Onto Innovation Inc. (ONTO) Q3 2007 Earnings Report, Transcript and Summary

Good morning and welcome to Nanometrics' third quarter 2007 financialresults conference call. The speakers today include Tim Stultz, President andCEO, and Quentin Wright, Chief Financial Officer of Nanometrics. The following discussion may include forward-lookingstatements regarding, among other things, Nanometrics future financial results,business performance and market conditions. These forward-looking statementsare subject to risks and uncertainties that could cause actual results todiffer materially from these statements. Factors that could cause such differences include, but arenot limited to, changes in demand for the company's products, changes in thecompany's ability to ship its products in a timely manner, changes in businessor economic conditions, and the additional risks and uncertainties set forth inthe related press release and in the management discussion and analysis sectionof the company's latest annual report on Form 10-K filed with the Securitiesand Exchange Commission. I will now turn the call over to Dr. Tim Stultz. You mayproceed, sir. Tim Stultz: Thank you. Goodafternoon, everyone. I appreciate your calling in today. With me on this callis our CFO, Quentin Wright, who will go through the details of our results atthe end of my prepared remarks. This is my first earnings conference call as the CEO ofNanometrics. I've been on board for just over two months, and I'm very pleasedto be sharing some positive financial results with the investment community. Q3was another record revenue quarter for us, and our third consecutive quarter ofrevenue growth. Q3 was also our third straight quarter of improving grossmargin, and we achieved our first service gross profit in six quarters. Thisperiod marks our third straight quarter of reducing our operating expense, bothas a percentage of revenue and in absolute dollars spent. We again achieved an operating profit and an operatingmargin improvement of close to 4 percentage points versus Q2. Theseimprovements resulted in our first net profit in ten quarters, a majormilestone in our turnaround effort. Finally, this is our third straight quarterof improving tangible book value per share. A couple of quarters ago, Nanometrics was a turnaroundstory. In April of this year, Bruce Rhine assumed the role of interim CEO andwas instrumental in leading the team's turnaround of the company. Our Q3results are proof that that turnaround is now complete. The merger integrationwhich Bruce stated last quarter was 75% done is also now essentially complete. Going forward we will continue to drive Nanometrics in theareas of profitability, cash flow and predictability; the key metrics of ourturnaround strategy. But today I would also like to speak briefly about ourstrategy to achieve efficient growth based on profitability, competitivenessand customer satisfaction. First, we will continue to run the business to reach anoperating model which will make a profit, generate cash, and be responsive tochanges in our markets and the general financial climate. Second, we are working to better align our product andapplications development efforts with our customers' technology and productroadmaps. Third, we are increasing our focus and directing resourcesto improve quality and customer satisfaction. These steps should result in a better, more nimble companywhich is responsive, competitive and capable of delivering continued profitablegrowth. Now I'd like to provide several updates on businessobjectives which have been discussed in previous reviews. First, an update onour merger integration. Our goal in acquiring Accent was to expand ourfootprint in the metrology space while also realizing a post-merger annual costsavings of $8 million to $9 million. After stumbling in the first six months ofthe integration, the team made the changes necessary to recover and realizethese savings. Specifically, net of intangible asset amortization, we havereduced OpEx by about $3 million a quarter from $17 million in Q1 to $14million in Q3. This is an annual OpEx reduction of $12 million, which isevidence that we have achieved our merger integration cost savings goal inaddition to other efficiencies. Part of our success in improving our businessmodel post-acquisition is evidenced by our revenue per employee, which in Q3was $295,000 on an annualized basis, a 25% improvement relative to the initialphase of integration. My second update is on the consolidation of ourmanufacturing facilities and our outsourcing initiatives. During the quarter,we completed the shutdown of the IVS facility in Concord, Massachusetts, and integrated themanufacturing into our Koreaoperations. We also transferred 100% of the systems manufacturing from our Yorkfacility to our manufacturing site in Korea. We sold our Japan building, which formerly housed our flatpanel business, and we have taken substantial steps to unwind our previousvertical integration strategy, including shutting down our machine shop andplating shops in Milpitas and outsourcing systems manufacturing to third-partyturnkey suppliers. So essentially, we went from four underutilized factorieswith virtually no outsourcing to two factories with nearly 20% of our productsoutsourced at the systems level. Finally, I would like to update you on our target businessmodel. For two years, Nanometrics has maintained a gross margin target of 53%on a GAAP basis. This is still our goal. Though our quarter-on-quarter grossmargins performance is definitely improving, we still need to gain a betterunderstanding of our true costs and expense structures to improve the businessesprocesses in order to take the next appropriate actions to further grow ourGAAP gross margin to our model level. Our OpEx percentages have come down to approach our goalmodel, however we expect to shift the mix somewhat in 2008 with an increases inR&D spending, mostly offset by reduced G&A expenses. We have alsomaintained for several quarters that our target cash breakeven is $25 millionin quarterly revenues. With our current revenue run rate and gross margins, andexcluding non-cash charges such as stock-based comp, depreciation andamortization, right now our breakeven level is about $28 million. This meansrelative to where we were six months ago, we are three quarters of the way tomeeting that target. We are not, however, forecasting significant sequentialdrops in our OpEx at our current level of revenues. If, however, businessconditions deteriorate to the sub-$30 million level per quarter, we areconfident that the steps we have taken to reduce our fixed costs and shift to amore variable cost structure will enable us to get our OpEx to the $12 million to$13 million range within a quarter of notice. The takeaway is that we aremaking every effort to run the business to make a profit and generate cash withreduced sensitivity to revenue level. Lastly, an update on our cash balance. Our cash balancedeclined modestly in Q3 after a significant increase in Q2. The primary reasonfor the decrease is that our shipments were very backend loaded. The timing ofshipments was driven more by demand than supply in that our customers werebeing conservative in placing orders, probably due to uncertainties in thefinancial and consumer markets. We observed similar behavior through our OEMpartners. We also repurchased about 26,500 shares of stock, and our overallworking capital increased during the quarter. To conclude my first call as CEO of Nanometrics, I would saythe following. We are running the business to a model to make a profit andgenerate cash as best we can given the inelastic demand for our products. Wefeel good about the demand for our products, especially given the disruptiveadditive growth of flash memory, which is being driven by the consumer's needfor low power, large capacity media memory. The integration and consolidation is behind us, and we arenow transitioning from turnaround to profitable growth. Finally, we areconfident about our product roadmap and competitive position and our ability toimprove our business performance. I would like now to turn the call over to Quentin to discussmore details regarding our Q3 results.

Thank you, Tim. Earliertoday we released our third quarter 2007 financial results. If you have not yetreceived them, you may find them on our website at Nanometrics.com. I will nowaddress some financial aspects of the quarterly announcement. Total revenues were up 3.5% in Q3, representing anotherrecord revenue quarter for Nanometrics. Revenues were up 33% over the thirdquarter of 2006, which was the quarter in which the Accent acquisition closedand which included close to a full quarter of Accent results. Our operatingprofit in Q3 was $1.7 million, an operating margin of 4.5%. This compares toour Q2 operating profit of $0.3 million and an operating loss of $5.8 millionin the third quarter of 2006. Net income in Q3 was $2 million compared to a netloss of $130,000 in Q2 and $6.6 million in the third quarter of 2006. Similar to Q2, Q3 again showed strength with our memorycustomers in Japan,with continued strength among customers in Koreaand the U.S.and increased penetration into China.Samsung and Toshiba were our only customers representing greater than 10% of Q3revenues. For the third quarter, revenues were divided by channel asfollows: standalone metrology, $25.8 million or 67%; integrated metrology, $7.5million or 19%; service revenues, $5.3 million or 14%. Revenues were dividedgeographically as follows: Japan,$13.0 million or 34%; North America, $9.4 million or 24%;China, $5.8million or 15%; Korea,$5.5 million or 14%; and the rest of the world was $5.0 million or 13%. Regarding our gross margins, our product gross margins forQ3 were 50%, roughly flat compared to Q2. Our service gross margin was 10%, upfrom a negative 5% margin in Q2. Our blended gross margin was 44%, an overallimprovement of 1% versus Q2. Our service gross margin improved for a few reasons. First,we enjoyed an especially high level of upgrade activity in the quarter, whichtends to be fairly profitable. Second, our installed base is growing. Andthird, we have focused on reducing our overall service-related expenses. Regarding our operating expenses, total GAAP OpEx of $15.4million represented a decrease of $0.5 million compared to Q2. As expected,during Q3 we reported a gain on the sale of real estate in Japanand Milpitas, as well as the saleof other non-strategic assets and a restructuring charge related to theshutdown of our machine shop and plating facility. Both the gain and the chargewere about $2.1 million, so they roughly netted each other out on the totalOpEx line. Excluding amortization of intangible assets, therestructuring charge and the gain on sale of assets, total operating expensesdecreased to $14 million in Q3 from $14.2 million in Q2. Our combined R&Dand SG&A expenses continued to decrease as a percentage of revenue from 38%in Q2 to 36% in Q3. Our GAAP operating profit was $1.7 million. That includesnon-cash charges of $2.2 million, broken down as follows: amortization ofintangible assets of $1.3 million; stock-based compensation expenses of$873,000, of which $206,000 was in cost of net revenues, $231,000 was inR&D expense, $140,000 was in selling expense, and $296,000 was in G&Aexpense. Therefore, while our GAAP operating income was $1.7 million,when we exclude non-cash charges for stock-based compensation, depreciation andamortization our operations generated approximately $5 million of cash flowreflected in our working capital. Our headcount decreased from 529 at June 30, 2007 to 519 at September 29. A few quick aspects of the balance sheet are as follows. Cashat September 29 was $14.9 million, a decrease of $0.5 million from June 30. AsTim remarked, this is primarily the result of back end loaded shipments. Thisis evidenced by the increase in accounts receivable, which stand at $34.2million, up $7.1 million from the last quarter, therefore resulting in higherDSOs of 80 days versus the Q2 level of 65 days. Inventory levels were flat at$33.1 million, with inventory turns at 2.6X for the quarter. Our working capital increased by about $7.5 million, withour current ratio going from 2.5% in Q2 to 2.9% in Q3. We also used $0.2million in cash for share repurchases, which included 26,500 shares in Q3. That concludes our prepared remarks. Operator, now poll forquestions.

Your first question comes from Gary Hsueh - CIBC WorldMarkets.

Timothy, welcome on board. I notice you guys are not givingguidance again. I was wondering if you could help me out with some of theoutlook, particularly against a backdrop of peers who have basically reportedorders down in Q3, revenues down in Q4, but orders maybe popping up slightly inQ4, boding well for revenue stabilization here in Q1. Is that the same case forNano? Tim Stultz: I think we have to remind ourselves that we are basically asmall company in a very large market and we have a very small market share. Wedo have a broad portfolio of products, and we have a balanced geographical stream.We really have the ability to grow independent of some of those trends that arereported on a more global basis.

Okay. That helpscertainly. If you look at the industry here facing an '08 CapEx that isdeclining, particularly in the memory segment, how do you feel comfortable withyour current cost structure? Why not continue to push the metal to the pedalhere and reduce OpEx even further. Tim Stultz: The OpEx work thatwe're putting in place is really to make sure that we shifted, as you know,from the fixed to variable costs and to track our OpEx with our revenue stream.We have the ability to adjust it if our market outlook changes, but we don'tthink it's terribly out of balance with the current revenue.

Timothy, if you could just help me remember or recollecthere, what's your general sort of product mix here in terms of memory, logicand foundry customers? I know it's a little up with the integrated side but ifyou could help me outside of the integrated market, what would the mix ofstandalone and your other products be? Tim Stultz: Well, if we look atthe product line, the thin film and the OCD products represent about 45% of ourbusiness. The integrated metrology is roughly 20%. Our overlay is around 10%. Whatwe call our materials characterization is roughly 25%. If we look at it by theend use, the memory represents about 50% of our markets, with a heavierweighting on the flash versus the DRAM. We're seeing about 25% to 30% infoundry and logic, and between 20% and 25% in other areas.

So about the industry average product mix from a customerstandpoint and use standpoint? Tim Stultz: I think so.

Quentin, I have a question here for you. If I just look atthe balance sheet, one thing that kind of sticks out is just how low we'vedrawn down on this deferred revenue account for the last three quarters. Canyou tell me what's going on there in terms of deferred revenue going down somuch?

The larger numbers in previous quarters had to do withdeferred revenue of tool shipments, and that's something that we have to livewith in today's world where there are certain revenue recognition criteria thatwe have to accomplish before we can recognize revenue. We had a lot of machines in deferred revenue in previousquarters. We worked very hard in the last few quarters on getting all themachines accepted or whatever hurdle we had to get over to get the revenuerecognized. Currently we've got I think pretty much all the tool revenueout of that number. I think that number pretty much just refers to deferredservice contracts, deferred service revenues. But that's not to say that wecan't run into the problems with specified customers or specified toolshipments in the future that we may end up having to defer those tools. We've worked very hard on getting those numbers down andgetting over the hurdles on the revenue recognition for those tool shipments,and I think we've been very successful in doing that.

So that's helpful. So it's an indication that you've workeddown the cycle time for customer acceptance on a tool. It's not an indicationthat there's less cushion for revenue numbers in Q4, Q1? That's not the rightreason?

We don't really have a cushion for revenues. I mean, we takethe revenue, of course, when we accomplish those revenue recognition criteria. We'vebeen focused very hard on getting over the hurdle with our customers to get therev rec accomplished.

Your next question comes from Steve Lambert – WashingtonMutual Investments.

Great quarter. Thank you very much for that quarter. Can youbriefly comment on the share repurchase, 26,500 shares? Is there an averageprice per share there, and do you plan on continuing to buy those shares again?Is there a maximum dollar amount you'll pay per share?

We repurchased 26,500 shares at about $200,000 so I thinkthat the average price was about $7.47. The board's authorized the company togo up to $4 million, and I think we're just going to look at that sharerepurchase on a more opportunistic basis. We still have authorization to buythose shares, but at the moment we have not been buying shares lately and we'lltake a look at that, we'll watch the share price and decide whether we want tocontinue with that or not.

Timothy, welcome aboard and great quarter again, guys. Tim Stultz: Thank you.

Your next question comes from Phillip Zhara – The AlgorithmGroup. Phillip Zhara – TheAlgorithm Group: Congratulations on the great quarter. Besides Samsung, what wasthat other customer that was over 10%? Tim Stultz: That was Toshiba. Phillip Zhara – TheAlgorithm Group: Toshiba. How doesthat compare, the concentration, to2006? Tim Stultz: I will try to findthat. I'm not sure I have that data at my fingertips here. Just a moment. In2006, it looks like the only one that crossed the 10% was Applied Materials,and the other ones were below -- I'msorry. Samsung was 14% and Hynix was 14%. Phillip Zhara – TheAlgorithm Group: How does the transition from DDR1 to DDR2 or from DDR2 toDDR3 benefit Nanometrics, the DRAM technology? Tim Stultz: We continue to havestrength in both markets, but the flash has been much stronger for us.

Your next question comes from Jared Cohen - J.M. Cohen &Co. Jared Cohen - J.M. Cohen & Co.: I was wondering,given how well you're doing, if you can give us some idea why you seem to beable to grab more orders than some of your competition, particularly some ofthe companies your own size? Tim Stultz: I'm not sure that I can respond to that. We really focus onour customers much more than we do on our competitors. We believe we have adiversified portfolio of products sold primarily to wafer manufacturers and LEDmakers. We think that they're good products, they're competitive, and, youknow, candidly speaking, what we do is we try to close the orders that are infront of us. Jared Cohen - J.M. Cohen & Co.: Just out ofcuriosity, if we take a look at your last quarter, how much of your productrevenue came from existing customers? Tim Stultz: Off the top of my head, I don't think we have anysignificant business from any new customers.

Your next question comes from Weston Twigg - Pacific Crest.

I wanted to go back to the service gross margin. 10% is apretty big increase over last quarter. I know you mentioned some of that wasfrom upgrades, but I'm wondering how should we look at an improvement ofservice gross margin moving forward, and do you still have the 19% goal?

One of the luxuries of being in business for a long time isthat we have a pretty large installed base out there, and we're focusing ontrying to sell more of these upgrades into our installed base. I think that trend will continue into thefuture here. As far as your question to the goal I mean, we still havethat goal out there. I mean, kind of refer you back to Tim's earlier commentsabout the company moving towards a blended 53% gross margin for the company. We'regoing to continue to move towards that goal.

On the equipment side, on the product margin side, it lookslike 50% in June and then 49.6% inSeptember, even on a little bit higher revenue. Just wondering if you can explainthe slight drop in the product gross margin?

The biggest piece of that was just the mix of the productsthis quarter versus last quarter. Also, you know, I think Tim referred to ourintegration being completed. But during Q3, I don't think we have reallyrecognized or realized the full impact yet of the cost savings that we're goingto be getting out of our transition and our integration of the two companies. I think it's just a reflection of those twoitems in Q3.

Okay. So that shouldtrend upward then in Q4?

Again, we're moving towards a goal of 53% as our grossmargin, and we're going to continue to move towards that goal.

Also wondering on theOCD and overlay markets, you know, we've talked about ASML entering the OCD andoverlay markets and I'm wondering if you can comment on how that might impactNanometrics in the sense of should we expect royalty revenues to kick in, orcan you comment on that relationship? Tim Stultz: Well, the onlycomments that we can address right now is we certainly have a well-known IPagreement and we do believe there's commercial value in that agreement, and weare working to realize that. We have discussions underway, but we're bound byan NDA and so we really can't discuss it in more detail.

Just wondering if you could give me CapEx and depreciationfor the quarter?

It was about $1 million.

CapEx?

CapEx was about $300,000.

Going back to the deferred revenue question that Gary askedabout, wondering if we should look at it as essentially there being a bump inthe revenue this quarter from working out some of that deferred revenue, andwould that then imply that maybe we might see a down revenue quarter inDecember, next quarter? Does that make sense? Tim Stultz: Obviously, we do not give specific guidance. I reallywouldn't be addressing that one.

Your next question comes from Michael Amari - Americo.

Congratulations, guys, a great quarter. You're doing a greateffort to turn the company around. I know your business is lumpy, but did yougive any figure on backlog? Tim Stultz: No, we don't.

At one time you attempted a relationship with ASML in photolithography. Did this come out to any conclusion? Tim Stultz: It has not reachedany conclusion. As I mentioned earlier, we do have an IP agreement with them,and we believe there is some commercial value in the agreement. But we reallyaren't in a position both to talk about it nor quantify it.

That was the last question in queue, so we'll turn it backover to management for closing remarks. Tim Stultz: I want to thank everyone for calling in. I personally feelpleased to be in a position that I was able to report on the work that was doneby a great team of managers, and we're ready to close the meeting.