Tom Diffely - D.A. Davidson Josh Baribeau - Canaccord Patrick Ho - Stifel Nicolaus Jairam Nathan - Sidoti

Good day ladies and gentlemen and welcome to MKS Instruments Third Quarter 2014 Earnings Conference Call. (Operator Instructions). As a reminder this conference is being recorded and I would now like to introduce your host for today's conference Vice President and Chief Financial Officer, Seth Bagshaw. You may begin.

Thank you. Good morning everyone. I'm Seth Bagshaw, Vice President and Chief Financial Officer and I'm joined this morning by Gerry Colella, our Chief Executive Officer and President. Thank you for joining our earnings conference call. Yesterday aftermarket closed released our financial results for the third quarter of 2014. You can access this release at our website www.mksinstruments.com. As a reminder various remark 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 as a result there are 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 the 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. A forward-looking statements should not be relied upon as a representing the company's estimates or views as of any date subsequent to today. Now, I will turn the call over to Gerry.

Thanks, Seth. Good morning everyone and thank you for joining us on the call today. As in recent calls I would like to start with an overview of the third quarter then I will give a brief update on the progress we've been making against our strategic initiatives and some highlights on our business in the third quarter of 2014 and finally I will provide our outlook for the fourth quarter. Following me Seth will give further details of our financial results and then we will open the call for your questions. The third quarter was another strong one with sales of $187 million, which was up the high-end of our guidance while non-GAAP earnings of $23 million or $0.43 per share were also above our expectations. Semiconductor sales both with OEM and device manufacturers continued to remain strong and sales through all the other markets further increased sequentially a reflection of the contribution from Granville-Phillips as well as our continued emphasis on these adjacent marketing I am pleased with these results and anticipate continued strength as we exit the year. Seth will have more details on this quarter as well as Q4 later in the call. When I assumed the role In January, the team and I focused on strategic initiatives with specific goals to continue to broaden especially our leadership in vacuum processing, measurably improve our profitability throughout the cycle, efficiently deploy capital to increase shareholder value and aggressively pursue opportunities created by current technology inflections. In the third quarter we made additional progress towards achieving these goals. Starting with first with our goal to improve leadership in vacuum processing we continue to integrate Granville-Phillips or GP operationally and technically into MKS. Product lines have been combined and rationalized, operations have been consolidated and the union has progressed…

Thank you, Gerry. I will first discuss the Q3, 2014 financial results before providing further details on our Q4, 2014 guidance. Revenue for the quarter was $187 million increase of 1% compared to Q2 revenue of $185 million and increase of 12% from $166 million a year-ago. Our Q3 revenue at the higher end of our guidance range due to bad anticipated sales in the semiconductor market continued growth in our other advanced markets which were up 5% sequentially in over 17% from Q3, 2013. Non-GAAP gross margin was 43.3%, which was slightly above our expectations at this sales volume primarily due it more favorable product mix. On a GAAP basis our gross margin was 42.5% it included $1.6 million of amortization of the inventory step-up related to the GP acquisition. Non-GAAP operating expenses were $48.2 million which was also favorable to our guidance range due to lower employee related costs, the timing of R&D, IT and other project spending. GAAP operating expenses were $51.2 million included $1.8 million of amortization of intangible assets as well as $1.2 million of restructuring charges. Our non-GAAP operating margin was 17.5% of sales which remains ahead of our target model at these volumes. Non-GAAP net earnings were $22.8 million or $0.43 per share compared to $22.6 million in the second quarter and $13.3 million in the third quarter of 2013. Our non-GAAP tax rate was 31% as expected. GAAP net income was $29.1 million or $0.55 per share including GAAP net income with discrete tax credits totaling $9.5 million related to favorable settlements of both domestic and international tax audits as well as a tax credit from and intercompany dividend from a foreign subsidiary. As we mentioned before we’re committed to making continuous improvements in our financial performance over the operating cycle. In…

(Operator Instructions) Our first question comes from Tom Diffely with D.A. Davidson. Your line is now open.

Maybe first couple questions on just the business trends today. It sounds like, based on your comments, there were some nice orders placed for the fourth quarter going into the first quarter. So do you view this as kind of a multi quarter ramp in your business on the semiconductor side?

And part of the problem we have is our lead times are so short our visibility is relatively modest. But if you -- if we look at what the range of growth in the equipment spending is supposed to be on the average is 7%, and the shift to more favorable mix for MKS to 3D NAND and FinFET and multi patenting, it would tend to lead us to believe that yes, it would be something we'd expect to see continued growth. So we think it's a positive trend for us, yes.

Okay. And then the range of your guidance is based just on timing then of those projects?

Yes.

Whether they hit in the fourth quarter or first quarter?

Exactly.

And then, Gerry, you talked a lot about Korea being a nice kind of a growth area for you, assuming your relationships with the local guys. What about China? We know we hear a lot of chatter, lately, about the Chinese government trying to support their own industry. Are you positioned there? Are you seeing any activity there?

We actually have had a large presence in China for some time, both operationally in sales and service. We continue to see significant growth in our Chinese operation. Actually second only, primarily, to Korea and we're very well-positioned with OEMs there across-the-board. Whether primarily things like LED, (indiscernible) it continues to bounce back. Semi as well. So yes, our Chinese business is very strong and we have a good, solid operations over there. We're very happy with what's going on there. You know, we highlighted Korea because it's such a growth in the semiconductor equipment space there and again with the device makers. But we certainly are just as focused in Taiwan. We've seen good growth there. China, solid positioning in Japan. It just happens to be that Korea has really accelerated in its growth.

Are you getting the sense that the Chinese government is really trying to grow equipment companies or is it more on the design side?

Well we really don't have a lot of visibility into the Chinese government. Just the OEMs themselves and on the equipment, it looks like that what we're seeing is a lot of really capable people in China now. Actually, some people that came from the equipment industry in the U.S., and in Japan are now in China. We have faith and confidence in these people. We've worked with them in the past. So they are very entrepreneurial. So if the government is assisting them they still have really strong people that know what they're doing and we're pleased with that.

And, Seth, when you look at the $10 million per year savings or cost reduction that you have done, should we look at the model a little differently now? We are we moving some of those costs now from COGS and SG and (indiscernible) for the reinvestments?

Yes. I would say you're right, Tom. So $10 million -- the $6 million net savings on $10 million gross we're going to reinvest $4 million back in other areas. Most of that reinvestment will be in the R&D or really market based either sales, application (indiscernible) or business development functions. Yes, not in manufacturing and certainly not in the back ops operations. So it's really targeted to really expand the opportunities we see in other advanced markets even semi as well.

And then, finally, Gerry, when you look at some of these air quality programs that you've talked about in the last few calls, what are kind of the relative size of the opportunities for you per project and how many projects are there out there potentially?

Well, it really varies by application. You've got engine testing. You've got emissions stack monitoring. In this particular case, chemical weapon detection. I would probably say that the one with the biggest area of growth for us could be chemical weapon detection and that business was relatively small by our standards but the growth potential is very significant. So I really can't get into specific details of what each project could entail because there's still a lot of things we have to keep discreet. And we have to use discretion in discussing it because of the sensitivity of it but they could be very significant. I don't mean to be evasive but we just have to be careful what we say.

Thank you. Our next question comes from Josh Baribeau with Canaccord. Your line is now open.

Did you guys ever think -- I'm sure you do. Can you share with us the ideal mix that you'd like between semi and let's call it, the other markets?

Well, I would like during a peak, if we were more like 60:40 or 55:45 during a semi peak which means we really grow in the other advanced markets without turning our back on our semiconductor industry, which we think is a great place for our continued growth and strength. But it would be nice to have in case there's some modifying cycle. We would have a strong basement for our business by having grown the other advanced markets. So that'd be a nice mix. It may take us a while but I think that would be a great mix, if we could do that. And you're looking at things like industrial, more in the industrial markets where it's more steady in terms of the business that we see, those types of things.

And then as you kind of look around at valuations across-the-board in a lot of sectors, as of the past couple weeks and months, has your appetite increased or has your quoting activity potentially increased for acquisitions with some of your potential targets maybe looking a little bit more attractive?

Well, I think what we're trying to do is keep a steady hand on our acquisition strategy and I think what we'll do is we would pay a fair value for a company that we think it fits our model that's accretive, our growth strategy and our markets. So we continue to look on a continuous basis. I've got M&A [ph] team that we're looking throughout the world, being proactive rather than waiting for things to come to us. And we see things that are of a decent value. And if we think things are overvalued then I'm not so sure we would act on them. I think we paid a good price for GP but I think we think, based on the business growth and on the tax advantage of it, that it was a good deal. So I think we would be very careful and good stewards of the Company's money but make sure we invested for good, high growth opportunities.

Thank you. And our next question comes from Patrick Ho with Stifel Nicolaus. Your line is now open.

Gerry, can you give a little bit more color in terms of the strength in your semi business, particularly in Q3. It held up it appears better during this industry pause than a lot of your peers. Can you comment whether it's the exposure to some of the key process segments that are increasing capital intensity like etch and deposition? Or were new design wins a contributor to, I guess, the better than expected performance?

I think it's actually a combination of all three. I think the shift in the technology is good for MKS and I think we're seeing great benefit from that. I think our position in Korea has helped us a lot. We’ve got good business with Korean OEMs over there and we've seen some significant orders coming our way. And I think that's helped a lot maybe compared to others. And also the other thing is we're kind of first in line in the food chain, Patrick. So sometimes we'll call the downturn and people will think that we're kind of Debbie Downer because we say it first, but it's based on where we are. So I think a little bit of it is because we're so early on in the supply chain. And I think there's some significant design wins, like the Liquozon and other things that we got in our technology shifting to the 3D NAND and FinFET multi-patenting and I think our strength in Asia has contributed to all of that.

Maybe going to the non-semi side for a second, excluding the Granville-Phillips, what other markets are you seeing kind of emerging strength or building momentum, particularly as we head into the end of the year as well into 2015? Are you seeing any more activity in some of your traditional markets, like flat panel display or LEDs? What are some of the other markets you're starting to see strengthen?

Yes. Well, the medical was a nice business in the quarter, which is a nice part of our business. So we saw some strengthening there. The biopharm is also starting to see some good strengthening there and the LED, we talked about it being off life support. We think maybe the patient is now taken its first step out of the hospital bed because we've seen a little better increase on the LED side as well. So I think those three markets kind of led a good strengthening for the company and we're well-positioned there. And those are places we are really trying to penetrate further. And as well as air quality, air safety emissions control.

And the final question from me for Seth. In terms of the inventory levels, you guys did a pretty good job in Q3, especially as orders were building. How do you see that trending in Q4 and maybe even a little bit of color early parts of Q1, 2015 given some of the comments by your customers?

Yes. I think, Patrick, what's going to drive inventory levels is really our sales guidance, I would say. So it'll move by a little bit but I wouldn't expect a major change in inventory volumes by the end of the fourth quarter. And it more correlates with the revenue guidance we gave. If that were to move, obviously, that would probably drive inventory levels and it can be a little lumpy sometimes. We don't instruct the teams in manufacturing to do anything that's unnatural. They'll do sort of the normal cadence on the buys. You might see a lumpiness there, which is better for them to really level out the factory and get the best pricing from the suppliers. But I would say, it would be fairly consistent right now based on the guidance we gave and revenue in the fourth quarter.

(Operator Instructions). Our next question comes from Jairam Nathan with Sidoti. Your line is now open.

My first question was on the Korea wins. The significant end customer there seems to be having some trouble. So in light of that -- would you kind of -- could the wins in Korea, are they mostly memory related where you are seeing more spending? Or can you give us some more idea there?

Well, I think that, generally, across the board. There are also multiple end-users there other than just one that people talk about, which we have strength with and I think that the Korean OEMs we work with are very close to the device makers, the end-users. And so I know -- I don't think that they would be strengthening their position with us if they were skittish about the long term outlook for work with their end customers. I know these customers well and I know how they order and I think they see confidence in the business going forward. And I think -- and I also think it's basically across the board.

Just more broadly on design wins. How long does it typically take once you win a design to kind of start seeing it in revenue?

Well, it really depends on the individual OEM. Some can be a quarter or two out. Some might take 7 or 8 months out on the design cycle. So it really depends and it depends on where their product is in their release cycle too. So it's really kind of hard to say. Some could be -- almost be immediately, as an immediate replacement. And we've seen that. And some could be a matter of their acceptance of their tool into the market and how they go from pilot to production release. So it really kind of varies.

And my last question on -- you mentioned in your press release about redeploying resources, refining the cost structures. Do you see more opportunities on the efficiency front on OpEx?

I think that we're dedicated to continuing to look at the cost to run this business and where our money is being invested. And I think the thing that you've seen us do in the last number of months, the last three quarters is to evaluate where we're spending and the return we're getting on it. I think MKS has always been seen as operationally excellent and financially prudent. We don't expect to do that. But we do think that there is -- as we continue to look at the business that's growing, if we have to shift or reduce costs in order to strengthen investments elsewhere, we'll continue to do that. So it's something my team is continually looking at on a monthly basis, absolutely.

Thank you. And, at this time, I'm showing no further questions. I would like to turn the call back over to Gerry Colella for further remarks.

Thank you. This quarter was another strong quarter for us and I'm very pleased about our performance. We have targeted specific goals and focused our actions to achieve them and are now seeing the results. The fourth quarter has started strong with several semiconductor OEMs placing orders to satisfy the increasing capital intensity requirements facing the industry. We continue to leverage our technologies into adjacent markets and to address megatrends such as air quality and safety. I'm very optimistic about future opportunities and I look forward to updating you on our continued progress in January. Thank you for joining us on the call today.

Ladies and gentlemen, thank you for participating in today's conference. This does conclude the program and you may all disconnect. Everyone have a wonderful day.