of 13.9%. As a reminder, the Services business has a higher fixed cost structure when compared to our Measurement Solutions business. The Q1 cost structure also reflects the investments we are making in additional capacity to expand our multi-vendor calibration and asset management services. Moving to the balance sheet and cash flow, we ended the quarter with $572 million in cash and cash equivalents, of which approximately 75% is located offshore. In the quarter, we generated $92 million in cash flow from operations. As I mentioned last quarter, cash flow is seasonally lower in Q1 due to the payout of variable compensation. In addition, we had higher capital purchases this quarter totaling $34 million, which brought our free cash flow to $58 million. As Ron mentioned, our board has authorized a share repurchase program of up to $200 million. The new repurchase program goes into effect immediately and shares may be purchased from time to time. The program will be funded from current and future cash flows, and is consistent with our phased approach to return of capital. While we remain focused on identifying M&A opportunities that will help us achieve our growth objectives, this repurchase authorization reflects our confidence in our growth opportunities and strong cash flow generation. Turning to our outlook and guidance for the second quarter. Taking into account our order performance in the first quarter and the broader market sentiment, we expect Q2 non-GAAP revenue to be in the range of $695 million to $735 million, which at the midpoint reflects a 3% decline, or 9% on a core basis. With our ongoing attention to cost management and the leverage and flexibility of our operating model, we expect to deliver operating profit in the high-teens, while continuing to invest in the growth areas of our business. Balancing these factors, we expect second quarter non-GAAP earnings per share to be in the range of $0.48 to $0.62 and our weighted diluted share count to be approximately 173 million shares. 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. Tracy, will you please give the instructions for the Q&A?

And your first question comes from the line of Richard Eastman from Robert W. Baird. Your line is open. Richard Eastman - Robert W. Baird & Co., Inc. (Broker): Okay. Yes. Ron, could you maybe speak a little bit to the Communications business? And excluding Anite, which looks like it came in from a revenue standpoint about as expected, just speak to the core decline in Communications. I think math suggests maybe around 12%. Just a little bit of color on the pieces there. And maybe on the order side, how did orders fare in the quarter for the Comm business? Ronald S. Nersesian - President, Chief Executive Officer & Director: Sure, Rick. I'll turn this over to Mike Gasparian who leads that business, but let me make a couple of comments. You're right, on a core basis, we were down 11%. There are a couple things that are going on in the industry. First, there is consolidation of some players, there's restructuring, also and both of those things lead to a rationalization of spending. On top of that, you've heard about some of the contraction in the smartphone supply chain that's going on from some big players. So that's the macro picture of what's going on in the market overall. Our strategy has been, and it's been a multiyear strategy and we continue to make progress on it, is to move from wireless manufacturing to more of our business in wireless R&D. Wireless R&D has higher gross margins. It is a business that is more differentiated than manufacturing and is less cyclical or has less volatility than manufacturing. And I'm glad to report that our wireless R&D business is bigger than our wireless manufacturing business now by a good bit. And we'll continue to move towards a larger and larger percentage of our business being in wireless R&D with Anite being added. Our wireless R&D business with Anite grew, our wireless manufacturing business contracted and our other Communications which leads really into a lot of the fiber and a lot of the backhaul Communications also grew on a revenue basis. So, with that, I'll turn it over to Mike for a few comments.

Yeah, let me just add little color to that. I think, Ron, outlining a number of short-term factors that will put the Communications market under pressure. Nevertheless we believe there are still excellent long-term growth opportunities in the Communications segment, people will continue to invest in the evolution. As we go from 4G to 5G, there will be many points at which we'll get additional investments. And then we're seeing a really good uptick in the 5G research space. Our 5G orders have doubled in this most recent quarter, it's still on a small base, but it does reflect a number of engagements we have with research institutions around the world, and we have delivered a number of very unique solutions which will be showcasing at Mobile World Congress next week, where several of us will be there interacting with our key customers. Ronald S. Nersesian - President, Chief Executive Officer & Director: And one other comment, a question that you asked Rick was, how our orders in the Communications sector with Anite? Our orders were up slightly in total. So our comps business is up slightly, but that includes an acquisition. Richard Eastman - Robert W. Baird & Co., Inc. (Broker): Okay. And just maybe Ron, one other thought. On the modular test side, again good double-digit growth. Is the growth coming heavily or is the growth heavily slanted towards the Communications business (22:33)? Ronald S. Nersesian - President, Chief Executive Officer & Director: Yes. The Communications business is one significant part, plus also if you look at not only wireless R&D in general, but what we call other Communications, we're seeing a lot digital applications move over to modular. So, we have both of those areas or both of those subgroups in Communications that are moving. But as we expand our portfolio, you'll see more and more solutions in the industrial space too, which will allow us to make some traction against some competitors. Richard Eastman - Robert W. Baird & Co., Inc. (Broker): Okay. Very good. Thank you. Ronald S. Nersesian - President, Chief Executive Officer & Director: You're welcome. Thanks, Rick.

Your next question comes from the line of Brandon Couillard with Jefferies. Your line is now open.

Thanks, good afternoon. Ron, just sort of a big picture question for you. You've been with this business obviously a long time, been through several cycles over the past decade or so. How do you view the macro environment today relative to let's say the past few cycles? In terms of demand picture and what's different today versus what this business was like ala 2009 or prior? Ronald S. Nersesian - President, Chief Executive Officer & Director: Sure. I have seen many cycles over the last 35 years, this one is pretty typical. And to be very honest, we don't have very good visibility on this cycle. There's a lot of things that are being created from the overall macro environment of the markets which is causing folks to hold on to their wallet. But let me give you some color commentary on to what happened this quarter. Our orders were tracking to expectations right through mid January. And as you know, a lot of the compares that you see, they report results or have reported results through December. But in January, in the middle of January, we saw a market slowdown in our incoming orders, and that's not inconsistent of what you've seen from some other larger players in the overall electronics markets. This macro uncertainty that is there, has caused people to pull back on CapEx and has caused customers to be much more cautious. So, if you look at that, if your revenue growth for the quarter was 4%, but if you look at our order growth it was minus 2%, but on a core basis it was minus 5%. And given this macro uncertainty, it's probable that the 2% market growth that we saw before this real, let's say, disconnect in January will probably not play out. Now what we're doing about it is we're taking action. We have an operating model, because we know our business has some cyclicality and this model allows us to deliver strong cash flow and solid double-digit operating margin throughout the cycle. And as you see, and as Neil mentioned in his script even in Q2, we're planning to deliver upper teens operating margin. And this is all why – while we continue to invest in growth and continue with our strong R&D programs in modular, software, wireless, and services. And we're getting great traction on all of those fronts. So, bringing it back, this cycle is not that untypical. I think when the markets stabilize, you may see some performance begin to return. So little unclear how quickly it will return, but again, we're talking about minus 5% core revenue growth in Q1.

Thanks, that's helpful. And just to be clear, do you have a revised market growth outlook for the year? And would that be simply a function of comms, and do I understand your comments that suggests that ICS and the aerospace and defense orders actually held up pretty well through January? Neil P. Dougherty - Chief Financial Officer & Senior Vice President: Yeah. We don't have a revised market forecast for the full year. Actually, we'd expect with the kind of inflection point that we saw in orders in mid-January, our visibility out beyond, really beyond more than one quarter is increasingly limited. And so it's very difficult to call. I think as Ron said, it's highly unlikely at this point that we see 2% growth. But we do not have an updated forecast based on the 5% order decline, the core order decline that we saw in Q1. Ronald S. Nersesian - President, Chief Executive Officer & Director: And when we see some of these big macro cycles and while we continue to generate great cash, sometimes it provides great opportunities for us to create value for our shareholders by doing share repurchase programs. We've talked in the past about still, number one, our priority is to fund strategic M&A, but we will be opportunistic when we can create value for our shareholders with buybacks such as we're doing right now. So I really believe we know how (28:08) to manage this business through the cycles to deliver profitability and to create shareholder value for the long term.

Super. And then one more for Neil, just on the CapEx side, was there something one-time in the front-end loading in the first quarter? And do you have a target that we should expect for the full year? Neil P. Dougherty - Chief Financial Officer & Senior Vice President: Yeah. I wouldn't read more into that than it should. Some of the equipment that we buy is longer lead time and the actual cash flowing is a function of acceptance and installation and the rest. But we still intend to manage our overall CapEx budget to the year to the same $90 million to $100 million range that we put out in the past. And so just a little bit of a timing difference caused that to be more front-end loaded this year.

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

Your next question comes from the line of Patrick Newton from Stifel. Your line is now open. Patrick Newton - Stifel, Nicolaus & Co., Inc.: Yeah. Good afternoon, Ron and Neil. Thank you for taking my questions. I'm sorry if missed this in the prepared remarks, but just kind of looking at the Customer Support and Services gross margin below 40% for the first time in our historical model. I'm curious if you could talk through some of the impacts and maybe the duration of some of the pressures there. Neil P. Dougherty - Chief Financial Officer & Senior Vice President: Yeah. Happy to do that. If you think about our services business, it's a higher fixed cost business when you compare it to the rest of Keysight. As you can see, our Q1 revenue was – were down in that segment, but that's as compared to kind of the run rates over the second half of last year, they were flat to Q1. But compared to the second half, when profitability was much higher, revenues were down. But you'll notice that the costs in that business are very stable. As we noted in prior quarters, we're still navigating through a change in our standard warranty from one year to three years, and that impacted the sale of extended warranties in that business and we're still essentially working through the impact to deferred revenue. We're losing about $7 million per quarter in deferred revenue as those previously sold extended warranties work their way through our P&L. This quarter, incidentally, will be the last quarter and we'll be through that, although it'll still be in our compares for remaining year. But the underlying growth rate of the business is strong. We mentioned the 11% growth rate if you adjust for that warranty impact and for currency, and we're confident that the profitability of that business will be in the upper teens over the longer term as we're continuing to make investments to grow that business, particularly in the areas of multi-vendor calibration and asset management. Patrick Newton - Stifel, Nicolaus & Co., Inc.: Great, okay. And then just a few modular questions for you. I guess just given the double-digit growth that you're seeing in modular in the face of macro headwinds that are hitting the rest of the business, is this growth stemming from the broadening of your portfolio? Is it stemming from share gains? Or conversely, do you think that it's having a negative impact or perhaps cannibalizing the rest of your business? And then could you also remind us the relative size of your modular business currently? Ronald S. Nersesian - President, Chief Executive Officer & Director: Sure. First of all, I think it's a mix. Some of the products that we're selling were products that were sold in the past in our feature-rich boxes, but a lot of it is also incremental. There are customers that want modular solutions for some reasons why it is a distinct advantage and we continue to win that business against the competition. Our business, we talked about last year at Investor Day about being approximately $150 million of our new modular products and we talked about that in September and we did achieve or beat the $150 million last year and this year, we're just saying we've grown 11% from Q1. Neil P. Dougherty - Chief Financial Officer & Senior Vice President: The 11% is not a modular growth, we grew – that we grew double digits. Ronald S. Nersesian - President, Chief Executive Officer & Director: Yes. Patrick Newton - Stifel, Nicolaus & Co., Inc.: And then just this last one if I may is on the R&D side, you talked several times in the prepared remarks about a continued focus on investing in R&D and still maintaining that solid teens op margin even through this challenged time. But I'm curious now with you being a standalone company for over a year, is the 13% R&D target still the right number? Is that still the right way to think about it? I think that some would argue that on an absolute basis is a very aggressive R&D spend and more than enough. While others would argue that as a percentage of revenue, you're still running well below peers. So any thoughts around is 13% the right way to think about R&D? Ronald S. Nersesian - President, Chief Executive Officer & Director: We're looking at what does it take to win in the marketplace, and what do we need to do to accomplish our strategy. We spent 12% in the past. We up that to 13% last year. And clearly, as the top line moves around you will see that percentage vary. There is no doubt that on a total basis, we're spending less than the competition on average, but we do have some economies of scale from having our own, for instance, internal fab that can go ahead and provide products and solutions to multiple businesses and multiple product lines. As far as the R&D percentage, we're going to monitor that with regards to our ability to go ahead and to win in these marketplaces. But I think it's directionally correct. Patrick Newton - Stifel, Nicolaus & Co., Inc.: Great. Thank you for taking my questions. Good luck. Ronald S. Nersesian - President, Chief Executive Officer & Director: Sure.

And your next question comes from the line of Vijay Bhagavath with Deutsche Bank. Your line is now open.

Hi. Can you guys hear me? Ronald S. Nersesian - President, Chief Executive Officer & Director: Yeah. Hi, Vijay. Neil P. Dougherty - Chief Financial Officer & Senior Vice President: Hi.

Hi. This is AJ Shrestha in actually for Vijay Bhagavath. Just had two questions really. The first one was trying to get your thoughts on the product mix for the rest of the year. Should we expect a higher percentage in software mix? And the other one is the OpEx, how should we think about that for the rest of the year? Ronald S. Nersesian - President, Chief Executive Officer & Director: Yeah. So, let me try and address those questions. I think we are making a concerted effort over time to shift the mix of our business towards more R&D solutions and more software. But if you put that in the scale of the rest of the year, our markets – our markets don't move that quickly, you're not going to see fundamental shifts in our mix. Based on those efforts, over that short of period of time, it's a bit more of a methodical slog than that. With regard to our OpEx, again, we'll be working hard to manage our spending as we move through this economic cycle. But our Q1 results, now reflect a full quarter of Anite spending and you could view those as representative of what we expect for the remaining quarters of the year.

Got it. Okay, appreciate it guys.

Thank you. That was our last question. That concludes our question-and-answer session for today. I would like to the turn the conference back to Jason Kary. Jason A. Kary - Treasurer, Investor Relations & Vice President: Thank you, Tracy. That's all we have for today. So thank you everyone for joining the call and have a good day.

This concludes our conference call. You may now disconnect.