MKS Inc. (MKSI) Q3 2013 Earnings Report, Transcript and Summary

Good day, ladies and gentlemen, and welcome to the MKS Instruments reports Q3 2013 results conference call. [Operator Instructions] I would now like to introduce your host for today's conference call, Mr. Seth Bagshaw. You may begin, sir.

Thank you. Good morning, everyone. I'm Seth Bagshaw, Vice President and Chief Financial Officer, and I'm joined this morning by Leo Berlinghieri, our Chief Executive Officer and Jerry Colella, our present Chief Operating Officer. Thank you for joining our Earnings Conference Call. Yesterday, after market close, we released our financial results for the third quarter of 2013. You can access this release at our website, www.mksinstruments.com. As a reminder, the various remarks that we may make about future expectations, plans and prospects for MKS comprise forward-looking statements. Actual results may differ materially from those indicated by these forward-looking statements, as a result of various important factors, including those discussed in yesterday's press release and in the company's most recent annual report on Form 10-K and most recent quarterly report on Form 10-Q, which are on file with the SEC. In addition, these forward-looking statements represent the company's expectations only as of today. While the company may elect to update these forward-looking statements, it specifically disclaims any obligation to do so. Any forward-looking statements should not be relied upon as representing the company's estimates or views as of any date subsequent to today. Now I'll turn the call over to Leo.

Thanks, Seth. Good morning, everyone, and thank you for joining us on the call today. In a moment, I'll review third quarter and provide our outlook for the fourth quarter. Following me, Seth will provide details of our quarterly results and guidance, and then we'll open the call for your questions. First, however, I'd like to say a few words about my upcoming retirement and the announcement that Jerry Colella will succeed me as CEO at year end. It's been a terrific 33 years at MKS. I greatly enjoyed my time spent with our employees, our customers, suppliers and our shareholders. I'm immensely proud of how our organization has grown and performed during my tenure as CEO. Aside from meeting our growth and financial performance objectives, one of my personal goals has been to build the strongest possible executive team to lead the company after I retire. Jerry and I have worked together at MKS for nearly 31 years and in total, more than 33 years. He has been a key contributor in our combined efforts to cultivate a company culture centered around success in delivering results. His new role will bring additional leadership responsibilities and a greater role in guiding the strategic direction of the company. While he is new to many of you in the investment community, he has been the face of the company with our customers and suppliers for some time now. I know that each of you listening on the call today will enjoy hearing Jerry update you on our business during future conference calls. I shall look forward to that as well. Now to our third quarter results. Third quarter revenues were above the midpoint of our guidance at $166 million, up 6% from Q2. Over the course of the third quarter, we saw improvement in our semiconductor sales, which were up 10% to $115 million driven by strong sales to both OEMs and device manufacturers. Sales to all other markets remain stable quarter-over-quarter. As I do in most calls, I'd like to share a few highlights from the quarter, which give a greater insight into our business. Starting with our semiconductor market. We continue to work with OEMs as they develop new tools and new applications. This quarter, multiple MKS products were designed in on PECVD, epi, etch, strip, cleaning and other tools. The PECVD win is a good example of technical synergies we can provide through our broad range of technologies and global scope. The win was a result of cooperative development between our RF power products engineers in the U.S. and our new Plasmart matching network team in Korea. RF matching networks or RF matches maximize the amount of RF power that is delivered to the process, improving process performance and control. By combining our global RF expertise, the team incorporated sensing functionality into the matching network, resulting in better process performance. This combination of technology enable a device maker to use the matching network to monitor the process in real time, which was a critical OEM requirement and resulted in the design win for us, as well as the OEM. Another trend we are seeing in the semiconductor market is the increasing use of our latest-generation Ethernet-based automation controllers. These products have been designed to meet the process control challenges of manufacturing next-generation semiconductor devices by providing better process uniformity and faster communication speed for higher throughput. Over the past few years, we have steadily increased our customer engagements for control products and with the advances in our new Ethernet-based I/O capability, our controllers are gaining increased acceptance due to the speed and support of the communication needs of the new OEM tool designs. Several new technology innovations are beginning to enter production at leading-edge chip makers including 3D NAND, FinFETs and multiple patterning. These technology changes enable smaller, faster and more powerful chips to support mobile devices and the rapidly expanding use of video. These technologies add additional process steps, especially in etch and deposition, which are significant applications for MKS technologies. These technologies changes -- these technology changes are propelling increased demand. In this quarter, we received initial orders for pressure control, flow, power, reactive gas and other products for multiple production tools from a number of OEMs for a new 3D memory fab in Asia. Mobile devices are driving other opportunities as well. In addition to providing smaller products with richer features, electronic companies are striving to improve the quality and durability of mobile devices. One focus is improving the scratch resistance and robustness of portable device screens. Stronger glass, advanced coatings and new materials are being evaluated. One of the materials of interest is sapphire, which is more than double the strength of glass and is nearly scratch proof. Sapphire has a long history of use in military, point of sale, scanners, optics, LEDs and other applications. Over the last several years, sapphire production has increased, and costs have begun to come down. As the costs have come down, more applications for sapphire are opening up. For example, in some smartphones, software is used to cover camera lenses, and sapphire was recently introduced as a cover for fingerprint readers. Some experts believe that in the future, sapphire may replace glass on the displays of some mobile phones. This would represent additional opportunity for MKS, as we are designed in on multiple sapphire production tools. And I'm pleased to report that in the quarter, we received significant orders for multiple MKS products, including pressure control, flow controllers and advanced gauges for a major sapphire tool OEM. I've talked in the past about our gas analysis products and how they are used by automobile manufacturers, as they develop cleaner burning engines. Clean Air Legislation is driving these requirements across the entire stationary and mobile engine market, including in shipping where the EPA is finalizing a change to the diesel fuel program that will allow for the production and sale of low-sulfur fuel for use in oceangoing in large Marine vessels. Our MultiGas analyzers are a preferred solution to design for lower emissions and to ensure compliance. And this quarter, we received our first order from a major global marine diesel engine manufacturer to use our MultiGas analyzer to ensure compliance to these more stringent EPA regulations. This customer selected our analyzer because of its high-speed data collection capability, which allowed them to measure transient signals and its ability to measure sulfur compounds and acids in a wet gas stream. We have also seen stronger interest in diesel engine testing from the large truck engine manufacturers who have a similar need for transient measurements, as well as engine optimization for future alternative fuels. In the last call, I talked about a new opportunity for our residual gas analyzers or RGAs in freeze drying, which removes moisture during the manufacturing of food and drugs. As I mentioned in that call, RGAs are used to monitor the process gases to detect impurities, monitor for leaks and identify the endpoint of the process, ensuring quality, process integrity and the consistency of the end product. I am pleased to report that this quarter, we received additional follow-on orders from an existing pharmaceutical customer and anticipate further orders in 2014. As drug manufacturing expands globally, new OEMs and new drug manufacturers are emerging in Asia. We are using our global capabilities to target these emerging opportunities, and I'm pleased to report that we have also been designed in at a major Asian freeze dryer OEM for a similar growing application in pharmaceutical manufacturing. These examples provide just a snapshot of where we are leveraging our technologies and global capabilities to support our semiconductor customers, as well as other new and growing applications. And they also demonstrate how we win in the markets we serve. Now looking ahead, we have seen a recent acceleration in order rates, particularly from our customers in the semiconductor industry and anticipate continued sales growth in the fourth quarter. Semiconductor industry analysts are projecting that 2014 should be a good year for the industry driven by ongoing transitions to smaller geometries and implementation of new device technologies in support of demand for full-featured mobile devices. Looking at current business levels, we anticipate that sales in the fourth quarter may range from $155 million to $200 million. And at these volumes, our non-GAAP net earnings could range from $0.31 a share to $0.41 a share. At this point, I'll turn the call over to Seth to discuss our results and to expand in our guidance.

Thank you, Leo. First, I'll discuss the third quarter results before providing further details on our Q4 guidance. Revenue for the quarter was $166 million or a 6% increase compared to Q2 revenue of $157 million and an 18% increase from $141 million a year ago. Q3 gross margin was 37.4% and included a $6.4 million obsolete inventory charge for certain products that are for a key solar customer in China whose technology funding by the Chinese government has recently been reduced. Non-GAAP gross margin, excluding this inventory charge, was 41.2% within our expectations at this volume level. This compares to 39.5% in the second quarter. Non-GAAP operating expenses decreased in the third quarter and were $48.4 million compared to $51.7 million in the second quarter of 2013. Third quarter non-GAAP operating expenses reflect typically higher vacation schedules in addition to a 1-week shutdown in certain locations, a decrease due to timing of certain R&D projects and favorable foreign exchange. During the quarter, we also recorded approximately $1.1 million in restructuring charges in connection with the planned consolidation of certain facilities to allow for more effective service and support to our customers. Our non-GAAP operating margin was 12.2% of sales, up from 6.6% in Q2. Non-GAAP net earnings were $13.3 million or $0.25 per share compared to $7.3 million in the second quarter and $8.4 million in the third quarter of 2012. GAAP net income was $2.5 million or $0.05 per share. The GAAP tax rate for the quarter was 80.4%. In the quarter, we're able to take advantage of a favorable short-term tax election in a foreign location. This favorable election will permit the company to substantially reduce future income tax expenses when moving cash among foreign entities and resulted in a onetime income tax charge of $6.5 million. In addition, for the favorable tax planning opportunities we completed in the quarter, we've generated increased U.S. income tax credits of $1.2 million. We recorded discrete benefit in the quarter. Excluding these items, our non-GAAP tax rate was 35%. This rate increased slightly from over prior quarters due to changes in the geographical mix of taxable income. Cash in short- and long-term investments increased by $28 million to $626 million as of September 30. During the quarter, we paid a quarterly cash dividend, $8.5 million or $0.16 per share. We did not repurchase any shares during the quarter. As we stated in prior calls, the timing and quantity of any shares repurchased will depend upon a variety of factors, including business conditions, stock market conditions and business development activities, including, but not limited to, merger and acquisition opportunities. These repurchases may be suspended or discontinued anytime without prior notice. Total book value net of goodwill intangibles was $841 million or $15.82 per share. In terms of working capital, days sales outstanding improved to 54 days at the end of the third quarter compared to 56 days at the end of Q2. Inventory turns were 3.1. Excluding a special obsolete inventory charge of $6.4 million, inventory turns were 2.8 or in line with Q2. Capital additions for the quarter primarily related to investments in manufacturing and test equipment and IT systems were $2.8 million. Depreciation and amortization expenses were $4.2 million, and noncash stock compensation was $2.7 million. Now I'll provide further detail regarding the composition of revenues for the third quarter. Sales for the semiconductor market were $115 million, up 10% compared to the second quarter, and it represented 69% of third quarter revenue. Within the semiconductor market, sales to semiconductor OEMs increased 8% from the second quarter and comprised 54% of total sales. Sales to semiconductor fabs increased 16% in the quarter and comprised 15% of total sales. Sales of semiconductor fab customers can vary from quarter to quarter depending upon the timing of customer projects. Sales to other advanced markets remains stable quarter-over-quarter and were $52 million, representing 31% of total revenue. Geographically, sales in the U.S. were 55% of total sales. Sales in Asia were 33%, and sales in Europe were 12%. Sales to our top 10 customers comprised 44% of total sales. Sales to Applied Materials and Lam Research comprised 16% and 14% of third quarter sales, respectively. Our headcount decreased slightly from Q2 and as of September 30 was 2,298. Now I'll turn to Q4 2013 guidance. Based upon current business levels, we estimate that our sales in the fourth quarter could range from $185 million to $200 million. Based upon this expected sales range and product mix, Q4 gross margin could range from 41.5% to 42.5%. We expect Q4 non-GAAP operating expenses will increase from Q3 due primarily to the timing of incentive compensation, as well as R&D projects and could range from $51 million to $52 million. In the fourth quarter, R&D expenses could range from $16.1 million to $16.5 million. And SG&A expenses could range from $34.9 million to $35.5 million. As I mentioned on previous calls, these expenses can vary from quarter-to-quarter depending upon the timing of various R&D and IT projects. In the fourth quarter, we expect to incur the following additional GAAP operating expenses: $2.3 million in executive retirement costs, $400,000 of amortization of intangible assets, and $100,000 in restructuring expenses. Net interest income is estimated to be approximately $200,000. We expect that our fourth quarter income tax rate to be approximately 35%, reflecting the projected geographical mix of taxable income. Given these assumptions, the fourth quarter non-GAAP net earnings could range from $16.6 million to $21.9 million or $0.31 to $0.41 per share, and GAAP net income could range from $14.8 million to $20.1 million or $0.28 to $0.38 per share on approximately 53.6 million shares outstanding. This concludes our prepared remarks. We now open the call for questions.

[Operator Instructions] Our first question comes from Jim Covello with Goldman Sachs.

This is Jack Sheng on behalf of Jim Covello. So I guess, last night, a major OEM client of yours, just guided to higher margins. How should we think about your longer-term margin structure given the recent wave of consolidation with your customers? I know you guys mentioned how Lam and Applied are currently about 30% of your sales.

I think if you're referring to the impact on us relative to pricing pressures, the industry's had pricing pressures for the 33 years I've been here. You work on improving your own cost structure. You work within the industry. We don't expect anything significant. You've got our numbers, estimates for the quarter, and we also show a model. We don't expect anything would change in both of those.

And as a follow-up, I was wondering if you guys can talk a bit more about your lead times. Have you guys have seen lead times stretch out given the pickup in the industry, particularly from the memory end market?

If you're talking about our ability to deliver to our customer lead time, I think that's what you're talking about.

Yes, that's right.

In our business, we are single source. So our customers count on us. One of the ways, aside from technology that we maintain that position, is through operational excellence. So we gear up as the industry gears up. We have a flexible workforce. We're able to bring in temporary workforce. We use over time to expand capacity. Our suppliers, we do long-term contracting with them, so they make commitments on materials that are available. So we don't anticipate -- we're happy to see the orders and don't anticipate anything changing in the lead time significantly.

Our next question comes from Krish Sankar with Bank of America.

Leo, couple of quick questions. Number one, in your guidance, how would you expect the semiconductor revenues to improve sequentially in December?

Yes, I think, in general, we have -- the non-semi business has been relatively stable. I think you can assume that most of that is in semi, although as you know, we -- we're sort of a turns business. So there can be some lumpiness in the quarter, and so I would say, in general, our thinking is that it's primarily semi.

Got it. And then you highlighted that you guys sold some -- sold a sapphire toolmaker [ph] . Kind of curious, was these sales for sapphire for mobile applications? Or was it for regular LED?

We prefer not to provide too much information on that. I think there's -- I don't think initially it's LED. Put it that way.

And are these shipments more than what you'd normally sell for LED segment? Or is it a brand-new opportunity that this would be difficult to be qualified [ph] ?

I didn't quite understand the question because you asked if these were shipments based on LED when I said likelihood is they're not going on LEDs. What -- can you repeat that again?

- Just the quality of shipment that is shipping for this application, is it -- is this the normal or...

No, higher than usual.

Our next question comes from Josh Baribeau with Canaccord.

Some of our -- some of your customers and some of their customers have started talking a little bit about equipment reuse, probably expect this trend to continue as each node gets much more expensive. Can you talk a little bit about how that affects you, if there's a services component or some of your subcomponents get swapped out or made more intensive as that happens?

Well, a piece of our both OEM and end-user business is upgrading existing tools, and we look forward to those kinds of things because typically what happens is they will upgrade a particular tool, prove out better performance and then upgrade a series of those tools that are doing the same thing. So we do that both directly with the fabs themselves and with OEMs who do some type of upgrade kits or refurbishments. It's been a trend for a while. I don't know that it -- the other thing we have seen is that with some of these new device structures, it's more difficult to reuse and needing some new tools. So I don't know that we're sitting here today expecting a major change in refurbishment or upgrades to tools, but we've been doing that for a number of years. It has grown, as you've said. There are more refurbishing, but we're not expecting at least in the near term anything unusual to change there. Typically, we get to put new products on exist -- older tools that they get to -- and it helps us get those components adopted on the next-generation tools as well.

Okay. And then are you able to quantify the increase in capital intensity for your business through some of these new processes, new structures, new nodes? A lot of your customers talk about what they think, let's say, the etch intensity would be or the deposition intensity. Would your component or subcomponent intensity mirror that? Would it -- might it be higher? Have you ever quantified that?

I think the only way we have quantified that, because you can imagine that we sell thousands of line items and various components, and different equipment companies migrate to that. So I don't go from where they are today to a completely different process at volume. So this happens over time. And so I think the way we've demonstrated that is if you look at our content, our dollar content as a percent of capital spend, that we've demonstrated has gone up over time. That's probably when you have thousands of line items with various customers with different acceptance and timing of acceptance within a process, that's probably the most concrete way we could measure that.

[Operator Instructions] Our next question comes from Patrick Ho, Stifel, Nicolaus. Patrick J. Ho - Stifel, Nicolaus & Co., Inc., Research Division: Leo, I want send my best wishes to you. Congratulations on your time at the company, as well as your CEO tenure. And Jerry, good luck on a going-forward basis.

Thank you.

Thanks. Patrick J. Ho - Stifel, Nicolaus & Co., Inc., Research Division: Leo, maybe just as a parting shot, you're departing as the semi-cap industry appears to be heading up. There's talk of the sustainability of these CapEx trends heading into the early parts of 2014. Can you give a little color and granularity in terms of your readiness and your ability to ramp, particularly as lead times and the equipment vendors tend to be shorter and shorter over these past several cycles? How ready are you? And how will you be able to react and keep your margin profile going up during this time?

I guess, first of all, I'll say that as the technology keeps advancing and we go to smaller nodes and newer structures, we are an enabler to that. So often if we can't provide technology to those customers, that -- the industry slows down. So first of all, from that standpoint, we're ready in terms of the products that we have available, the way we're adding features to products that can allow our customers to be able to keep advancing technology maps. I think as far as being able to produce, the other area is I think each -- as time has gone on, we get better and better able to meet these types of ramps, both in output and technology for a number of reasons. One is as we go through these, we discover where the weakest link is, and we fix that weakest link. And then we go to the next ramp, and we determine where the weakest link is, and we fix it. So I think over time, each area, with the global operation and the global design centers, every time we've gone through changes and ramps, we get better at doing what we do across more of the entire organization. So I think today, I'm confident we can meet the deliveries, we can meet the technology needs. I don't see that being the challenges. I think having -- I think as the lead times get tighter and shorter, I actually like the fact that we don't buffer this industry quite the same way with inventories because it sort of gives false demands up and down. So I think it's a healthier sort of overall industry model, and I think we get healthier as time goes on based on the things we do. We used -- we used to have used downturns to improve the business, either structurally or in the way we perform. So I'm very confident going forward. And Jerry has been doing that with me for many years with the whole team, and so I think it -- he'll bring another level of improvement to the organization. Patrick J. Ho - Stifel, Nicolaus & Co., Inc., Research Division: Great. That's helpful. And my final question is on the non-semi side of things. And I know it's very diverse. You have many markets that you participate in outside semiconductors, and they can be lumpy in some of those segments. But as you look forward to 2014, do you have any feelings about some of the other markets that could pick up and where you could see some tailwinds from those non-semi markets?

Yes. Well, I will say this. It's only as good as the forecast of the people that give them, but at least, from the data we see, while solar and LED are sort of at the very, very bottom of what we've seen in many, many years, both of those markets show double-digit expected growth from the experts that forecast those. And so as long as the experts are right, then those look like they would be growth areas for us. I think we still see gas analysis. I think we mentioned earlier in the year that we have been making investments in other parts of the world in our gas analysis and the combination of EPA regulation tightening, going across more type of engine manufacturing and putting some resources in other parts of the world. I think that has us optimistic that, that would be a growing segment of the business. So I think a lot of it will depend on the global economy as well when -- our business has been relatively stable, but when I read other reports from other companies and I talk to other CEOs, I think everyone's sort of surprised that it's been as stable as it is. In some cases, they've seen it down. So I think it's been low for a while, and so I'd have some expectations that eventually it has to come back. And certainly, the experts in those industries are forecasting it to be better.

I'm not showing any further questions at this time. I'd like to turn the conference back over to our host.

Great. Thank you. Thank you for joining us on the call today. Before concluding, I would like to thank both the company and all those who have been associated with it for the support I have received during my many years here at MKS. You've all been part of helping make us a successful company. I'm excited to begin to have time to enjoy some of the other aspects of my life while watching MKS continue to grow and be successful in the years to come. Thanks again.

Ladies and gentlemen, this does conclude today's presentation. You may now disconnect, and have a wonderful day.