Earnings Call Transcript - ONTO Q2 2021

Operator, Operator

Please standby. Good day, everyone. And welcome to the Onto Innovation Second Quarter Earnings Release Conference. Today’s call is being recorded. At this time, I would like to turn the call over to Mike Sheaffer. Please go ahead.

Operator, Operator

Thank you, April, and good afternoon, everyone. Onto Innovation issued its 2021 second quarter financial results this afternoon shortly after the market closed. If you have not received a copy of the release, please refer to the company’s website, where a copy of the release is posted. Joining us on the call today are Michael Plisinski, Chief Executive Officer; and Steven Roth, Chief Financial Officer. As always, I need to remind you of the Safe Harbor regulations. Any matters today that are not historical facts, especially comments regarding the company’s future plans, products, objectives, forecasts and expected performance, consist of forward-looking statements within the meaning of the Private Securities Litigation Reform Act. These estimates, whether expressed or implied are based on currently available information and the company’s best judgment at this time. Within these is a wide range of assumptions that the company believes to be reasonable. However, it must be recognized that these statements are subject to a range of uncertainties that can cause the actual results to vary materially. Thus, the company cautions that these statements are no guarantees of future performance. Risk factors that may impact Onto Innovation’s results are currently described in Onto Innovation’s Form 10-K report for the year ended December 2020, as well as other quarterly filings with the SEC. Onto Innovation does not update forward-looking statements and expressly disclaims any obligations to do so. Today’s discussion of our financial results will be presented on a non-GAAP financial basis unless otherwise specified. As a reminder, a detailed reconciliation between GAAP and non-GAAP results can be found in today’s earnings release. I will now go ahead and turn the call over to Mike Plisinski. Mike?

Michael Plisinski, CEO

Thank you, Mike. Good afternoon. And welcome to Onto Innovation’s second quarter conference call. Across the semiconductor value chain from silicon wafers to wafer fabrication and advanced packaging, Onto Innovation’s products are contributing to the faster ramps and higher yields necessary to support the unprecedented global demand for semiconductors. Onto Innovation is broadly participating in this growth from logic at 7-nanometer down to the 3-nanometer design nodes to the latest DRAM and 5G communication devices, and out to the rapidly evolving advanced packaging markets where accelerating design shrinks are creating strong demand for more sophisticated and versatile inspection solutions. As a result, in the second quarter, we reported record revenue of $193 million, well exceeding the high end of our guidance and we continue to see a stronger second half of the year. So let’s begin by looking at the highlights from the second quarter, starting with our largest segment, specialty devices and advanced packaging. End market demand for devices to support growing work-from-home and high-performance computer applications propelled revenue in this segment to increase by 45% over the first quarter and more than double the second quarter of 2020. Leading this growth was demand for inspection technology, which increased 24% over the first quarter and 65% year-over-year. Our recently released Dragonfly G3 systems improved sensitivity and speed, and integrated Clearfind technology is expanding our position in the most demanding and sophisticated packaging markets, while also opening new markets such as high-definition image sensors, where our growth continues ahead of expectations. For example, in the second quarter, we received orders from a fourth new image sensor customer, while a top three image sensor customer doubled their existing installed base to support the ramp of their latest sensor technology. Another segment we see expanding is our served markets, represented by panel-level packaging. We believe this market represents an important inflection point for the industry, particularly for high-performance compute engines and large heterogeneous packages. Our newest lithography tools deliver high-resolution imaging across a very wide field of view, which is proving to be a key enabler for next-generation packaging technology for larger advanced packages. We have started shipping our backlog and have received an additional four orders for shipment in the first half of 2022. Our total lithography backlog is now over $30 million and we expect to close 2021 with several more tool shipments and a fully booked production schedule for 2022. We are working closely with our customers and suppliers to determine additional capacity needs for 2023. Revenue to support both power and 5G applications increased to over $24 million in the second quarter. This included demand for our inspection systems, new overlay metrology from our acquisition of Inspectrology and strong demand for metal film metrology. This also included the addition of four new RF and power customers, which we expect will contribute to our projected stronger half of the year. Turning to the advanced nodes, in the second quarter, we set a quarterly revenue record for our flagship Atlas OCD metrology platform. This record demand was primarily in support of expansions for leading-edge DRAM and logic devices, where our greater sensitivity provides a central metrology for a growing number of critical dimensions at speeds required for volume manufacturing. We expect demand for our Atlas OCD to continue to strengthen in the second half of the year, both to support additional investments in advanced logic and DRAM, and an increase in the number of applications on our tools in support of higher yields. Even as demand for our core products have record levels to support overall market growth, we are enabling future growth by expanding our position in new markets such as planar films and high aspect ratio metrology for 3D NAND. We are also seeing revenue synergies in specialty markets as we introduce our metrology suite to these customers. For example, in the second quarter, we received orders for our latest film system from six new customers in the specialty device markets. These orders will ship in the second half of 2021, and including projected repeat orders from our first customer, we expect second half growth of our planar films to be over 50% from the first half, providing nice momentum into 2022. And finally, I wanted to also highlight our ongoing commitment to raising our corporate and social responsibilities by becoming an affiliate member of the Responsible Business Alliance. We are already actively committed to responsible environmental and social policies, but our membership in the Responsible Business Alliance is another important step forward. By joining our fellow members of the RBA, we will serve as an example to our suppliers of how the RBA code of conduct can create a more successful industry climate and a better world. I will now turn the call over to Steve Roth, who will cover the second quarter financial highlights before I provide some color on our third quarter. Steve?

Steven Roth, CFO

Thanks, Mike, and good afternoon, everyone. In my remarks this afternoon, I will provide some details on our Q2 results, then follow that with what we are seeing for guidance for the third quarter. As Mike mentioned, our second quarter revenue was $193.4 million, up 43% over the same period last year and up 14% over last quarter. During the quarter, we received approval from the U.S. government to ship certain systems that we had in backlog since the end of 2020 to a customer in China. Those shipments totaled $13.1 million in the quarter. Due to a delay in getting this approval, our customers’ ramp plans and their customers’ orders shifted downward, and we agreed to cancel a portion of the original order totaling approximately $8 million and redeploy those systems to other customers. We still have other systems awaiting government approval, which at the end of the second quarter totaled approximately $7.3 million. Breaking down the revenue by market, 48% of the sales were from our specialty device and advanced packaging market, with strengths coming from RF and power markets, which combined were up 200% over the first quarter. The advanced node market represented 33% of sales in the quarter, down from Q1. While we did see growth in memory, both DRAM and NAND, those increases were offset by a temporary pause from logic customers. Finally, software and services increased slightly in the quarter and represented 19% of revenue. Our gross margin continued its strong quarter-over-quarter performance, increasing to 55% compared to 54% in the first quarter. Higher revenues covering our fixed manufacturing costs and product mix helped offset supply chain cost increases in the quarter and drive the gross margin improvement. Second quarter operating expenses were $55.8 million, an increase from $49.2 million in the first quarter of 2021. This unusual increase in operating expenses was mainly due to our variable compensation plans now forecasted to far exceed targets. As such we had to true-up our accruals, including a catch-up of the Q1 shortfall. In addition, stock-based compensation expense was higher in the quarter due to annual employee grants and headcount increased to support the growth we are seeing now and in the future. Even with the increase in operating expenses, our strong financial model resulted in an increase in operating margin to 26%, up from 25% in the first quarter. In fact, our operating margin has improved every full quarter since we completed the merger of Rudolph and Nanometrics, and we feel confident in achieving our long-term operating model, which at a revenue level of $800 million, calls for gross margins of 55% to 56% and operating margins of 29% to 30%. Net income increased in the second quarter and was $45.9 million, or $0.92 per share and above the high end of our guidance. In the 2021 first quarter, we reported net income of $36.3 million or $0.73 per share. Moving to the balance sheet, we ended the quarter with a cash position of $411 million, up $18 million from Q1. Accounts receivable increased to $175 million in the quarter due to an increase in revenues and the linearity of our shipments, which were heavily weighted to the back half of the quarter. Our inventory turns improved in the quarter. However, overall inventory increased slightly and ended at $207 million. Now turning to third quarter guidance, we expect revenue to be in the range of $190 million to $200 million, with earnings per share in this revenue range anticipated to be between $0.85 and $0.99 per diluted share. We also expect our gross margins to be between 54% and 56%. For operating expenses, the compensation plan true-up I just discussed should have minimal impact on our quarterly operating expenses going forward, but we will continue to have active recruiting plans in place for the strong growth we are seeing. Therefore, we anticipate operating expenses to decline in the third quarter and be in the range of $52 million to $54 million. And with that, I will turn the call back to Mike for additional insight into Q3 and the remainder of 2021. Mike?

Michael Plisinski, CEO

Thank you, Steve. We entered the third quarter with strong momentum across all of our markets and strategic initiatives, which include continuing to increase operational efficiencies to further strengthen our foundation for sustainable growth. We have a record backlog and visibility out to early 2022, so even with our strong results for the second quarter, we remain confident in the expectations set last quarter for continued growth in the second half, with the fourth quarter stronger than the third. Specifically, for the third quarter, we expect spending on logic to increase significantly in support of additional expansions by several logic suppliers in the second half of the year. We see continued strong demand from packaging and RF customers in the third quarter and expect a sharper increase in the fourth quarter as our expanding number of customers increase their investments in 5G to support new applications and infrastructure and transportation in addition to the current growth in mobile applications. We expect memory overall to decline in the third quarter with DRAM spending to pick up significantly in the fourth quarter to support investments from leading suppliers. With the continued growth we see for the second half of the year, our supply chain team is increasing their focus on deliveries and supplier backlog from each of our supplier partners to minimize impact to our customers. As I mentioned earlier, our growth is not only driven by the surge in demand for our products in existing markets, but also the progress we are making expanding into new markets such as image sensors, planar films, panel packaging, and high aspect ratio metrology. In total, these initiatives expand our served markets by over $350 million, creating additional revenue opportunities for 2022 and beyond. And with that, we will open the line for questions from our covering analysts. April, please go ahead.

Operator, Operator

Thank you. And we will hear from Patrick Ho of Stifel.

Patrick Ho, Analyst

Thank you very much and congratulations on a great quarter and outlook. Mike, to start with the advanced packaging market, there are clearly significant growth opportunities, especially at the forefront, as top chip makers discuss their prospects in this area. Can you provide an overview of those opportunities and explain how they connect to some of the volume purchase agreements you've mentioned previously? More of those agreements are possible as you leverage the advancements in the advanced packaging processes.

Michael Plisinski, CEO

Patrick, you broke up a bit, but I believe I got the main idea of your question. From a packaging standpoint, the demand is growing across various applications. Leading manufacturers and IDMs are investing significantly more in R&D and capital expenditures to enhance advanced packaging technology and capacity. Regarding volume purchase agreements, you are correct that these top IDMs are also recognizing opportunities on the back end while we're gaining traction with our metrology platforms. We have worked on cross-training our service and support teams during COVID, which has improved our coverage and capability, allowing us to provide better service and uptime. This strengthens our position as a supplier, giving us an advantage in negotiating volume purchase agreements for 2022.

Patrick Ho, Analyst

Great. That’s helpful. And maybe as my follow-up question for Steve. First off, Steve, given your recent announcement, I want to again wish you the best of luck. It’s been a pleasure all these years working with you and I think going forward, I will be one less person to harass you. So thank you again.

Steven Roth, CFO

Thanks, Patrick. Thanks for the words.

Patrick Ho, Analyst

Going to the near-term environment, given your results and outlook, you obviously manage the supply chain very well. The entire industry is going through constraints right now to varying degrees. Given your results and outlook, what have you been able to do differently from other equipment companies, but the full understanding each equipment company is very different? Their supply chains are different and the types of components there are in short supply are also different. So if you could just give a little bit of color on what efforts you have done to mitigate the situation?

Steven Roth, CFO

It's a good question. A lot of credit should go to our supply chain team. They have been excellent at monitoring where we are experiencing component and assembly delays, and for the most part, we have managed them well. We are certainly facing some challenges on the logistics side in getting materials to us. As I mentioned, there has been some pressure on our gross margin, which is mainly due to expedited shipping charges we've incurred to reduce transit times and ensure timely deliveries. Alongside this, we are also looking ahead to ensure we have sufficient resources to support our growth. Overall, I believe we have done a commendable job managing these issues, even though we are still facing them.

Patrick Ho, Analyst

Great. Thank you again.

Operator, Operator

Quinn Bolton of Needham & Company.

Quinn Bolton, Analyst

Hey guys, Congratulations on the nice results, and Steve, I will say the same congrats and best wishes to you. I wanted to start with just sort of the visibility that you have into the second half, sounds like Q3 up over Q2, Q4 up again. As you look at WFE, I think many analysts predict WFE up 30% plus, maybe even into the mid-30%s and based on your visibility right now. I am wondering if you think overall product revenue at Onto will sort of keep pace or perhaps even outperform that WFE level in 2021?

Steven Roth, CFO

Yes. So, Quinn, we believe that we will be outpacing the WFE. If you look at the expanding capital intensity for our Atlas Metrology platforms in the advanced nodes and we look at the different applications, we see happening on the advanced packaging front. And then combine that with the new market expansions that we are only in the early stages of gaining traction. We look at all that combination and some of the guidance we have given would indicate that we are fairly confident in outperforming a 30% kind of WFE number.

Quinn Bolton, Analyst

Great. And second question, as you are going through the comments looking into Q3, Q4, it sounds like you saw memory picking up in the fourth quarter. It sounds like that’s driven more by DRAM, but I am wondering if you had any thoughts on the NAND outlook Q3, Q4?

Michael Plisinski, CEO

We perceive a softening in the NAND market for the second half. Despite the overall strength we are experiencing, this is the one sector where we are noticing a decline as we move into the latter half of the year, and it appears it might stabilize at that lower level.

Steven Roth, CFO

Yeah. Quarter-over-quarter…

Quinn Bolton, Analyst

And last one for you, Steve, on the litho. The litho backlog has increased nicely again this quarter. As you begin to ship those systems, I understand they carry lower gross margins. Are there any concerns that this could pull you below the 55% to 56% range that it seems you're getting close to on a quarterly basis, particularly regarding the $200 million quarterly run rate, likely at the high end of guidance for Q3, but if not, then definitely for Q4?

Steven Roth, CFO

That's a great question. I'm not worried about Q3. We've just begun shipping new systems, so revenue recognition will likely be delayed for these tools. I don't expect them to be recognized in Q3. For Q4, we'll have to see how the mix develops, but if all the tools were recognized then, it could put some pressure on the margin. The overall model takes into account lithography with lower margins, so there might be a situation where it backs up to impact one quarter. However, the model includes lithography with those lower-than-normal margins.

Quinn Bolton, Analyst

Got it. Great. Thank you very much.

Operator, Operator

And next we will hear from Craig Ellis of B. Riley Securities.

Craig Ellis, Analyst

Thank you for taking the question, and congratulations on the strong performance. Mike, I wanted to start with you regarding a point mentioned in the press release. I believe the SAM expansion opportunity you outlined was valued at $350 million, but my notes indicate it at $260 million, so my previous notes might be incorrect. It seems that the SAM expansion opportunity is increasing, which is the focus of my question. As we progress through 2021 and move towards 2022, do you see a larger SAM expansion opportunity now compared to what you saw six to nine months ago?

Michael Plisinski, CEO

Yeah. We do. We do in panel level packaging, which is one of the areas. We see a little bit more in the CMOS image sensor, but the biggest probably shift is also on the planar films. So that’s another area where we are starting to see a little more demand, not just in the traditional markets, but also in the specialty device markets. We didn’t appreciate just how much opportunity there was there and as we started to leverage our broader channels, our broader sales channels, the opportunities have been very positive. The customers have been very receptive to the new products.

Craig Ellis, Analyst

Got it. Got it. And then, Steve, I will do a follow-up with you. So if I were to annualize the current quarter’s revenue guidance, I get something that is close to $800 million, not quite there, but close and the gross margin is very close to the target, but it looks like operating margin has a bigger gap target. So I am just wondering if you can walk through some of the things that will be needed to close the operating margin gap from where we are now to target levels at 29.5%.

Steven Roth, CFO

The factor that's slightly holding you back, Craig, is that, as I mentioned earlier, the compensation plans are performing significantly above expectations.

Craig Ellis, Analyst

Got it.

Steven Roth, CFO

...and the model assumes they are at 100%, so there’s a lot of catch-up entry going on in the quarter.

Craig Ellis, Analyst

Yeah.

Steven Roth, CFO

That’s why I say I am confident if you were to back out that run rate, as a run rate, you would actually be very close to the long-term model.

Craig Ellis, Analyst

Great. And then lastly and I will keep it there, and before I ask the last question of you, Steve, I just want to join the group in echoing the, thanks for all the help over the years. You have been tremendously valuable not just with Onto, but with the broader industry and I greatly appreciate that and wish you well. But as we look at the next milestone now that we are really at the midpoint gross margin target looking up to the next level, which is 56.5%. Is it about an equal contribution between mix and volume that gets us there or what are the ingredients that take us to your 56.5% target from today’s levels?

Steven Roth, CFO

Yeah. It’s just keeping the standard mix of metrology inspection, obviously, litho is built into that too. So it’s really just keeping a somewhat growth across all the segments, even that Mike talked about where you see a lot of the growth. You keep that proportionally up, you start leveraging up into those numbers that you see in the next level of our long-term operating model.

Operator, Operator

And next we will hear from Tom Diffely of D.A. Davidson.

Tom Diffely, Analyst

Yes. Good afternoon and thanks for the question. First, Steve, I am very sorry to see you go. You have been the one constant in the 20 years I have been in this business and almost your chats.

Steven Roth, CFO

Yeah.

Tom Diffely, Analyst

So, maybe starting with you, when you look at the supply challenges you have seen over the last few quarters, how would you characterize the transition or the move of that? Are they getting better, are things getting resolved, is it getting worse? How do you view the supply chain issues?

Steven Roth, CFO

I think right now the situation hasn't worsened. It's been relatively stable. We initially noticed challenges in the logistics area, particularly with longer freight times as we relied heavily on container ships for our shipments. Over time, the focus has shifted to issues related to individual components, including assemblies and concerns with our suppliers' suppliers. We are actively working with our suppliers to ensure they are testing their sourcing effectively, as we are encountering some Tier 2 issues that are affecting timely deliveries. Overall, in the past month or two, things have leveled out, and I haven't seen a significant decline in conditions.

Tom Diffely, Analyst

Okay. That’s quite helpful. And then, Mike, when you look at the long-term drivers in your market and your products serve in those markets, what do you think the natural split between specialty and advanced news nodes is for you?

Michael Plisinski, CEO

Over time, I think, we are going to continue to be right around that 50-50 mark. Right now, we are 60-40, where specialty and AP is a bit stronger. But as the expansion of our new metrology suite continues, I’d expect that to balance out. So, we will alternate quarter-to-quarter, but I would say that when we look out four years, five years and full adoption of these new products and additional new products from the markets and expansions, I’d guess that we are going to maintain this 50-50 kind of split, maybe slightly tied to the advanced packaging specialty, just because we have more products that play into that in a bigger way and that’s growing fairly aggressively.

Tom Diffely, Analyst

Okay.

Michael Plisinski, CEO

But right around that level.

Tom Diffely, Analyst

Okay. That’s helpful. So would you say over the next year that perhaps the biggest drivers are just all the products you have that serve this emerging foundry war that’s going to the leading edge?

Michael Plisinski, CEO

Not just that, but also the planar films and some of the new market opportunities we are seeing for the aspect ratio metrology for 3D NAND, high aspect ratio metrology. I think we are opening up the doors to some markets we didn’t participate in advanced nodes in the past. So I think that’s going to drive some outsized growth for us in advanced nodes, as well at the same time, we have the growth on the advanced packaging and specialty.

Tom Diffely, Analyst

Okay. All right. Thanks for your time.

Michael Plisinski, CEO

Yeah. Yes.

Operator, Operator

Next we will hear from David Duley of Steelhead Securities.

David Duley, Analyst

Thanks for taking my question. Congratulations on strong results, and Steve, congratulations on your retirement and good luck to you on everything. I guess, my first question involves, can you just help me with what the TAM of the planar films business is of this new $350 that you are referring to?

Michael Plisinski, CEO

So it's about $200 million of that, which represents approximately half of the overall planar films market. We categorize it into really critical films, some ultra-thin films, and then more standard planar films. Currently, our products are mostly aligned with the standard films, making up about half of the overall planar films market.

David Duley, Analyst

Okay. And do you have a revenue target, perhaps, you could share with us for this product either this year or next year or help us frame how big of an opportunity it is for you in the near term?

Michael Plisinski, CEO

Steve, how would you view that? We have hinted at our momentum, indicating that it is growing by about 50% in the second half. We mentioned that a realistic goal would be $50 million by the end of 2022. You can observe this momentum starting from zero at the beginning of the year, or possibly a couple of million in the first quarter or the end of the previous year, which shows that the trajectory suggests a model we could develop.

David Duley, Analyst

So $50 million will be the total over 2022 and 2021 or that’s what you might expect.

Michael Plisinski, CEO

That would be... that’s what we said, we could achieve when I was pressed a couple of quarters ago, that’s what we could achieve as we look out one year or two years. It was not cumulative as an annual basis.

David Duley, Analyst

Okay. Great. Regarding the advanced packaging inspection business, could you provide your prediction for the growth rate for all of 2021 in light of the statistics you shared about expected increases in the latter half of the year?

Michael Plisinski, CEO

We didn’t break it out, but I believe we grew over 20% last year and we expect to grow at similar levels this year.

David Duley, Analyst

Okay. And then for my final question, I want to ask about the advanced packaging lithography business. Congratulations on securing four additional orders; reaching a $30 million backlog is impressive. You mentioned that your slots are full through 2022, so if that’s the case and you have an idea of your revenue potential based on current execution, could you share whether you expect to ship the entire $30 million backlog? What should we anticipate regarding the revenue potential of this business this year and next year?

Michael Plisinski, CEO

We will provide that guidance as we get closer to it, but I want to clarify that I didn’t say the slots were full. I mentioned that we expect to end the year with full slots for 2022. We are continuing to build the backlog, which includes shipments planned for this year as well as those expected for next year. We anticipate that with the engagements we have, we will be able to close out the backlog before the end of this year. So they are not yet closed.

David Duley, Analyst

Okay. If you were to fill all your slots, what would be the revenue potential for the lithography business this year or next year, or however you can help us understand it at this point?

Michael Plisinski, CEO

I would say you can view the $30 million as a solid bottom estimate, and we should exceed that if we are able to fill all the available slots.

David Duley, Analyst

I guess the core reason that this business is all of a sudden taken off is you have got multiple customers that have moved into actual production with your tools?

Michael Plisinski, CEO

Well, we just shipped the first one. We have multiple customers planning to move into production, yes.

David Duley, Analyst

Thank you and again congratulations on nice results.

Michael Plisinski, CEO

Thank you.

Operator, Operator

And there are no further questions at this time. I will turn the call back over to Mike Sheaffer for any additional or closing comments.

Operator, Operator

Thank you, April. As a reminder, we will be participating in the B. Riley Summer Summit on August 18th and Needham Semi Cap and EDA Conference on August 24th. We’d like to thank everyone for participating in the call today and for your interest in Onto Innovation. That concludes our remarks for the call April. Please wrap up the call.

Operator, Operator

Again that does conclude today’s conference. Thank you all for your participation. You may now disconnect.