Photronics, Inc. (PLAB) Q4 2015 Earnings Report, Transcript and Summary

Ladies and gentlemen thank you for standing by. Welcome to Photronics’ fourth quarter earnings call. During the presentation, all participants will be in a listen-only mode. Afterwards, we will conduct a question and answer session. [Operator Instructions] As a reminder, this conference is being recorded Thursday, December 3, 2015. I would now like to turn the conference over to Troy Dewar. You may begin.

Thank you, [Doug]. Good morning everyone. Welcome to our review of Photronics’ 2015 fourth quarter financial results. Joining me this morning are Dr. Peter Kirlin, Chief Executive Officer; Sean T Smith, Senior Vice President and Chief Financial Officer; Dr. Christopher Progler, Vice President, Chief Technology Officer and Strategic Planning. The press release we issued yesterday along with the presentation material which accompanies our remarks are available on the Investor Relations section of our web page. Comments made by any participants on today’s call may include forward looking statements within the meaning of the US federal securities laws. Forward looking statements are based upon a number of risks, uncertainties and other factors that are difficult to predict. Actual results may differ materially from those expressed or implied. For a complete disclosure regarding these forward looking statements can be found at the bottom of our press release. Photronics assumes no obligation to update any forward looking information. Finally, during the course of our discussion we will refer to certain non-GAAP financial metrics. These numbers are useful for analysts, investors and management to evaluate our ongoing performance. The reconciliation of these metrics to GAAP financial results is provided in our presentation materials. At this time I will turn the call over to Peter.

Thank you, Troy and good morning everyone. By just about any metric, our fourth quarter was one of the best quarters in the history of the company. We achieved record quarterly revenues with strong demand across High-End product groups, including memory and logic IC and FPD. Our gross margin was higher than we have achieved in nearly a decade and our operating margin was the highest ever with both measures exceeding the financial target established at our analyst day in March. Our operating model which is capital intensive with high operating leverage is over delivering with incremental margins again ahead of our targets. Additionally we’ve added to our growing cash position providing us with significant financial strength and flexibility to invest in our future. While there is always room for improvement and we are by no means complacent, I am extremely pleased with our results and the performance of everyone in the organization. Several years ago we established a strategic focus to invest and grow our high end business. Our investments in advanced tools for IC and FPD as well as PDMC have not only grown our high end revenues but have firmly established us as both a global technology and market leader to supply photomasks. For example, total sales in the fourth quarter increased 14% compared with last year while total high end, including IC and FPD increased 49%. This is a clear indication that investments we’ve made to grow our high end business are paying off. Customers rely upon us to provide them with high quality masks as we launch new designs and are increasingly looking to us as a trusted resource when they plan their future product roadmap. I am proud to say that we were recently named the best partner by UMC and we were awarded the Best Mask Shop Supplier of the Year Award by TowerJazz, achievements that you do not receive without a lot of hard work and dedication by the entire organization. I think it’s fair to say our strategy to grow high end business is working. As we begin a new fiscal year, I would like to spend a few minutes discussing the strategic priorities that we are focusing one as an organization. The focus for 2016 and beyond is growth. First, it boils down to three simple objectives: Win high end business in IC and FPD; expand our market leading position in mainstream IC and expand our geographic footprint and to areas where we see opportunities for long term growth. In order to discuss our first objective we must look back about 10 years ago when we were best described as a low cost technology following the photomask industry and our high end IC business was essentially zero. We then made a strategic decision to partner with Micron growing a mask joint venture with them that provided us with advanced process technology. Over the last eight years our high end business has grown such that today it represents nearly half of our IC revenues. While that is a tremendous accomplishment, we believe that there is still room for us to significantly expand our high end presence. The advanced semiconductor market is now consolidating dominated by a handful of IDMs and foundries. To win we must deliver great customer service utilizing our global manufacturing footprint and unmatched process technology to provide the best photomasks to our customers. To this end, we are currently working to leverage the power of the Micron process of record to expand our memory market share in the foundry memory’s base in Taiwan while ensuring that we are well positioned to supply the memory market in China as it develops. The format should hedge any potential reduction in Micron demand post the termination of our JV in May, the latter will be a growth driver for us in 2017 and beyond. In the logic space, we shipped several hundred 14 nanometer masks in 2015 to the semiconductor industry’s technology leaders. But we are still in very early stages to ramp at this node. It is no secret that each customer has their own captive masks making operations. However these masks by the far are the most complex ever fabricated and they consume disproportionate amounts of high end mask making capacity. When this node ramps, we believe that our customers would need significant merchant capacity in order to meet their cycle time targets and we stand ready to support them. In the meanwhile we are already well engaged in 10 nanometer and EUV development work with these very same customers. Similarly the high end FPD market is consolidated among a few key customers located primarily in Korea. Our facility there with unmatched capability has enabled us to grow our business. Demand for our masks is very high and we are actively working to incrementally raise our high end output with our current asset base. Display quality is an increasingly important differentiator for the mobile market and we see the long term demand for advanced FPD photomask growing. Beyond the high end there is significant growth occur in FPD market in China and although small, our Chinese FPD business which are serviced primarily out of our facility in Taiwan nearly doubled in 2015. To further develop this business we recently opened a sales and application office in China for both IC and FPD customers. Our second growth objective is based on new opportunities we see in our mainstream IC business. Historically this business has been tough due to high level of competition and constant pricing pressure. These factors have not changed but we believe there is potential for growth in this market segment driven by the overarching application called the Internet of Things. While much has been said and written about this megatrend and at times it seems reality doesn’t match the hype. It is definitely happening. Some industry research suggests that the semiconductor market targeting applications for the Internet of Things could grow by over 30% on a compound annual basis for the next few years but this is coming off a small base, expectations are high. We think that means a lot of new designs and consequently a lot of new photomasks. These products don’t offer the same ASP as their high end counterparts but they drive volumes to our facilities, absorbing fixed costs on relatively low cost assets having us maintained attractive margins even with legacy products. Moving to our third objective, in addition to growing current industrial footprint, we are exploring strategic geographic regions to which we can expand our business. Our planning process is still in the early stages regarding this initiative but there is little doubt that China presents an opportunity for us in both the semiconductor and flat panel display markets. We believe there is a role we can play and are currently implementing strategic plans to establish a local presence. This is not likely a significant move the needle on the revenues during the next four to six quarters, but we believe the long term outlook for this country is very compelling. 2015 was a great year for Photronics but there are many reasons to believe the best is yet ahead of us. If we perform against our growth objectives while continuing to drive costs out of the business, we have the potential to reach new highs in both market share and financial performance. Before turning the call over to Sean, I would like to thank all the Photronics’ employees for their commitment and dedication to improving our company in 2015. Sean will now provide more details on our Q4 performance and our outlook. Sean?

Thanks, Peter and good morning everyone. I’ll provide a brief analysis of our financial results for the fourth quarter of 2015, review our operating results, balance sheet, cash flows, and forecast. I will also briefly review our results for fiscal 2015. Please turn to Slides 4, 5, and 6, which shows our sequential quarterly results in IC and FPD revenue performance. Total revenue for the fourth quarter was a record $141.7 million, up 8% sequentially and 14% versus last year with the growth in high end photomasks for both IC and FPD. Total high end revenue improved 28% sequentially and 49% year over year as demand was very strong. Revenues for IC photomask were $111.5 million as compared to $104 million for Q3. As Peter alluded to, revenues for high end IC photomasks which are 45 nanometers and below were a record $50 million representing 45% of our total IC sales. Sequentially high end IC revenue was up $11 million as a result of increased high end memory and logic during the quarter as memory customers continued to ramp 20 nanometer DRAM products and logic customers launched new design at 40 and 28 nanometers. Mainstream IC sales during the quarter were $61.6 million, a sequential decrease of $3.4 million or 5% as a result of reduced foundry demand in Asia. Revenues for FPD photomask were $30.2 million, up 9% or $2.5 million sequentially. The increase was related to increased G8 and above orders as market demand for advanced displays was extremely high. The new writing tool we commissioned earlier this year has been running at capacity and demand from our customers for advanced mobile displays such as AMOLED is high. High end FPD revenue was $22.5 million or 75% of total FPD revenues, an increase of $4.4 million sequentially. Breaking out Q4 sales geographically, 66% of total sales were from Asia, 28% from North America, and 6% from Europe. Now let’s continue through the income statement. Gross margin for the fourth quarter was 31.5%, up 320 basis points which equates to an incremental drop-through to a 74% sequentially. This represents the highest gross margin since Q2 2006. The increase was related to high operating leverage on the increased sales, improved manufacturing efficiencies and reduced variable costs as certain litho tools were fully optimized this quarter. Operating expenses were essentially flat compared with the previous quarter resulting in an operating profit margin of 19.2%, the highest in over 15 years. This represents an increase of 510 basis points from Q3 and amounts to an 87% incremental margin on a sequential basis. EBITDA for the quarter was $15 million and was $161 million for the full year. Other income net for the quarter was $300,000 as compared to expense of $600,000 last year, the improvement resulting from favorable foreign exchange. During the quarter we recorded a tax provision of $5.4 million which was higher than our guided range as result of increased profits outside the US. GAAP net income was $18.6 million or $0.25 per diluted share. Now taking a brief look at our results for the year. Our revenues were a record $524 million. IC revenues were $421 million with high end at $167 million or 40% of total IC revenue. FPD revenues were $103 million with high end at 59%. The gross margin of 27.3% was the highest since 2006. Operating income was $72 million or 13.8% of sales, the highest since 2011. Year over year the incremental gross and operating margins were 68% and 63% respectively and net income for the year was a record high at $44.6 million which equates to $0.63 per diluted share. Now turning to the balance sheet. Please turn to Slide 7. Cash and cash equivalents at the end of the quarter amounted to $206 million. Our net cash, or cash less debt, was $73 million at the end of the quarter, an increase of $16 million sequentially. Our investment in our JV in Boise amounts to $93 million which we expect to monetize once the JV concludes. Total debt at quarter end was $133 million which includes a $57.5 million, 3.25 senior unsecured convertible note which is due in April of 2016. And our leverage ratio is now less than 1 at 0.82 which is our lowest leverage ratio in many years. Taking a look at our cash flows. Cash provided by operations for the fourth quarter was $41 million and was $133 million for the year. Depreciation and amortization was $21 million in Q4 and $82 million for the year. Cash flow used in investing activities in Q4 amounted to approximately $24 million and $104 million for 2015 which is primarily all CapEx. Please turn to Slide 8 as we take a look ahead. Taking a look at CapEx, we expect our 2016 cash CapEx needs to be approximately $50 million to $75 million of which approximately $26 million was accrued for year end. Our 2015 investments will be principally geared towards high end leading edge products for IC and FPD applications. We do expect to continue to generate free cash flow in 2016. Our visibility, as always, continues to be limited as our backlog is typically one to two weeks. For Q1 2016 we do expect to experience some variability with high end foundry logic orders as customer ordering patterns tend to be lumpy with the introduction of new product designs. As a result, we are projecting revenue for the first quarter of 2016 to be in the range of $133 million to $143 million. We also expect our depreciation and amortization to increase modestly during the quarter as additional tools come online. For the first quarter, we are estimating taxes to be in the range of $4 million to $6 million. As a result, based upon our current operating model, we estimate earnings per share for the first quarter to be in the range of $0.14 to $0.23 per diluted share. In summary, I’ll leave you with a few key thoughts. As Peter said, we expect to have top and bottom line improvement in 2016. We expect our EBITDA grow as well, and we are confident about our business model and our ability to grow market share at the high end. We see continued opportunities in our customers’ businesses and node migration plans, and we have a strong financial position and excellent technology to capitalize on those plans. And finally, we expect to continue to build on the momentum that we’ve established over the past few years as a leader in advanced photomask technology. Now I’d like to turn the call over to the operator for your questions.

[Operator Instructions] Our first question comes from William Stein with SunTrust.

I am hoping you might talk a bit about the longer term strategic options that the company has with the cash flow delivering a greater cash balance and of course with the end of the Micron joint venture and the cash that comes from that, I believe in May of next year, I think you alluded to evaluating capacity additions in China as the potential main use of those funds. Did I understand that correctly or are there other alternatives that the company is contemplating for the strategic use of that cash?

Bill, if you look at what we might do in the future, I think you correctly heard that we see China as an area for organic growth and of course, the high end business is another area for organic growth. So both of those would require additional CapEx. Beyond that, of course, we have the ability – with the cash we have and cash flow we are generating to reduce debt, moving beyond that we would – and are thinking about accretive M&A to further expand our footprint and then finally there is the traditional – more traditional methods of returning value to shareholders. So we are actively discussing and looking at all of those uses of the cash the business is generating.

That’s a very helpful clarification, thank you. If I can just squeeze one more in perhaps on the margin structure of the company, you clearly out-delivered relative to your targets in the quarter, and the guidance implies to me I think another quarter of being above your target level. And so I am wondering when you might re-evaluate your margin targets whether it’s something that we should expect in an upcoming event or how we should think about that?

50% drop-through which we generally target is quite I think – is still quite relevant. One of the reasons why we over-delivered in the current quarter – if you look at our FPD business, it’s running at full capacity utilization, so we are sold out. And when you are running consistently sold out, you have another gear which you typically don’t have. And our team in Korea did an outstanding job in ramping that tool, it’s a highly seasoned group and they are now managing the order intake to maximize our profitability. Normally we wouldn’t have that extra gear, and we have it now, we are likely to have it or expect to have it in the coming quarter, how long we will have it depends a lot on how the market itself evolves.

Our next question comes from Patrick Ho with Stifel Nicolaus.

First off, on the logic commentary that you’ve made in your prepared remarks, as you look forward and the variability that you talked about, are you seeing that on, say, the foundries or the second tier foundries 40 and 28 nanometer node or are you seeing some of that variability on the 14 nanometer side?

It’s both, Patrick. Our high end logic business went up both in Taiwan and Korea last quarter, and it’s across both the 14 and 28 nanometer nodes. And there’s still a lot of chop in our predictability in that segment and doesn’t have anything to do with our execution, it’s everything to do with our customers’ execution and the development of the market. So it’s tough for us – it’s really tough for us to predict what’s going to happen there as every quarter goes by.

Maybe moving to the memory side of things, obviously the last couple of quarters you have been benefitting from the industry transition to 20 nanometer DRAM. As you look forward into both the first quarter as well as the rest of 2016, how do you see the industry’s ramp of 3D NAND to being a growth driver for the company as we look forward?

Yes, it’s basically – what we see is as the 20 nanometer DRAM ramps down, we see the 3D NAND ramping up in 2016 and obviously where the Intel announcement for ramping non-volatile memory capacity or capability in China, so that should give that transition up more legs than it normally otherwise would have, it would kind of be a bit prolonged.

And final question from me on the flat panel display market, you saw – I guess some of the traditional strength in the Gen 8 picking up. Can you give at least qualitatively how the AMOLED market did in the past quarter as well as your outlook for kind of 2016 as a whole?

Well I think in the mobile space there is clearly a trend afoot with more large customers evaluating the adoption of AMOLED and we see that in our business presently, the extent that, that trend builds on momentum or gains momentum, it will be very good for us. It’s hard, I don’t think we can make any definitive comments about that but it looks like the winds are blowing in the right direction.

Our next question comes from Edwin Mok with Needham.

First question on the guidance. Just trying to understand how much of that is just seasonal effect given January quarter is typically a seasonal softer quarter for you guys, versus this foundry variability that you mentioned in the call.

As Peter was mentioning and I mentioned in my prepared remarks, Edwin, the foundry business is a bit choppy, logic, so it’s hard to predict and with the ASPs, those products can wreak havoc with the range and there will be some seasonality in Q1 but to the extent we hit the high end of our guidance we would still expect to have a 50% drop-through at the operating margin line.

That’s helpful. On the quarter I noticed that mainstream IC declined I guess [indiscernible] how do you kind of think about that business going into January quarter and going into 2016, what contributed to the sequential decline in last quarter and is that kind of a short term event or do you expect that to continue?

If you look at our mainstream business for the last – more than the last 12 months the US and Europe mainstream has been rock solid and stable. The reduction in mainstream revenues in the fourth quarter was all in basically in the foundry market in Asia and I think the softness in that business is well documented everywhere you look, maybe in our industry. So we would expect that when the Asia business comes back, the foundry business comes back, mainstream business in Asia will come back with it, we see no loss of market share, we just see a loss of market in total.

If I can add on it, the mainstream business year over year was up from – up to $254 million which is about 63.5 million, 64 million per quarter, and if you remember in Q2 of 2015 we did see a drop, I think it went down about 62 million related to the lunar new year in Asia. So to Peter’s point, it’s been pretty stable throughout the year and we expect that to continue into 2016.

On the memory side, with the end of the Micron joint venture in May, how do you kind of think of Micron as a customer, do you expect them to do more in sourcing right up to that end of the joint venture or should we expect that to be -- continue to be a pretty decent customer until at least the next technology for the DRAM ramp which probably won’t happen until ’16 or ’18, how do you kind of think about that?

I can take this one. Thanks, Edwin. I think as far as the Micron business per se, I mean we have the technologies transferred for the current nodes and the next couple nodes. You probably know Micron is working with customers in tech transfer outside of their company, companies in Asia and other places, we are working with them as well. Peter mentioned the Intel fab in China, obviously we are looking at that. So we do expect a gradual decline in the Micron business as they start to do more in-sourcing. We continue to believe we will be the largest supplier, perhaps exclusive outsource partner. On the other hand, we also think we have a very good position with some of the companies around the world that are adopting the Micron processes into their fab. So our intention of course is to make that as smooth as possible, continue to be a strong supplier to Micron and then also take advantage of the technology with other customers around the world.

And then lastly on the flat panel display, I think you mentioned Gen 8 was a big driver for the quarter. Can you maybe provide some color on that, if you, Chris, -- go back to you, Chris. In terms of how that this is trending, my understanding is there is increased complexity especially on the 4K TV [indiscernible] driving that demand, right? And it seems like that to be a trend that can continue with AMOLED potential layer on top of that, so even though your flat panel displays at peak or pretty close to call, record revenue, that can continue to grow, is that the right way to think about that business?

Yes, for the high end FPD a little more strength recently on the large format displays, some 4K smart TV and other things as well more complex transistors. AMOLED is used of course in certain applications quite widely particularly for Samsung products. We are also starting to see it move outside of that space in that particular application too. So regarding your question I think right now the LCD TFT side is a little bit stronger but we see the early signs of AMOLED kind of breaking out of its traditional use model and hopefully we will get wider adoption and the complexity of the masks and the technology to build those masks is actually quite advanced, the tool we have in Korea is well suited for it. So we are very well positioned to take advantage of that I think.

Our next question comes from Tom Diffely with DA Davidson.

First, Sean, in the past when there has been a slight miss, penny or two, you pre-announced the downside. With such a big upside this quarter, why didn’t you pre-announce upside?

That’s a good question, Tom. Well we are going through our year end processes and out audits. So we want to ensure the numbers were rock solid before we announce anything.

So I guess starting with the AMOLED or OLED part of the business, I know for several years you have been working very closely with Samsung, you’ve developed some really great technology there, you are one of the leaders in the marketplace. Does the relationship with Samsung preclude you from supplying anybody else?

No, it certainly does not and I think the right way to answer is that the leaders in the FPD market in Korea look to us to supply the most advanced photomasks, so it doesn’t preclude us from working with others and as Chris mentioned both in AMOLED and now in the FPD space there is more and more – we can think of like the traditional approach to building high end IC photomasks is finding its way into the FPD space, and we are at the cutting edge of that, and the pricing on those masks right now – because they are novel for the market – is quite high.

And you talked earlier about how the dynamics on the memory space, you have DRAM, the 20 nanometer buildouts that are slowing down a bit and then NAND is picking up. When we go through that transition from DRAM to NAND from a mask point of view, what is the impact to your business? I know the NAND masks themselves are less expensive but there is probably more of them, so I was just kind of curious the net net if you look in the out year what do you expect memory to be up or down?

I think that’s a very tough question, so that it really depends on the speed at which one node ramps down versus the speech at which the other goes up, and you are right about the flash – 3D NAND flash, so that is, the price is less but the units are greater. So it’s a very tough call but I think generally speaking we are expecting the memory market to be more or less stable.

So the tools are – you have that same utilization rates and the market is pretty similar.

Without any other greater color, this is something that we will – obviously we are very close to, we are working hard at and as the year evolves, we will update you every quarter but it’s very tough to give you any more clarity than that.

And then with the huge growth in the high end business over the last year, did you mention that you are fully utilized with some of your tools at this point with your capacity?

We are not at capacity in the IC business, we are at capacity in the FPD business. Having said that we are watching the market where we have some capacity additions coming online, demand is very strong. So we are very much on top of – can and should we add capacity in our display business. Right now we are trying to incrementally increase our capacity through tuning of the tool set that we presently have, whether that’s going to be enough to capture both demand that’s out there is something that we evaluate constantly.

And if the market moves from more of the large panel TVs to the smaller panel AMOLEDs over the next year or two, does that free up capacity, does that utilize more capacity for you, the transition from large screens to small screens?

That’s a highly mix dependent question. So I really can’t answer, there is not a great difference. What I can tell you is that it doesn’t matter what the size of the mask is, P-80 tool is significantly faster than the P-10. So whether it’s a large format mask or whether it’s AMOLED mask, the P-80 tool will write those layers with higher fidelity, higher CD performance and higher speed.

And then when you look at the mainstream business, would you expect greater than normal levels of shutdowns over the holiday period this year versus normal years just from the softness in the marketplace?

Well we have seen that, we have seen it and we are expecting to see it in some of the foundry business in Asia. Again if you look at US and North America they have holiday plans as we understand now are pretty traditional, no great variance really.

And over time as you see IoT becoming a bigger driver of your mainstream business how much access or how much capacity could you expand into or bring online on the mainstream side if that continues to ramp here?

Our mainstream is very much – I think the challenges there are different than the high end and generally we look to add capacity in the mainstream from the used tool market rather than new tool market given the ASPs that are out there. And thus far anyways we have been able to cost effectively add mainstream capacity anywhere we found the bottleneck and certainly that’s what we will continue to do going forward.

And then final question, when you look at the Chinese market, what is the competitive environment like there now, are the domestic players popping up or is it still a market that’s mainly served from the other regions?

If you look at China there is – so SMIC has their own captive just as TSMC has their own captive. Outside of that there is one supplier of mainstream photomasks in China. The real growth in the China market in the mainstream is that 40 nanometers and below. So there is right now an absence of domestic merchant that has the capability to supply the high end market, and those reticles are presently being supplied from outside of China.

Our next question comes from Steven Chin with UBS.

You mentioned before that you are looking at M&A given the high cash balance. Can you just talk about sort of how you approach that, what you are looking for in a potential target and when you think we will start to see some M&A activity?

It’s quite clear that there is a lot of consolidation happening in the semiconductor space presently both at our customer level as well as in the supply chain. If you look at our JV in Taiwan we formed a little more than a year ago now, about a year and a half ago actually with DNP, at the time we said we thought that it was the first step down the path of the consolidation of the photomask industry. So when we look at M&A the first place we look is where we know the best. So – and we are in constant discussion with all the players in the space. So consolidating our core business is job one. And then beyond that, we look at similar players where we believe that strategically some of the things we do well could play well in our business but the keyword there is you heard me use is accretive. So that’s generally how we look at consolidation.

And then looking into 2016, can you just give us an initial view of how you expect spend to trend for the merchant photomasks and IC and then how you see that playing out in the logic market and the memory market?

Well I think as Sean and I both said we are expecting to grow as a company in 2016. There is no doubt that – if you look in the industry right now – our industry is not growing but we are growing because we are gaining market share. And our objective for next year is to grow the business regardless of whether the market improves or not. End of Q&A

And I am not showing any further question at this time. I’d like to turn the conference back over to our host.

Thank you everyone for participating on this morning’s call. I am encouraged by our performance in 2015 and believe that 2016 being another year for Photronics. We look forward to updating you throughout the year on our progress. Thank you.

Ladies and gentlemen, this concludes today’s conference call for today. We thank you for your participation and ask that you please disconnect your line.