Advanced Energy Industries Inc Q3 FY2020 Earnings Call

Ladies and gentlemen, thank you for standing by, and welcome to the Advanced Energy Industries Third Quarter 2020 Earnings Conference Call. Please be advised that today's conference is being recorded. I would now like to hand the conference over to your speaker today Mr. Edwin Mok, Vice President of Strategic Marketing and Investor Relations. Thank you. Please go ahead, sir.

Thank you, operator. Good morning, everyone. Welcome to Advanced Energy's Third Quarter 2020 Earnings Conference Call. With me today are Yuval Wasserman, our President and CEO; Paul Oldham, our Executive Vice President and CFO; and Brian Smith, our Director of Investor Relations. If you have not seen our earnings press release, you can find it on our website at ir.advancedenergy.com. There, you’ll also find a slide presentation to follow along our discussion today. Before I begin, I would like to mention that AE will be hosting a virtual investor event on Monday, December 14. We welcome all of you to join us at this event. In addition, we will be participating at multiple investor conferences in the coming months. As events occur, we will make the announcements. Let me remind you that today's call contains forward-looking statements, which are subject to risks and uncertainties that could cause actual results to differ materially and are not guarantees for future performance. Information concerning these risks and uncertainties is found in our filings with the SEC. All forward-looking statements are based on management's estimates, projections, and assumptions as of today, November 5, 2020. And the company assumes no obligation to update them. Long-term targets present today, which include our aspirational goals and the integration targets should not be interpreted as guidance. On today's call, our financial results will be presented on a non-GAAP financial basis unless otherwise specified. An explanation of our non-GAAP financial measures as well as reconciliations between GAAP and non-GAAP measures can be found in today's press release. With that, let me pass the call to our CEO, Yuval Wasserman. Yuval?

Thank you, Edwin. Good morning, everyone, and thank you for joining us on this call. Overall, this was an outstanding quarter for Advanced Energy with record revenues, earnings and operating cash flow. We delivered sequential revenue growth across all of our market verticals and recorded new quarterly highs in semiconductor, data center computing and service. Good operating leverage and continued execution on our synergy goals, resulted in gross margins approaching 40% and non-GAAP earnings per share, up over 3x from last year, validating our financial model and demonstrating our ability to accelerate earnings growth. Overall, demand for our products continues to be strong, driven by ongoing investments in technologies associated with the data economy. Great execution by our operations and supply chain teams enabled us to catch up on COVID-related delays and respond to the burst of demand. During the quarter, we continued to ramp our Malaysia factory, which is next to one of our leading customers, as we integrate and optimize our global operational footprint. It provides us with business continuity and resiliency in meeting our customers' demands in a dynamic operating environment. In addition, we continue to execute on our integration plans, delivering synergies and record accretion from our Artesyn acquisition. We expect additional synergies to be realized through 2021, as we execute structural changes in our manufacturing and supply chain. Beyond cost synergies, we have started to secure new cross-selling design wins across both semiconductor and industrial end markets, and we expect those wins to drive incremental revenues in 2021. We continue to invest aggressively in R&D, which enables us to win multiple design wins across all markets and to launch 6 new products across different portfolios during the quarter. These new wins and new offerings are expected to generate continued growth for AE going forward. Turning now to our products and performance by market. As I mentioned, semi revenue was a quarterly record, growing nearly 15% sequentially and over 70% from last year as we continue to meaningfully outperform the market and our semi peers. Service revenue also reached a record high, driven by improved fab utilization across multiple regions and strong demand for upgrades and retrofits. We believe process power has become one of the fastest-growing subsystem segments within the semi equipment supply chain. As the market leader with the broadest product portfolio, end market and customer exposure, we are gaining market share with design wins for many critical processes. The combination of strong market growth and our share gains are driving our semi revenue to grow faster than all of our semi peers in 2020. For example, our advanced RF matching technologies are getting adopted in multiple advanced etch and deposition process tools, resulting in revenues growing over 120% year-over-year in Q3 after doubling in Q2. Our remote plasma sources revenue grew again this quarter and is on track to double in 2020, resulting in double-digit millions of dollars of incremental revenue. In Q3, we secured a dielectric etch design win at one of the leading OEM suppliers. And in Korea, we won several designs for memory and advanced packaging deposition applications. We believe our continuing investment in product development will enable us to capture an expanded pipeline of opportunities in new and exciting areas, including additional wins in dielectric etch. Looking forward, we expect semi revenue in Q4 to remain strong. Long term, with our design wins, growing power content and a favorable market trend, we believe we are well positioned to continue to outgrow the market. Revenue from our industrial and medical markets increased by nearly 23% sequentially, driven by increased factory output to deliver on strong backlog and general improvement in the industrial markets. For example, in industrial, demand for consumer electronics coating and motion control applications improved. Revenues for medical applications remained strong, driven by continuing demand for critical care applications. Noncritical care applications also began to improve, but remained well below pre-COVID levels. This quarter, we secured multiple design wins across a wide range of medical diagnostic, imaging, and therapeutic applications. Of note, we won a sole source position for a next-generation diagnostic blood analyzer at one of our leading medical customers, and our power solution was designed into a new air filtration system for preventing the spread of COVID. As we look forward, we expect the industrial and medical markets to continue their modest recovery with revenue around current levels in Q4. Our data center computing revenue hit another quarterly record in Q3, up 5% sequentially and 91% year-over-year. Despite industry headwinds of data center digestion and a generally weak IT spending environment, new design wins and growing share have enabled us to meaningfully outgrow the market. In hyperscale, revenue was down slightly from a record quarter in Q2 but jumped 380% from last year. Revenue from a third hyperscaler customer helped to offset initial digestion from our earlier wins and we made good progress in winning new businesses from additional hyperscalers that should contribute to revenue next year. Although revenues in this market could be lumpy quarter-to-quarter, we remain confident in the long-term market growth and our ability to outgrow the market. Demand from enterprise OEM customers recovered in Q3 partially due to our ability to deliver to customer needs and capture market share. In addition, one of our power design wins into a high-performance computing platform started to ramp. We expect HPC to be a secular driver for our business going forward, given that our industry-leading product power density is the ideal solution for meeting the high-power, high-density requirements for those server racks. Looking forward, our data center computing revenue is expected to remain at elevated levels and well above last year's run rate. However, we anticipate digestion in the data center market to impact our revenue in Q4. We expect growth to return later in 2021 driven by additional investments in data centers with the releases of new CPUs and accelerated by our share gains. Telecom and networking revenue grew over 18% sequentially as the market improved modestly from the trough levels in the first half of 2020. Q3 revenues also benefited from some catch-up shipment from our backlog and incremental share gains. Data center networking remains a bright spot in this market as data traffic shifts from enterprises to the cloud due to remote working trends. In addition, during the quarter, we secured a critical design win in a next-generation cloud networking platform that will support revenue growth as the industry migrates to 400-gig networks. In the telecom market, overall investment remains limited, although our mix of products sold into 5G applications has risen considerably in 2020; large-scale infrastructure investment in 5G outside of China continues to be delayed. Looking forward, Q4 revenues are expected to come in around these levels as market signals remain mixed. Long term, our efforts in winning 5G and next-generation networking designs prepare us to capture the market's recovery as global 5G infrastructure investment accelerates. In summary, our Q3 results serve as a clear validation of our strategy and our business model. This strategy has enabled us to deliver industry leadership, revenue growth, innovation, synergies and earnings. I'm extremely proud of our global team who have responded to the myriad challenges this year to deliver outstanding financial and operational results while ensuring a safe environment for employees. I would also like to welcome our two new Board members, Anne DelSanto and Lanesha Minnix, who add complementary industrial market knowledge, experience and capability to our Board. As we continue to deliver on our strategic goals, we are realizing our vision of being a leading industrial growth company with a diversified revenue base, strong growth drivers and top-tier financial results. As we look forward, near term, we see increased risks due to the new waves of coronavirus, but longer term, we see 2021 setting up to be a growth year for AE. Although we see some variations quarter-to-quarter, we expect to continue to grow our earnings driven by our momentum in semi, share gains in hyperscale and macro recovery in industrial markets, and global 5G investments combined with our continuing efficiency gains, portfolio optimization and synergies. We are planning an investor briefing in December to discuss our progress to date, a deeper dive into our newer markets and an update to our aspirational goals. I'd like to thank our customers, shareholders, partners and our valued employees for your support, especially during this challenging time. I look forward to speaking with many of you in the upcoming quarter. With that, let me turn the call over to Paul.

Thank you, Yuval, and good morning. Before I begin, please note that all financial measures presented today will be on a non-GAAP basis, unless otherwise stated. Excluded from non-GAAP results are amortization, stock compensation, integration and transition costs, unrealized foreign exchange gains and losses, and restructuring items. This quarter, we recorded $5.6 million of acquisition-related costs related to the Artesyn acquisition and transition. We also recorded $3.5 million in noncash, unrealized FX losses related to long-term lease and pension liabilities. A full reconciliation from GAAP to non-GAAP measures can be found in our press release issued earlier today. As Yuval mentioned, this was an exceptional quarter as we delivered record results across a wide range of financial metrics. Strong execution by our team to meet our customer requirements and increased demand for our products enabled revenue and EPS to surpass the high end of our guidance ranges. In addition, we achieved an annualized return on invested capital of over 25%, and our cash balance increased by over $48 million. Perhaps most significantly, our financial performance validates our business model and demonstrates the leverage in our operation as we execute our strategy to accelerate earnings growth. Third quarter revenue was a record $390 million, up 15% from $340 million last quarter and 122% from a year ago. We saw sequentially stronger demand across all our markets and a burst of order activity at the end of the quarter that we were able to deliver to our customers' short lead-time requirements. In addition, we were able to ship backlog created during early 2020 due to capacity supply constraints, reflecting roughly half of the upside to our guidance in the quarter. On a pro forma basis, including a full quarter of Artesyn revenue in prior periods, Q3 revenue grew 35% year-over-year. Excluding Artesyn, organic revenue grew 12% sequentially and 50% year-over-year to $201 million. Turning to revenue by market. Sales in the semiconductor in Q3 were $167 million, up nearly 15% from a strong second quarter and up 73% year-over-year with good demand across foundry, logic and memory. Revenues were up 70% on a pro forma basis. Both semi product and service revenues were a quarterly record. Overall, we are growing faster than our peers and the overall market, with sales in both RF matches and RPS more than doubling year-over-year. Revenue from our industrial and medical markets was $87 million, up 23% sequentially as a result of modest market improvement and catch-up of backlog. On a pro forma basis, revenue declined 11% year-over-year as a result of ongoing general weakness in several of our industrial sectors, exacerbated by the COVID-19 crisis. Data center computing revenue was $88 million, up 5% from the second quarter. On a pro forma basis, sales were up 91% year-over-year, another quarterly record for the company. Hyperscale revenues declined slightly from record levels in Q2 as cloud digestion began, but were still up almost 5x from last year. Enterprise OEM revenues grew both sequentially and year-over-year driven by share gains and increased demand from prior design wins. Telecom and networking revenue was $48 million, up over 18% sequentially. On a pro forma basis, revenues were nearly flat year-over-year. Non-GAAP gross margin for the quarter increased by over 100 basis points sequentially to 39.8%. Margins benefited primarily from better fixed cost absorption on higher volume, partially offset by increased other cost of sales following a favorable quarter in Q2. Importantly, we are beginning to see the benefits of our synergy actions, including portfolio optimization and cost improvements shine through as volumes increase, validating our business model. Although gross margin is expected to decline slightly on lower volume in the coming quarter, we continue to make great progress on our goal to improve sustainable gross margins to greater than 40% as we complete our synergy and consolidation plans over the next year. Non-GAAP operating expenses were $78.9 million, up $1.1 million from last quarter, primarily due to ongoing investment in strategic R&D programs and innovation. Expense as a percentage of sales decreased by over 250 basis points versus Q2 to just over 20% of revenue and in the top quartile of our peers. Overall, we achieved a 19.5% operating margin, reflecting 45% incremental margins or operating leverage from last quarter. As a result, non-GAAP operating income improved to $76 million, up 41% sequentially and another record for the company. Non-GAAP other expense was $2.4 million, including $1.1 million of interest expense. We expect total other expense to be in the $1.5 million to $2 million range going forward. Our non-GAAP tax expense was $9.8 million or 13.3%, primarily as a result of favorable mix of foreign earnings and the integration of Artesyn into our tax structure on a year-to-date basis. Looking forward, we now expect the GAAP and non-GAAP tax rate to be in the 15% range. Non-GAAP earnings for the quarter were a record $1.66 per share, up 41% from $1.18 last quarter on higher revenue and margins. Earnings per share was up over 200% from $0.54 a year ago, demonstrating our goal of accelerating earnings growth. The Artesyn acquisition contributed meaningfully to our financial results. To date, we have achieved annualized synergies of over $30 million and earnings accretion over the past 4 quarters of over $1 per share. In addition to achieving our Phase 1 synergy targets ahead of schedule, we continue to find new opportunities for efficiency improvement as we integrate into a combined functional organization. Phase 2 of our synergy plan is well on its way, and we remain confident in meeting or exceeding our long-term targets of over $40 million of annualized synergies and over $1.50 per share in annual EPS accretion. Turning now to the balance sheet. We ended the quarter with cash and marketable securities of $431.6 million, up $48 million from Q2. Receivables increased slightly on higher sales. The DSO improved 7 days to 55 days on fairly linear shipments during the quarter. Inventory decreased by $3 million and turns were 3.7x. Payables were $159 million, representing 61 days of DPO. Total days of net working capital were 93, down 4 days from last quarter. The business continues to deliver excellent cash generation. Operating cash flow from continuing operations was $67.5 million, our highest level ever. Free cash flow from continuing operations was $56 million in Q3 and year-to-date free cash flow was $110 million. Capital expenditures for the quarter were $11.8 million, and depreciation was $7.2 million. The higher-than-normal CapEx in this quarter was due to a one-time investment in facilities to support expanded capacity in our Philippine operation. Overall, we expect capital expenditures to remain about 2% to 3% of sales in line with historical levels for Advanced Energy. During the quarter, we repaid $4.4 million of principal amortization on our debt, ending with total bank debt of $326.3 million. Our trailing 12-month gross debt leverage decreased to 1.34x, well within our target range of 1 to 2x. During the quarter, we also repurchased approximately $4.3 million of stock at an average price of $59.70 per share. Now let me turn to guidance. Overall, in the fourth quarter, we expect demand to continue to be solid across our vertical markets. We expect semiconductor revenues to remain strong, with the second half of 2020 growing 15% to 20% above first half levels. Revenue for data center computing applications is expected to be lower in Q4 as we see overall market and customer-specific digestion, following several strong quarters and share gains. We expect demand and revenue in the industrial and medical and telecom markets to remain relatively stable. Factoring in the limited visibility and ongoing operating and macroeconomic risks related to COVID, we are guiding Q4 at $360 million, plus or minus $20 million. Based on anticipated volume, mix and ongoing COVID-related costs, we expect non-GAAP gross margins to be in the 38% to 39% range. Operating expenses are expected to be about flat. As a result, we expect non-GAAP earnings to be $1.30 per share, plus or minus $0.20. In summary, we expect that 2020 will be a very strong year for Advanced Energy, as we have grown both organically and achieved our integration and financial performance goals related to the Artesyn acquisition ahead of schedule. Based on the midpoint of our guidance, second half 2020 revenue growth would be nearly 15% over the first half of 2020, and full year revenue would be up 17% from 2019 on a pro forma basis. Earnings per share would be up 42% from the first half and more than double for the full year, demonstrating our goal of accelerated earnings growth. In addition, our financial performance in the third quarter illustrates that our long-term financial targets of over 40% gross margins and over 20% operating margins are achievable. Our strategy of being a pure-play power provider to industrial growth markets is enabling key competitive advantages and our continued focus on improving our operations to drive further revenue growth and profitability. Looking forward, while the timing of orders and market dynamics may drive some quarter-to-quarter variation, we believe overall demand for our products remains solid. And 2021 is setting up to be a good growth year for AE with multiple drivers across our verticals.

Let's take your questions.

So I have a couple. Could you talk a little bit more about the high-performance computing and calling that a secular driver? This is a ramp of a win. How even if you could just give us some type of parameter for how big that is within data center computing and I guess it's important enough where you listed it on this page. So if you can maybe give us more color on that?

I think it's a trend right now as we see migration to high-performance computing driven by increased focus on AI, artificial intelligence, machine learning and more focused on edge computing. These applications are requiring a significant amount of power; they are power-hogs. And we are well positioned, and specifically in this area because of our high efficiency of power conversion, power density, and our solution provides a competitive advantage when it comes to the actual total cost of ownership of the asset. Now I cannot comment on the size of the market. I'll ask maybe Edwin, if you have any information about the size of this market, but it's definitely a trend that will continue to grow, and we are well positioned to benefit from this growth.

Yes. So this particular one, we won this design on an enterprise OEM who has a high-performance computing platform that they are rolling out. But I think the whole idea is that as things move forward, there are more AI or machine learning kind of applications being adopted and you hear from multiple companies talk about high-performance computing as an area that will grow.

Got it. That's very helpful. Paul, I have a question for you. You mentioned a one-time or expected nonrecurring benefit in the third quarter related to gross margin. You also mentioned that a significant portion of your upside for the quarter was tied to something like end-of-quarter shipments. Could you clarify both the gross margin and that comment?

Yes. Sure, Scott. So on the revenue, obviously, we had an outstanding quarter, even above our guidance range that we gave before. What we said on the call is about half of that upside came from catching up backlog from earlier in the year, that essentially was a result of operational supply constraints related to COVID. So that was better than we thought we could do. So we had a really good quarter, and that's why we wanted to call that out, in particular, the catch-up on that backlog. Now if you look at our backlog numbers, they were still quite strong because we were able to fill some of that in at the very end of the quarter due to the strong demand we saw. The second comment on gross margin, what we said is the sequential improvement from last quarter was largely the result of higher volume. And what it illustrates, though, is that some of the underlying improvements we've made in portfolio rationalization, as well as cost are really shining through. As you saw this quarter on a non-GAAP basis, margins are almost 40%, which is close to our goal. Even though we haven't completed kind of our Phase 2 structural changes for cost of sales and supply chain and some material cost savings that we think we can achieve over the next year or so.

One comment about the quarter is our ability to respond very quickly to changes in volume and mix, and that allows us to deliver to customers when they need it and address this burst in demand in Q3.

Could you briefly discuss your expectations for improvement in the telecom and networking market? I thought you mentioned it would improve in late 2021. Is this related to a delay in your customers' 5G spending?

I think we mentioned later in 2021, not late in '21. We believe that data center computing will recover later in 2021. The telecom networking sector has come from a low point, and we are seeing some recovery. However, due to the geopolitical situation and delays in some investments in 5G infrastructure, we anticipate some pushout into next year. Despite this, we are very excited about 5G. To clarify, 5G drives growth across all our verticals, not just in telecom networking. The 5G products we offer in telecom networking are aimed at base stations and radio towers. Additionally, 5G overall promotes an increase in semiconductor devices, leading to a greater demand for semiconductor processing tools. It also speeds up the transition to Industrial 4.0, which further increases the need for some of our advanced solutions in medical, industrial, automation, and other areas. We are extremely enthusiastic about 5G and believe that we are only at the start of its adoption, which will continue to drive long-term growth for us across all our verticals, not just in the power supplies for infrastructure.

Great. What is the medical component? How much is that within the industrial and medical business? And how are you looking for growth potential for the medical part of that business?

Yes. Overall, we said last quarter that our medical is about $75 million, and it's been growing. This is an area we're excited about. If you go back 3 or 4 years ago, we had virtually no presence in this market, and we've been able to grow that both through products we've acquired and organic growth. So it's an area that we see of growth going forward.

And the growth is driven both by, I would say, short-term need, a burst of need for critical care applications like ventilators and also some life science equipment that goes into gene sequencing, vaccine development and testing. Long term, we expect to see a continuation of the growth coming from the noncritical applications. And we mentioned just a few examples: we became a sole supplier for a blood analyzer and additional applications that go to diagnostic, imaging and also therapeutic applications.

Interesting. And then within the industrial part of that business, are there any specific end markets that you think have been a drag on growth? And any thoughts on when those slower growing or not growing end markets might recover?

The industrial market, specifically the non-medical segment, is very diverse, which is quite exciting. Every application around the globe can experience fluctuations and cycles of investment since these involve capital investments. In this particular market, we anticipate growth driven by consumer electronic product coating, including tribological and optical coatings. There is also a growing demand for automation and motion control across a wide range of applications. We expect the mix of products, markets, and applications to evolve dynamically, but overall, we foresee this segment of our business continuing to grow at a rate above GDP.

Understood. And maybe if I could ask just one last quick one for Paul. And just on your balance sheet and capital allocation philosophy, given where you ended up at the end of this quarter. Just any thoughts on how you’re looking to deploy cash in the quarters ahead?

Yes. Clearly, our primary goal in cash deployment is to continue to grow the company. We've stated that, broadly speaking, we'd like to deploy roughly 70% of our capital to smart M&A to continue to build out our strategy as a pure-play power provider. And the balance we would look at as available to return to shareholders. We've done that historically and continue to invest through an opportunistic share repurchase program. It doesn't mean we're buying every quarter, but we're looking for opportunities that make sense to be in the market. And we did buy additional shares this quarter, as you saw stock dipped; we were able to pick up a few shares. I think year-to-date, we've purchased something like $12 million or $13 million of stock through the first 3 quarters of this year. And that will vary by year, but that's our goal, a roughly 70-30 split.

Congratulations on the results. Wanted to just come back to the semiconductor business and your comments about growing faster than peers. I think MKS talked about growing its power business over 100%, both in the quarter and I think year-to-date, which sounds perhaps faster than your overall semiconductor business. So wondering if you might be looking at apples and oranges here? Or just could you clarify your comments about your belief you're growing faster than peers? And then I've got a couple of follow-ups.

Thank you for the question, Quinn. I believe there might be a misunderstanding in the comparison. It's important to take a closer look at what we define as growth. Right now, I can confidently say that we are growing faster than MKS across all metrics, whether it's year-over-year, year-to-date, or comparing the second half to the first half. We will share some numbers with you later to support this. In every category of growth comparison, we're outperforming MKS. I’m not sure how they measure growth, but in the areas where we compete directly with them, we are seeing higher growth and gaining market share, which fuels that growth.

We expect to manage and adapt to changes in volume and mix without trying to predict the market. We believe that the industry will grow over the long term, even though there will be fluctuations in quarterly performance. In Q3, we experienced a surge in demand for faster delivery, and we have the capacity and operational excellence to meet this need. Regarding inventory levels, there has been some inventory accumulation in the industry, influenced by factors like trade restrictions, but it is not significant enough to dramatically affect our future operations.

Got it. Paul, second question for you. You talked about catching up on backlog built earlier this year due to COVID supply constraints standard for half of the upside in the third quarter. As you come into the fourth quarter, do you expect to catch up on additional demand? Or do you think with the third quarter upside, you're largely back now, and all of that catch-up is behind you?

I think we're largely caught up from things that were delayed due to the supplier constraints and some of our operational challenges, particularly out of the Philippines. And most of that came out of the I&M and telecom side for embedded power type products. So we think we're largely caught up. Having said that, we continue to have a very strong backlog position because we continue to see good demand across our other markets. So we think that helps the quarter certainly. But we wouldn't expect to see that catch-up or a big backlog drawdown necessarily as we look forward.

Yes. I have a couple of follow-ups. And one as a follow-up to Quinn's question. I think it would be very helpful if you could give us an update on how you're increasing market share or presence in Japan, especially as it relates to semi cap. And I have a few follow-ups.

Well, Mehdi, obviously, we need to be very careful about customer information and our business size and activities of customers’ sites. We are definitely gaining share in Asia, including Japan, and the areas that we are gaining share are related to etch and deposition. We see dramatic growth in general in our RF matching technology. And as you know, RF matching is sort of the glue between the power supply and the process. It's an area that is extremely critical, especially as multiple frequencies are being used to drive advanced processes. We are the leader in technology in RF matching and our RF matches continue to be adopted across the board as an enabler for next-generation technology. And that's the reason, if you go back to our prepared remarks, you can look at the growth rate we exhibit in the RF matching area, which is phenomenal. Another area that we openly talked about is key to our strategy in semi first is remote plasma source technology, and our remote plasma source product line continued to grow significantly, and we expect the business to continue to generate incremental revenue for the future as we continue to gain share, both in Asia and also in other locations around the world. I hope that answered your question, Mehdi.

Absolutely. I want to revisit some of your targets. You have consistently pointed out your aim to surpass a revenue target of $1.5 billion and an earnings per share of $6.50. Your Q3 results, despite the one-time backlog adjustment from earlier this year, position you above that run rate. Looking ahead, I understand you'll provide an update on December 14. As you look forward, do you anticipate maintaining your targets through organic growth, or will it be a combination of organic growth and selective, opportunistic acquisitions?

Yes. The long-term targets we discussed do not include acquisitions; they are our organic growth targets. Any additional acquisitions would be considered as extra progress towards those numbers. We are pleased with the progress we've made so far, and I believe we are ahead of schedule. However, there is still more to achieve, particularly in terms of improving gross margins structurally. Phase 2 is well underway, and we anticipate significant progress over the next year, which will further support our gross margin improvement efforts. The promising aspect for us is that with increased volumes and the changes we've made, we can already see a glimpse of the future. We are nearing those targets even before fully realizing all opportunities to enhance the business.

Right, Mehdi, to maybe reemphasize two points here. Q3 is kind of a peak into the future, even before we completed all these synergies that will be realized in the integration of Artesyn and future synergies that will come after that. In addition to that, to the point that Paul made, we remain acquisitive. And the plan that we basically described to you when we put together our aspirational goals does not include acquisitions.

I just want to highlight that. Now just one more quick question regarding the momentum. You talked about how you see the different business units trending. But can you answer qualitatively or quantitatively if your book-to-bill was above 1.0 exiting Q3?

Yes. It's a difficult question to answer because, as you know, we don't really have a book-to-bill ratio since many of our products, particularly in the semiconductor sector and to some extent in embedded power, are pulled rather than ordered. They are taken directly from a jet bin or a hub. However, overall, I would say that outside of possibly addressing the backlog, our book-to-bill is at least 1.0 or higher.

And again, Mehdi, significant portion of our business is based on long-term purchasing agreements and not purchase orders that are being placed every week or every day. So these are long term, and it's a demand flow of technology; our customers pull our products from hubs when they need them.

Yuval, I was hoping you could talk a little bit more about the cross-selling opportunities. It sounds like you've had a little success now. And if you could highlight where that's coming from and what's the opportunity, that would be great.

Thank you, Tom. Yes, cross-selling, as we mentioned earlier in previous quarters, started to realize itself faster than we predicted. And we see an increase in the number of applications that we can serve with our embedded power products, and we have launched a unique product called iHP at SEMICON West that goes into multiple platforms in the semi industry and in this case, Tom, it's auxiliary power; it's not process power. Now it doesn't mean that it's not important. These power supplies, if we do not operate, then the whole machine doesn't move. So these are really important power supplies with unique capabilities that serve the global platform, not only inside the fab, but also outside of the fab in the back end of the process, testing and packaging. So this is an area that we continue to drive in semi, but we also see additional growth coming to industrial applications as we start moving products from different product lines that basically belong to either native AE or native Artesyn. We're now cross-selling them to different markets. So it's an area of significant potential incremental growth and drives a lot of excitement. What we bring to the table in some of these applications, our global footprint, our global manufacturing capabilities and support infrastructure around the world with our high-density and high-efficiency of conversion plays well into those who start looking into the efficiency of power and performance locally around the world. So we're very excited about that. And we view that as one of the revenue synergies associated with the recent acquisition.

Okay. Are these situations where you have to catch the product release cycle, so it takes a few years before this gets fully integrated into the opportunity?

Well, in some of these cases, I would say, yes, it's a similar design cycle. However, we had a few cases when we were asked to step in and help a customer to displace an incumbent that could not perform. An incumbent that could not perform either because of COVID-19 or could not perform because of issues related to their operational supply chain, at that point, our resiliency allows us to very quickly derive products to our customers' needs and will come back with a plug-and-play solution to help our customers.

No. It's a good question, Tom. We believe we do have capacity to things that have constrained us this year have been, I'll say, COVID-related restraints, just the ability to get people into the factories as well as supplier constraints. And that's been the challenge. We certainly have physical capacity to continue to grow both in semi and data center across the board.

Yes. It's a great question, Tom. We expect our industry to continue to grow, but we may see quarter-to-quarter variations driven by our customers' demand profile. So we have designed a plan for managing bursts. And we have the capacity, we have the test equipment, we have the fixed cost in place already, and variable costs will vary with the volume. So we expect, not only to be able to address the capacity increase, but also to do it in a very efficient way financially.

Obviously, the election results are still a little fluid, but let's assume for the sake of argument that there will be a change in administration. And in that context, a different approach to trade with China specifically. What impact, if any, would the ending of the trade war have on your business?

It's a good question, Pavel. That's a difficult one to answer since there are many dynamics at play. However, I believe the effects of the trade and tariff war so far have not significantly impacted our business directly. Since we operate globally and serve global customers, we haven't noticed a major effect. Speculatively, a change in trade policies could lead to overall economic growth and improved trade, which I think would be beneficial for economies in general and for our industry as well.

Our global presence allows us to serve our customers worldwide and produce goods close to their locations. As a result, we have not experienced significant impacts on our business from restrictions so far. Unless there is a notable shift in the geopolitical climate that boosts GDP universally, which would be advantageous for us, we do not anticipate any major changes.

Understood. Let me turn to the service revenue. In a certain sense, you're kind of a victim of your own success. You have so much product sales now that service as a slice of the revenue mix is now less than 10%. I know you've talked in the past about kind of building up your recurring revenue stream. And in that context, is that something that would be relevant to vis-à-vis M&A, acquiring any kinds of service or perhaps software businesses if that's relevant to create or...

Yes. So Pavel, let me make a comment and maybe clarify something for you relative to the comment you made about our declining service as a percent of total revenue. A significant portion of our service revenue comes from our process power business from what we call the advanced power or native AE, if you may. And the reason for that these are extremely sophisticated and extremely expensive products. And when they need treatment or repair or calibration, normally, they're being shipped back to us to our labs around the world, and we take care of them and ship them back to our customers because the value of the asset is so high. In the embedded power business that came through the acquisition, many of these power supplies are not being repaired when they fail; they're being replaced. So it doesn't generate service revenue; it generates product revenue. And it's just a matter of category. Our native service business continues to grow with our installed base, and we expect the business to continue to grow, and we accelerate the growth of this business by offering service products like upgrades, retrofits, refurbishments, etc. So that will continue to grow, but the decline in percentage of sales total revenue is a result of the product mix. Now going to the other area that you asked about, software is becoming an important product for us as we launched our PowerInsight offering. We're making an investment and progress in providing software products to our customers that are adjacent to our core products and provide our customers with unique capabilities like big data analytics, predictive maintenance and process diagnostics. That will continue, and our aim is to continue to grow this business and to offer these software products to the market first in semi, but later in industrial and telecom networking as well.

I had two of them. First one, Yuval, when I look at your semi cap revenues or shipments compared with your peers and contrast it to your customers like Lam, it clearly looks like your growth rate is much higher than theirs. I understand that your customers are also building some buffer inventory because of COVID, but do you worry that at some point next year, this should normalize and your semi cap growth rate could slow down, especially as your shipments catch up with your customers?

Do you want to answer that, Paul?

We are cautious about predicting the market, as we are not market analysts. However, we are ready and capable of managing changes in volume and mix. We believe that, in the long term, the industry will experience growth, even if we don't see consistent quarterly increases. We are prepared for fluctuations. In Q3, we experienced a notable surge in demand for faster delivery. We have the capacity and operational efficiency to meet this demand. Regarding inventory building in the industry, some of it has been influenced by factors like the trade war and shipment restrictions, but it is not significant enough to dramatically affect us moving forward.

Got it. Yuval, that's very helpful. And then just as a follow-up on the data center side of the business, you talked a lot about the hyperscale segment and your traction there. I'm kind of curious to see on the other part of the data center, which is the enterprise spending, how do you see that business trending? Looks like budgets are down this year. And how do you expect enterprise to trend into next year? So let me address the hyperscale first. We believe that we are in the third inning of our journey in basically designing our products into the top hyperscalers, right? And if you look, based on the information we have shared with you earlier over the last 3 quarters, we have recently got set at the ramp of our product shipments into a third hyperscaler. At the same time, we're making great progress in designing our products into additional hyperscalers. Now if you look at right now where we are in the journey, we're still highly concentrated in just a few hyperscalers. Now we believe that in the short term, we're going to see digestion in the hyperscale market as some of the hyperscalers basically use the inventory that they acquired. And as we look at the market, and I think in our prepared remarks, we said we expect to see a resumption of growth coming in 2021. We expect when the market recovers to do better than the market because we continue to gain market share. And we continue to gain market share as a fast follower because of our unique product offering with very competitive energy conversion efficiency and power density.

Your next question comes from the line of Weston Twigg with KeyBanc Capital Markets.

I wanted to follow up on the increase in order activity that you mentioned at the end of the quarter. Why doesn't this surge in demand translate to guidance for Q4? In other words, why is Q4 projected to be lower if order activity was increasing at the end of Q3? I'm curious if you could provide more detail on which types of customers were involved and why this seems to be a temporary situation.

It's a good question, Wes. To clarify, the surge in orders we observed was primarily due to customers prepositioning inventory to stay ahead of seasonal shipment patterns and some near-term geopolitical concerns discussed by Yuval. However, this was not the case for all customers. Overall, we still expect demand to remain strong, as mentioned in our Q4 comments. This surge is not the reason for our lower guidance. We also indicated that we do not anticipate a repeat of the backlog catch-up we experienced earlier this year in Q4, which positively influenced Q3. Additionally, we noted that the data center sector will see a decline due to specific customer needs and industry adjustments. The main factors leading to our lower guidance are the lack of a repeat backlog catch-up and reduced impact from the data center market, which is experiencing some digestion. We've managed risks related to COVID and other environmental issues, but these two aspects are significant drivers of our guidance.

Thank you all for joining us today. We're very excited about the progress the company is making and our future projections. We see four key areas of opportunity: semiconductor, data center, medical, and 5G. We expect these areas to drive ongoing growth for the company. We're gaining market share and expanding our presence while investing in new products to accelerate our entry into new applications and markets. I look forward to seeing many of you in December when we will provide a more detailed analysis of our growth trajectories, the applications we target, and an update on our ambitious goals. Thank you very much.

Ladies and gentlemen, this concludes today's conference call. Thank you for participating. You may now disconnect.