Good afternoon. My name is Audrey, and I will be your conference operator today. At this time, I'd like to welcome everyone to the SkyWater Technology Fourth Quarter 2023 Financial Results Conference Call. Today's conference is being recorded. All lines have been placed on mute to prevent any background noise. After the speakers’ remarks, there will be a question-and-answer session. [Operator Instructions] At this time, I'd like to turn the conference over to Claire McAdams, Investor Relations for SkyWater Technology. Please go ahead.

Thank you, operator. Good afternoon, and welcome to SkyWater's fourth quarter and full year 2023 conference call. With me on the call today from SkyWater are Thomas Sonderman, Chief Executive Officer; and Steve Manko, Chief Financial Officer. I'd like to remind you that our call is being webcast live on SkyWater's Investor Relations website at ir.skywatertechnology.com. The webcast will be available for replay shortly after the call concludes. On our IR website, we also have posted an investor slide presentation as well as a financial supplement to accompany today's call. During the call, any statements made about future financial results and business are forward-looking statements. These forward-looking statements are subject to risks and uncertainties that could cause our actual results to differ materially. For a discussion of these risks and uncertainties, please refer to our filings with the Securities and Exchange Commission, including our earnings release filed on Form 8-K today and our fiscal 2022 10-K. All forward-looking statements are made as of today, and we assume no obligation to update any such statements. During this call, we will discuss non-GAAP financial measures. You can find a reconciliation of these non-GAAP financial measures to GAAP financial measures in our earnings release, our financial supplements and in our Q4 earnings presentation, all three of which are posted on our IR website. With that, I'll turn the call over to Tom.

Thank you, Claire, and good afternoon to everyone on the call. Today, we are pleased to report strong fourth quarter financial results. Revenues grew to a record $79 million, up 11% from Q3 and exceeded our expectations due to continued sequential growth in our ATS development business, which was up 6% from Q3. As expected, tool revenues totaled nearly $10 million for the quarter. As we discussed on our last call, we are entering a new multiyear stage of increased levels of customer-funded CapEx in support of our growing ATS business. The CapEx investments being made by our customers are targeted at building our platform development capability and putting the necessary capacity in place for volume production. Consistent with our expectations going into the quarter, Wafer Services revenues were $12 million, down 17% from Q3, driven by the continued softening in end market demand, chiefly from the broader industrial sector. In spite of this end market softness, the continued strong customer demand for ATS development business has driven six straight quarters of sequential growth and record revenue performance. For fiscal year 2023, we exceeded our long-term targets with total revenues growing 35% from fiscal 2022. The strength of ATS within a backdrop of an overall weak end market was reflected by the changing mix of revenues in 2023 with an 80-20 mix of total ATS revenues to Wafer Services compared to about two-thirds, one-third in 2022. As we have demonstrated, ATS is the major growth driver for SkyWater's business both for 2023 and we believe for the next several years as we continue to develop new advanced technologies for the aerospace, defense and commercial markets. We believe the strong demand for our ATS business demonstrates that our customers' innovation investments remain strong and that our unique business model offers a…

Thank you, Tom. Before I begin my review of our fourth quarter results, I will direct you to the financial supplement available on our IR website, which summarizes our quarterly financial results for the last three years. Starting in Q3, we changed our policy regarding a couple of our non-GAAP financial metrics, and the helpful supplement on our IR website is where you can find all comparable non-GAAP adjustments as well as the impact of tool sales on our gross margins. Now turning to our Q4 results. Fourth quarter revenues reached another record for us, exceeding our expectations to total $79.2 million, which was up 11% from Q3 and up 22% from the fourth quarter of 2022. Record ATS revenue of $67.1 million was up 17% from Q3 and up 40% year-over-year. ATS revenue included $9.9 million of tool sales compared to $3.2 million in Q3 and a nominal amount in Q4 of 2022. The growth in ATS exceeded our earlier expectations due to another quarter of sequential growth in ATS development revenues. Offsetting this growth was the decline in Wafer Services revenue, which, as expected, was down 17% sequentially as a result of the softening demand environment in the broader industrial markets. Our non-GAAP gross margin for the quarter was 17.4%, a bit better than expected, primarily due to more favorable ATS development revenue compared to the forecast. The nearly $10 million of tool sales in the quarter impacted non-GAAP gross margin by 130 basis points. As a reminder, tool sales represent CapEx that is funded by our customers. These enable us to increase our capacity and capabilities without requiring us to use our own capital. Additionally, since this CapEx is funded by our customers, there was no expansion of our fixed asset base and therefore no ongoing depreciation…

Thank you. [Operator Instructions] We'll go first to Quinn Bolton at Needham & Company.

Hey, guys. Thanks for taking the question. Just to start, just for the gross margin outlook, obviously, lots of puts and takes. I understand the tool revenue is a bit of a headwind and the $60 million of tool revenue, understand sort of the drag there. But you've talked about Wafer Services being down pretty significantly. And I know that's been sort of a fab filler. And so can you just kind of talk through the ramp that you see into the second half of the year, what kind of level of gross margin would you expect you need to get to hit that profitability target that you mentioned in the second half of the year? And then I got a couple of follow-on questions as well.

Go ahead and start with the revenue. I'll take Wafer Services.

Yes. So Wafer Services revenue, obviously, is feeling the effects of the overall industry softening. We, of course, have been in a transition mode over the last several years as we continue to bring in more of our ATS development programs preparing them to go to volume production. So as I mentioned in my prepared remarks, we are leaning hard into those transitions. We're doing this to prepare to not only ramp those into volume as this year unfolds, but more importantly, as we prepare for next year and beyond. And of course, we're taking into account the fact that lower utilization of our Wafer Services business does have an impact on gross margins, but that is somewhat being offset by the fact that we are bringing in new tools that, while not like a typical ATS development margin, does have an overall positive impact. So we believe that the work we're doing this year to position the business for continued ATS growth makes long-term sense, and we're doing that in a mode where we're still seeing gross margins performance at a level that is consistent with our previous discussions. Steve, anything to add?

Yes. And I'll just highlight two things. I'll address the tool revenue one first. And again, I think you referred to it as a headwind. We still look at it, like we said in the opening remarks, as a tailwind for the long term of our business. Seeing this level of tool investment coming in was much more than we probably could have ever imagined in the near term, and seeing the significant investments coming through to continue building out not only technology programs but technology platforms, in my opinion, is a significant sign of growth for the company in the future and not being funded by our customers. So to your point, on a margin perspective, it will have a headwind, if you will. But it does have some small contribution to profit. And even with the gross margin being impacted by the tool revenues over the course of next year, even a margin in the mid- to low 20s could be something that could generate some positive non-GAAP EPS for us over the course of 2024. And so we really think that's something that we could obtain over the course of 2024.

It sounds like margin for the year is a little higher than I think you said, the 22% for full year '23. It sounds like you probably are in that 23% to 25% kind of rate in the second half of the year if you're starting the year at 19. It's just the way the math works. It's sounds like that's kind of the rate we should be thinking about?

Yes. I don't think it has to be quite that high, again, depending on the timing of when these tools come through. Again, we see significant opportunity for the tool investments. We communicated that we expect not only a record year but something around the $60 million level on the tools. Now again, given the significant contribution or the significant amount, I should say, of the tool revenue coming in, even a little bit of contribution margin coming from the tools can have an impact positively on the gross profit performance and the bottom line as well. So I'm still saying within the low 20s on our margin with the tools coming in, it should be something that could get us to a breakeven point or slightly positive on the non-GAAP EPS.

And just one thing to add is we are positioned well. If the market were to turn, of course, we could begin to take advantage of that as well. Go ahead, Quinn.

Yes. Sorry, last one for you, Tom, just on the Wafer Service. Obviously, I understand the headwinds in the industrial side of the business with the legacy. You talked about the bio health business starting to transition to Wafer Services this year. When would you think that Wafer Services revenue bottoms? Is it kind of -- does it bottom middle of the year? It starts to recover sequentially into the back half of the year? Do you think it's kind of just trending at a pretty flattish level through the year? What's kind of the [indiscernible] you guys are expecting on Wafer Services?

Yeah. So we're expecting in the first half of this year, maybe going into Q3, that we would see a bottom. And then we would start to see recovery post that point. And again, the rate at which programs that have transitioned to Wafer Services, the rate at which they ramp is highly dependent on the customer and their ability to get their products to market. Our goal is to prepare them to ramp. We are very excited about the number of new programs coming through the pipeline, and the pace that they will grow will depend on the customer. There is a J curve effect that will come into play, but we believe the breadth and depth of the programs we have now will allow us to make that transition effectively.

Got it. Thank you.

We'll move next to Harsh Kumar at Piper Sandler.

Hey, guys. I had a couple of questions as well. I guess I was more curious about the spurt in the ATS business. Was there anything that happened in the end market or maybe your own focus as a company prompted this kind of growth? And then my second one is kind of tied to it, so I'll just ask it anyways. Historically, the model has been that ATS drives wafer revenues. But wafer revenues are coming down. Is that mostly the industrial sort of, call it, flushing out this year? Or is there something else going on, maybe a shift in strategy perhaps?

Yes. Well, so to answer the first question, it's all about transformation. We clearly are doing everything we can to maximize our ability to move our ATS programs as quickly as possible through the development cycle while at the same time delivering consistent Wafer Services output. That's what we've really been doing. I think our ability to not only execute the transition while delivering solid financial performance is a good testament to the team. And the kind of positioning legacy products and phasing those out as we move towards these new programs, it's kind of always been the plan for SkyWater when we spun out of Cypress. We have never put a lot of energy into our legacy mature technologies. They are there to fill the fab to allow the new business to be developed and put in a position to grow in the long term, and that's exactly what we've been doing. And really, as we said, '23 was driving that transformation. We've executed it, and now we're leaning into it hard and really taking advantage of maybe, call it, a weaker broad market to move some of these ATS programs at a faster pace and specifically the DoD programs, which, as we've been talking all year, already moving at a very fast pace. Anything to add, Steve?

Good response. Harsh?

Sorry, my second one was regarding the Wafer Services flushing out, I guess. And that just basically strictly sounds like it's industrial, correct?

Yeah. I mean the -- a lot of the industrial products are legacy products. I think there was a lot of inventory building in the industrial space. And as our primary customer, Infineon has made very public, there they're digesting that inventory. And obviously, for those type of products, we feel the effect of that as well. And that's really what we see happening as this year unfolds. And in parallel, we're going to continue to drive these ATS transitions and get these new tools installed, which ultimately just drive faster ATS transitions as well.

Gotit. Fair enough guys. Thank you.

And we'll move next to Robert Mertens at TD Cowen.

Hi. This is Rob Mertens on for Krish. The first one, you'd mentioned that the aero and defense customers were a big part of calendar year '23 revenues. What would you expect the mix to sort of look like throughout this year? And will this materially shift in calendar year '25 as Wafer Services start to recover? And then I have one follow-up.

Yeah. I mean I think as I put in my remarks, A&D is going to continue to grow. It was over 50% in '23. We expect that to increase further in '24. Again, there's a lot of focus on moving those programs very quickly. So we're taking advantage of that. And given the weakness and the broader Wafer Services market, as we just discussed, and the pace of transition for some of our commercial programs, we expect A&D to continue to be a strong contributor through this year and into next year as well.

Great. That's helpful. And then just a quick follow-up. I want to make sure I heard correctly that -- the consulting fees, were they $3.5 million in the December quarter? And then just based on the March guide of $14 million to $15 million OpEx, what are you sort of thinking the consulting fees would look like there then in out quarters?

Yeah. The transformation cost is what we referred to, and you can see those broken out in the non-GAAP tables in the supplements to the earnings release, were $5.3 million for the quarter, and again, went to around $11.3 million for the year. And as Tom mentioned, there is not an expectation of those recurring again in the year 2024.

Okay. Got it. That’s helpful.

Next, we'll go to Richard Shannon at Craig-Hallum.

Hi. Thanks for taking my questions as well. Maybe the first question is for Steve. I tried to absorb all the numbers here in terms of the guide for the year, and I just wanted to try to ask it. The question I have here is really thinking about the exit rate of gross margins exiting this year, both with and without tool sales. I tried to run all your numbers through here, and I wonder if you could just give us your thoughts here. You started with a 19.5% or 19% change or 19% number here in the first quarter. Obviously, you got a lot of depreciation kicking off after that. I mean is this something where we get into the upper half of the 20s exiting this year or how should we think about that?

Yeah. Good question. And again, it's going to depend on the level of the tool revenues coming through. We've been expecting and communicating that in 2024, the depreciation is falling off and coming down. We're seeing that take place, and we'll see that play out, starting really in the second quarter of this year. So that was a big tailwind that we've been looking forward to for quite some time. It’s really going to, like I said though, be impacted by the tool revenues. I think as we talked about a few quarters ago, we still look at our base cost of doing business at around $45 million. And excluding tool revenue, we still believe over the course of 2024, we'll continue to have better than a 50% contribution to the gross profit line coming through for incremental dollars on the revenue side above 45. Now that's excluding the tool revenue. Again, that's going to be a bit of a drag on the gross margin number. But when you pull out the tools and talk about the growth that we expect over the course of this year, we still do expect a better than 50% contribution margin for incremental revenue.

Okay. I'll try to run that through my model and try to nail that down a little bit better here. Maybe a follow-on question on tool sales here -- I guess a couple of questions here, really. I think, Tom, I heard in your prepared remarks you were about a $60 million number this year and then some more thoughts on years past this. Were you saying the tool sales you expect to be at or even higher levels in '25 and '26?

Yeah. Well, again, as I said, we're seeing similar levels for the next several years, so this year and next year and even through '26, so for model...

Okay. I just want to make sure I get the magnitude right. This is really -- the follow-up question is a more important one here, thinking about the contributors to this. To what degree is this government versus commercial customers? Obviously, you announced a big government contract earlier this year that's obviously contributing to this visibility not only past this year. But to what degree are we seeing contributions from commercial customers is multi-sales?

Yeah. I would say the majority are within the A&D space, the majority of these tool investments. There are some commercial customers, but the majority is definitely A&D. And that is, I would say, consistent with kind of the A&D model. They are investing to put capabilities in place, and we plan on leveraging those where we can into the commercial sector. But they're the majority investor right now.

And as we mentioned, when you see tool investments of this size, which is, again, much larger than what we've had in the past. It's really not for one-off individual programs. Although that can still be the case, and it's still part of our business model. That's by one tool here or there for development purposes. When you see tool revenues and contribution of this size, it's really to build out a platform, and that will be a platform that could be offered to many customers down the road. So again, that's when you see significant investments of this size coming in. You’ll see a good indication of growth in future years with a number of customers coming to development than manufacture off that platform.

Okay. Thanks for the detail guys. I’ll jump at the line.

Thanks, Richard.

There are no further questions at this time. Mr. Sonderman, I'll turn the call back over to you for closing remarks.

Thank you, operator. I want to close today's call by conveying the strong confidence all of us at SkyWater have and our ability to execute successfully towards our long-term growth and profitability objectives. Our amazing employees have now delivered a three year annual revenue growth rate of [indiscernible] exceeding our long-term targets. We intend to continue to build your confidence in our ability to execute on our future growth and profitability objectives as well. We look forward to talking to you again on our Q1 call in May. And with that, I will conclude today's earnings call. Thank you.

And again, this concludes today's conference call. Thank you for your participation. You may now disconnect.