Photronics, Inc. (PLAB) Q4 2018 Earnings Report, Transcript and Summary

Good day, ladies and gentlemen and welcome to the Photronics’ Fourth Quarter Fiscal Year 2018 Earnings Conference Call. At this time, all participants are in a listen-only mode. Later, we will conduct a question-and-answer session and instructions will follow at that time. [Operator Instructions] As a reminder, this conference call is being recorded, Wednesday, December 12, 2018. I would now like to introduce your host for today’s conference, Mr. Troy Dewar, Director of Investor Relations. Troy, you may begin.

Thank you, Chanel. Good morning, everyone. Welcome to our review of Photronics’ 2018 fourth quarter financial results. Joining me this morning are Dr. Peter Kirlin, Chief Executive Officer; John Jordan, Senior Vice President and Chief Financial Officer; and Dr. Christopher Progler, Vice President and Chief Technology Officer, Strategic Planning. The press release we issued earlier this morning, along with the presentation material which accompanies our remarks, are available on the Investor Relations section of our webpage. Comments made by any participant on today’s call may include forward-looking statements that include such words as anticipate, believe, estimate, expect, forecast. These forward-looking statements are based upon a number of risk, uncertainties and other factors that are difficult to predict. Actual results may differ materially from those expressed or implied and we assume no obligation to update any forward-looking information. 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. A 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. Earlier today, we posted another strong quarter with record revenue of a $144.7 million. This is the sixth consecutive quarter of sequential growth and the fifth consecutive quarter of double-digit year-over-year growth. The fact that we hit a record on the top line in the face of a semiconductor industry downturn is strong testimony to the effectiveness of our work to reposition the business to take advantage of growth in China, where we are finding our product offering to increase our penetration of captive customers. As with previous periods, we realized the benefits from both of these initiatives during the fourth quarter. Revenue shift to China increased to 146% year-over-year and revenue to captives improved 17% over last year. It was a superb quarter, which reinforces the fact that our strategy is working. In addition to record quarterly revenue, we also achieved record revenue of $535.3 million for the fiscal year. Entering 2018, we had the wind at our backs as the trajectory of the market along with qualifications wins we had secured indicated that we would have a solid year of growth. Looking back, our top line came in better than expected and we set a new record for Photronics. As an organization, I believe we did tremendous job of taking advantage of the opportunities afforded us by the market as well as creating some new ones to enable us to reach even higher. We have aligned our operation and business with secular market trends and I believe we are seeing the benefits of this approach. Despite the revenue growth, margins decreased sequentially. Some of this was driven by expenses associated with relocating existing tools as well as expected startup costs in China. Beyond that, we saw an impact from making mainstream IC product on some of our high-end tools, which produced lower levels of profitability. This was not optimal, but necessary given shifts in high-end logic demand. This resulted in operating margin of 12.5% and EPS at $0.18 per share. With these operating results, we were able to generate sufficient cash to offset CapEx and share repurchases during the quarter along at the end of quarter with a great balance sheet and essentially a flat cash balance relative to Q3. John will provide more details in his review, but I am very pleased with our performance in 2018 and how we are positioned headed into 2019 as we anticipate the completion and ramping of our new China facilities. For 2019, we are cautiously optimistic as we believe that for the first two quarters, we can capitalize on the growth segments of the IC and display photomask markets and deliver year-over-year growth. While in the second half of the year, the ramp of our China factories should drive revenues sequentially higher. We control our execution against these opportunities. In contrast, we do not control the geopolitical and related market uncertainties, which are large on notes. We are continuously monitoring developments in these areas and will respond as needed. Throughout our 50-year history, we have always made it a priority to keep cost as low as possible, while adjusting our industrial footprint to be aligned with our customers needs. It’s part of our DNA. And I am confident that as an organization, we will respond effectively to any future challenges. The record revenue level we reached in 2018 was accomplished by delivering on our strategic priority of repositioning the business. The objective of this strategy is to help us grow while diversifying our revenue stream. As an example, revenue to our largest FPD customer was down 8% for the full year of 2018. Yet, total FPD revenue increased 19%. This was due to our increased revenue in China which more than doubled. By the way, we began to see increased demand from our largest FPD customer with Q4 revenue up 18% sequentially reflecting improving demand for high-end AMOLED as well as our position as the technology leader with the most advanced P800 lithography platform in the industry. Moving to IC, revenue to captives increased 85% for the full year of 2018 and revenue in China more than doubled. This allowed us to grow total IC revenue 19%, while revenue to our largest customer was only up mid single-digits. We ended the year with shipments to China running at 22% of total revenue, a level we achieved during both Q3 and Q4. This helped us attain record total revenue and is one of the reasons we are optimistic regarding our China investments. Clearly, we have already established a strong presence in the region. The market is growing and our shares should only increase as we begin manufacturing in the country. On that note, I am pleased to announce that our work in China to build, equip and ramp our two new facilities is moving along very well. Construction of the clean rooms and related critical systems is essentially complete and we are in the process of moving in our tools. More importantly, we remain on track to begin customer qualifications in this spring with production slated to commence as we exit Q2. I am very proud of the tremendous amount of work the global team has done to bring us to this point with the finish line now coming into view. The market for photomask in China is continuing to strengthen. For example, power producers there introducing innovative technologies and pushing forward with larger screens and higher resolution. Recently, Royal, a Chinese power producer and customer introduced the commercial-ready foldable display for a mobile phone that can open up to the size of the tablet. This is the first that we believe to be many foldable devices that will be brought to market in the coming years. In large format TV, the primary market driver is increasing average screen size. Secondarily, 8K displays continue to gain market share. This business is supported by the transition to G10.5+ panel production and the second G10.5+ panel fab is currently ramping in China with three more fabs under construction. Our new facility in Hefei is designed to capitalize on this trend. While on China, we’d like to offer my perspective for the recent trade issues. Everyday a new piece of significant news seems to appear that more often than not demonstrates that the tension between the two governments remained high and the ultimate outcome of trade discussions is uncertain. There have been many surprises so far and there are most certainly more to come. Short-term, these actions can go either way as far as our business is concerned. Having said that thus far, the direct impact to Photronics has been minimal and not material to our results. In the long run, I believe this tension will motivate more not less semiconductor content to be manufactured in China. And without a doubt more chips and displays equates to more demand for photomasks, especially for China domiciled manufacturers. On a related topic, the U.S. District Court of Northern California filed an indictment against Fujian Jinhua Integrated Circuit Company, UMC and 3 former UMC executives alleging theft of trade secrets from Micron. This is an ongoing legal process and the ultimate outcome is not yet known. However, I can see that we have not seen a mutual impact as a result of these actions. We continue to monitor various situations and will provide updates as needed. In conclusion, I am extremely pleased with our performance in 2018. We grew revenue and earnings. Our business accelerated dramatically in China. We increased our market penetration at captives and advanced our technology leadership in AMOLED. Our balance sheet is strong and we are set to begin production in China at two new state-of-the-art facilities within the next few months. 2018 was a great year for Photronics and I believe that 2019 can be even better. Before turning the call over to John, I would like to thank all of the Photronics employees for your outstanding achievements to drive record business performance in 2018. John?

Thank you, Peter. Good morning, everyone. The record revenue of $144.7 million in the fourth quarter reflects the successful repositioning of our business by developing business with China customers and increasing our market share with captives. Demand for photomask remained robust across most of our markets and we posted revenue growth in both IC and FPD. Before reviewing the results for the quarter, I want to discuss a change that impacts the comparison of fourth quarter results with previous periods. Beginning in 2018, we moved the fiscal year end to October 31. Going forward, the first three quarters will continue to end on the last Sunday in the quarter. Fourth quarter will end on October 31 every year. For this quarter’s comparisons, the importance of this change is that Q4 2018 is 3 days longer than the two previous comparable quarters. Revenue overall increased 6% sequentially and 20% over the same quarter in fiscal 2017 to $144.7 million. IC revenue improved 15% year-over-year and 3% sequentially driven by strength in overall logic demand in Asia and by strong demand for high-end memory generally. High-end logic demand was somewhat softer as demand for products using these advanced chips was tepid, but that softness was more than offset by stronger mainstream activity. Revenue growth for products shipped into China was once again a big factor in our performance increasing threefold over last year and representing 17% of total IC revenue. Revenue to captive customers was up year-over-year after a very strong year last year and down only slightly quarter-over-quarter related primarily to the softness in high-end logic. Looking ahead, we believe high-end logic demand will recover, but timing of that recovery is obviously uncertain. FPD revenues were a record $33.7 million in the quarter, up 36% over last year and 16% over last quarter. AMOLED for mobile displays was the biggest driver, up 73% from last year. We have talked before about the trade-offs between AMOLED and LTPS in the mobile format. With the AMOLED trend strengthening during the past two quarters, it’s apparent that more and more panel produces are moving toward this technology. That being said, we still see solid demand for LTPS and expected to continue to be a contributor in the near-term. Masks for large format LCD panels rose slightly in the quarter. We expect to see more meaningful growth in this sector later this year when we begin to produce G10.5+ masks in China. Full year revenue of $535.3 million was 19% higher than fiscal year 2017 revenue. IC revenue increased 19% from $350.3 million in fiscal 2017 to $416.1 million in fiscal 2018, and FPD also increased 19% from $100.4 million in fiscal ‘17 to $119.2 million in fiscal year 2018. As Peter mentioned, gross margin was down from Q3 for a few reasons. First, the cost of moving tools during the quarter has readjusted our manufacturing footprint to match customer demand. Second, there was a lower margin mix of product produced on some high-end tools. Finally, we had a shift in product mix with an unfavorable impact on margins. We believe these factors are temporary and expect margins to expand when the high-end IC business recovers. In the operating expense area, R&D cost for qualification activity for several high-end products together with increased compensation expense and as anticipated, China’s start-up activity increased operating expenses from $15.2 million or 11.1% of revenue in Q3 to $17.4 million, 12% of revenue in Q4. Operating expense in China accounted for 30% of the increase in operating expenses in the quarter. Full-year operating expense of $65.9 million in fiscal 2018 or 12.3% of revenue increased from $59.4 million but compared favorably to the 13.2% of revenue in fiscal year 2017. Operating expenses in the China operations for the year accounted for 39% of the increase in operating expenses. Operating margin decreased from 15% in Q3 to 12.5% in Q4, but was much better than the 10.3% margin in Q4, 2017. Full-year operating margin of 12.3% was manifestly better than the 7.1% operating margin in fiscal year 2017. Below the operating line, other income improved on foreign exchange gain and the sale of an asset. Tax expense was higher in Q4 due in large part to a one-time tax benefit in Q3 of $2 million. Full-year effective tax rate was 10.7% due to net benefits of the Tax Reform Act, tax holiday in certain locations and other credits and one-time adjustments. Net income attributable to Photronics shareholders was $12.5 million in the quarter or $0.18 per diluted share, similar to the $13 million and $0.18 reported last quarter, but significantly higher than the $5.4 million net income and $0.08 per share reported for the same quarter last year. Full-year net income before minority interest was $61.2 million, minority interest was $19.2 million and net income to Photronics shareholders was $42.1 million for the year representing diluted earnings per share of $0.59 compared to $13.1 million and $0.19 per share in fiscal 2017. The strong operating results drove excellent operating cash flow of approximately $44 million for the quarter and nearly a $131 million for the year, a 35% increase over fiscal 2017. We continued the share repurchase initiative during the quarter and returned an additional $16 million to shareholders through that program. Full-year share purchases were $23 million, removing 2.6 million shares from the outstanding share count. As of year-end, there was approximately $22 million remaining under the current repurchase authorization. We made CapEx investments in the quarter of $39 million, $96 million for the year. Our China projects have progressed really well as Peter mentioned, but many project payments were rescheduled into first quarter 2019, so CapEx was significantly less than anticipated. The CapEx investments for fiscal 2019 primarily to complete the China initiatives will be approximately $210 million, $170 million of which will occur in the first quarter. To-date, this quarter $70 million of that $170 million has already been paid. As a result of the strong cash flow and the reduced CapEx expenditures, cash increased from $308 million at year-end 2017 to $329 million at October 31, 2018. The balance of long-term debt of $57.5 million at October 31, 2018 is the convertible debt issued due April 1, 2019. Post close, we announced a new working capital loan agreement of $25 million and a new $50 million fixed asset loan agreement for our JV in China. These will be drawn from time-to-time for general financing needs, payment of import taxes or VAT or for payment to suppliers for tools. While we have sufficient cash to fund the China initiatives, the local loan agreements to provide greater flexibility in managing cash flows and allow us to take advantage of local incentives on interest expenses. Before I provide first quarter guidance, I’ll reiterate the reminder that our visibility is always limited as our backlog is typically only 1 to 2 weeks and demand for some of our products is inherently uneven and difficult to predict. Additionally, the ASPs for high-end mask sets are high. And as this segment of the business grows, a relatively low number of high-end orders can have a significant impact on our revenue and earnings for a quarter. Given those caveats, we expect first quarter revenue to be in the range of $120 million to $130 million. The first quarter is typically a seasonally slow quarter for us and Q1, 2019 will be a net of 6 days shorter than Q4, 2018. When we assess each end-market, we believe our FPD operations will remain as capacity with mixed expectations in high-end IC as memory should be positive while logic is more uncertain. Based on this revenue expectation and our current operating model, we estimate earnings for the first quarter to be in the range of $0.01 to $0.07 per diluted share. This includes approximately $0.05 per diluted share for China start-up expenses. 2018 was a great year for Photronics. We achieved record revenue and made considerable progress against our strategic growth objectives, including our investment in China. At the beginning of the year, we discussed our acknowledgement of the risks of cyclicality and the China endeavor and the necessity of meeting our operating projections to ensure that we could fund our growth initiatives. We delivered on the operating challenge and fortified our liquidity position, the risk associated with the China effort has been substantially reduced and we are cautiously optimistic to be just ramping into initial production in China late in the first half of fiscal 2019. Our strong balance sheet and improving competitiveness in all our markets augurs well for continued growth and success. We’re looking forward to a challenging year in fiscal 2019 that will continue the progress on our strategic path. I will now turn the call over to the operator for your questions.

Thank you. [Operator Instructions] Our first question comes from the line of Tom Diffely of D.A. Davidson. Your line is now open.

Yes. Good morning. I wanted to dig into the impact that you’re seeing from the new costs. When you look at the gross margin impact of the reported quarter, is there some way to kind of give us the relative impact of the mix versus the start-up costs?

Tom, we don’t really get into the details of each of our operations other than at the bottom line we’ve given the result that we expect on the bottom line, but effect on margins, little more detail than we usually discuss.

Okay. So was the $0.05 [sic] projected impact in the current quarter similar to what it was last quarter?

I’m sorry, repeat that?

The $0.05 impact that you’re seeing for the current, the January quarter was at a similar level for the October quarter?

No, the October quarter was in the range of $0.01 to $0.02.

Okay. And then just on a broader basis when it comes to margins, when you look at China just ramping up overall becoming a bigger percentage of the business and growing very strong year-over-year. Has that had an impact on margins?

To the extent that we need to hire people in the production area, those costs don’t have revenue associated with them, so there isn’t an impact from those lead costs.

No, I think, I’m not sure – you answered – you interpreted his question, correctly.

Yes. No, looking forward –

So our variable margin model all year long has remained intact, no variation. What I said in my prepared remarks was we saw high-end demand drop, so – but we still saw strong demand in mainstream. So we built 45 nanometer and 55 nanometer business on tools that normally build 14 and 28. When we do that, we have depreciation running through the margin on those products that normally would not be there. So the way – our mainstream business and our high-end business has same margin as long as we’re building the business on the proper tools, when that’s not the case and we move mainstream business up, we see margin compression and that’s what we saw in the quarter, but it’s better than the alternative, which is to allow the competition to enjoy that business and the contribution margin is still positive, but it’s significantly less. So that’s what happened as far as the mix in the quarter was concerned.

Okay. But then maybe looking more broadly, when you look at the Chinese market for both IC and flat panel, do you see enough high-end business there to get back to kind of normal relationships between high-end and mainstream for your business and normal margin structure?

Yes, sure. And most of the lion’s share of the capacity on IC that’s headed into China initially is at the very top of the mainstream nodes, so it’s the right tools for the job at hand. And, of course, the FPD tools are targeted – first, the G10.5+, which has revenue associated with it like nothing we’ve ever seen. So it’s all new business. So we think the tools we have that we’re actively installing hit the sweet spot of both the IC and the FPD markets.

Okay, great. And it looks like the, obviously, the high-end flat panel facility in China is very much on track here, installing the equipment right now. What is the typical lead time or qualification time that you have with new customers for a new fab like that? Is it a situation where just within a quarter or two, you can have actual production revenue systems going out the door, does it take longer to qualify?

Yes, with FPD normally the qualification cycle concludes in a quarter unlike IC, which could easily take close to a year. So FPD is a much – all the guidance we have given around the China ramps, they all contemplate the fact that the FPD business is new for us as far as the substrate size is concerned. The customers are not new. We’re doing business with all of them and the qualification cycles are significantly shortened, right. I would also point out again that in the FPD arena, we have said that we have significant contractual commitments for the capacity there that will enable us to ramp the profitability quickly. So for us on the FPD side of business, it’s very much – the business is there, what’s gaining our ability to realize it is our ability to execute on the build plan for the factory, the equipping of the factory with the tools and then the ramp of our line and then finally, the qualification of our customers, right. So – but it’s in our hands, right. It’s – we’re not looking for business once the line is ramped, we’re looking to ramp the line, those are very different scenario.

Yes, no, it’s a good position to be in and then finally, what is the projected interest expense or the terms of the new credit line that you have in China it sounds like you’re going to take advantage of some tax benefits there?

Yes, the interest expense will be reimbursed by the incentives that we have there, Tom so the timing will be different, but that at the end of the period we’ll have zero for interest expense.

Okay, great. Alright well, thanks for your time today.

Thank you, Tom.

Thank you, and our next question comes from the line of Patrick Ho of Stifel. Your line is now open.

Thank you very much. Maybe as a follow-up to one of Tom’s questions about the startup costs Peter, you gave good color in terms of the qualification times between display and IC is it fair for me to look at that also as when you have to keep up the duplicate cost as you begin to qualify and get tools offline in China? Or do you believe that you can take away some of those duplicate costs faster than expected as you start ramping up the Chinese fabs?

I’m not sure Patrick, we any of us were looking at whole puzzle what you meant by the duplicate cost, can you explain that a little more?

Yes. So just to ensure that you’re qualifying and having the necessary capacity, I’m assuming you’re going to be holding costs at your current, where you’re actually qualify and where you’re doing production today into the Chinese fabs are up and running at optimum levels, you’re going to keep some level duplicate cost at your current capacity at your current facilities until the China fabs ramp up that’s kind of what I’m getting at?

Alright. So again, with FPD there really is no duplication, there is no duplication, of course, right now, our FPD capacity is fully sold out, right, this quarter it was fully sold out and what we said is next quarter, we expect it to be fully sold out at the end of the second quarter, we starting hope to see in the beginning of revenue coming out of China as long as nothing significantly changes between here and there, meaning Q2, will continue to be sold out so the new China capacity will be incremental to a business that has no more now they are early going in China, the major focus then what our two partner customers are asking us is to get the G10.5 qualified as fast as humanly possible as we’re doing that to the extent we have tool capacity will push that capacity to support the AMOLED demand in China and/or the LTPS demand won’t generate the same mobile revenue, but it’ll still generate incremental margin so as far as FPD goes, there are no incremental or duplicative cost in the system as far as IC business is concerned, the duplicative cost if they are there would be to like not fully loading, the global capacity footprint, right? That so I guess you could call those costs duplicative if you want to use a broad definition so that’s the only real inefficiency that I can point to in our system so we said, we have contractual commitments to drive Hefei sorry, John, and breakeven but not beyond it so we will have to ramp in new revenue in order to fully load the global factory now in the current quarter we had expenses related to tool moves, right of existing tools and we said before many times now that we’re billing some of that China business obviously in the IC arena, in other places so as China ramps were moving some of the existing capacity to build it there, so we’re not expecting it all to be greenfield once you start dismantling a line in a factory it doesn’t make sense may be to move all the tools to one location so you blend those tools across your network to get the most leverage out of them so the tool move expenses we saw on the quarter were primarily related to blending those tools out across the existing network, the ones not going to China so that was a onetime event that will not duplicate itself so they could also I guess be viewed as duplicative costs but they’re now through the P&L and go on so that’s the best I can do to answer your question.

That is helpful, Peter. Thank you. As my follow-up question, the weakness on the high-end logic side, I guess it’s not totally surprising given a lot of the uncertainty in the market to-date could you just give maybe a little more qualitative was it at a certain node whether 14 or 28 or was it broadly across a couple of nodes on the high-end logic front?

No, it was both 14 and 28 and as I said 45 and 55 really strong, but it was not confined to a single customer it was generally it was broad weakness that surfaced in the quarter and you don’t have to use too much imagination to understand where it was coming from in the downstream market so but anyways, there was enough business there that we were able to more or less continue to load or tools, it just wasn’t optimal.

Great. Maybe as my final question in terms of the relocation of some of the tools to I guess meet the appropriate demand it does that give an indication on your end over the next couple of quarters that the mainstream will continue to be healthy and the high-end logic I guess will continue to be a little bit softer than expected? Or I guess, it sound like it only took about a quarter for you to adjust the tool sets based on demand how quickly it high-end logic does turn around sooner than expected, will you be able to I guess reallocate those tools?

Yes, we can change. Yes, we are in a position to change the gear on the bike if in consistent with demand, right, and I will say that I’ve been here 10 years and we operated last quarter at the highest level of capacity utilization that I’ve seen in my 10 years at Photronics, because, again, the revenue potential of the more mainstream business is not as great as the high-end yet, we still had a record quarter so we were working hard generally, not at all our factories, but FPD was sold out we had several IC factory sold out there is still some capacity in the system, but we were running pretty fast and as I said earlier, fortunately, we haven’t slowed the capacity coming online in the second half of the year in both IC and FPD we would need to do that likely regardless even if we weren’t ramping factories in China in the second half of the year, depending on what happens obviously, with the overall market that’s the wildcard, nobody really knows, but there are still segments obviously of our business that John highlighted on the memory market for us right now is very strong and that obviously is a testimony to our specific customers and where they are in their node ramps and our FPD business particularly AMOLED segment of it is up, is strong and of course, we have the best technology so that puts our capacity preferentially in demand based on our market checks we don’t think any of our competitors in the FPD space are sold out right now, we are the only one because we have the right tools positioned against the right market segment.

Right thank you very much.

Yes.

Thank you. And I’m showing no further questions at this time. I would now like to turn the call over to Mr. Peter Kirlin for closing remarks.

Okay, thank you, once again for joining this morning. 2018 was a great year for Photronics, we performed well and our market strengthened. I believe that 2019 can be even better as our Chinese facility to come online and we take it to next step in our strategic growth plan. Happy holidays to all.

Ladies and gentlemen, thank you for participating in today’s conference. This concludes today’s program. You may all disconnect. Everyone have a great day.