Earnings Call Transcript - ONTO Q4 2021

Operator, Operator

Good day, ladies and gentlemen, and welcome to the Onto Innovation Fourth Quarter Earnings Release Conference Call. Today's conference is being recorded. At this time, I'd like to turn the conference over to Mike Sheaffer, Investor Relations. Please go ahead.

Michael Sheaffer, Investor Relations

Thank you, Keith, and good afternoon, everyone. Onto Innovation issued its 2021 fourth quarter and full year 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 current 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 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 obligation 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

Thanks, Mike. Good afternoon and a happy new year to everyone. We're pleased to start the year off by reporting fourth quarter revenue exceeded the high end of our guidance, growing 12% over the third quarter and resulting in our equipment business growing nearly 50% for the year. This was our fifth straight quarter of revenue growth, and it was our eighth consecutive quarter of increasing operating margins. The Onto team has done a great job unlocking operational synergies even in this environment of rapid expansion and disruptions from the pandemic and global supply chains. Despite these ongoing challenges, we expect to maintain our growth momentum into the new year with projections for first quarter revenue, up slightly at the low end and up approximately 7% at the high end of our guidance range. But before looking to 2022, let's begin with a few highlights from the fourth quarter, starting with the advanced packaging and specialty device markets, which grew by a very healthy 21% over the prior quarter. Revenue from compound semiconductor and RF manufacturers increased by 140% in the quarter and represented roughly 40% of total revenue from our specialty and packaging customers in the quarter. Our powerful combination of process control technology and process analysis software is delivering higher levels of productivity to our customers and contributed to this strong demand. As an example, a recent customer leveraged our integrated solutions to increase factory output by an estimated 10%. We see similar opportunities to increase productivity for our advanced packaging customers, especially in heterogeneous packaging. For example, by integrating our complementary inspection, lithography, and software technologies into a solution we call StepFAST, we simultaneously improved productivity and yield. In the fourth quarter, we delivered our third StepFAST solution to a leading supplier of panel level fan-out technology used for packaging, high-performance 5G devices. We expect to uncover additional opportunities to provide productivity solutions to our JetStep X500 customers as we begin to deliver against our $100 million of backlog. In parallel to heterogeneous packaging, we see a universal acceleration of interconnect strengths creating demand for more precise metrology and higher-resolution inspection systems. The Dragonfly platform meets these new industry demands by providing accurate 3D metrology, Clearfind reliability, and submicron inspection resolution in a single system. In addition, we leverage our software to automate the analysis of these data streams to provide not just critical data but critical decisions. As a result, revenue for our Dragonfly platform increased 67% over the prior year. Turning to our advanced nodes customers, revenue from this market increased 6%, resulting in another quarterly record. Our Atlas platform is proving to be a powerful base for optical metrology. It can be configured to measure everything from the most advanced 3D transistor structures down to common planar films. We see increasing capital intensity for the Atlas platform, especially in advanced logic, where we provide measurement sensitivity required for complex transistor structures such as advanced FinFET and gate-all-around at speeds orders of magnitude faster than X-ray systems. In fact, 60% of our advanced logic revenue in the quarter was to support metrology for the 3-nanometer node. Metrology for DRAM memory represented the strongest growth in the quarter with revenue from several large capacity expansions in Asia. The combination of our Atlas platform and AI to frac software delivers improvements in sensitivity and modeling times by aggregating data from multiple sources. We've shown this hybrid metrology solution provides a fivefold increase in sensitivity for our integrated metrology platform, resulting in a 74% increase in integrated metrology revenue for the advanced nodes in 2021. With several memory customers forecasting additional expansions in 2022, we're optimistic that this growth will continue into the new year. Before we discuss our outlook for 2022, I will turn the call over to Steve to review our financial highlights for the quarter. Steve?

Steven Roth, CFO

Thanks, Mike, and good afternoon, everyone. I will start by providing some details on our Q4 results and then follow with our guidance for the first quarter of 2022. As Mike mentioned, we had another record revenue quarter. In fact, we had several company financial records this quarter. Our fourth quarter revenue was $226 million, above the high end of guidance, up 12% over the last quarter and up 45% over the same period last year. The revenue growth was broad-based with metrology, inspection, and software all experiencing record revenue in the quarter. Breaking down the revenue by market, 48% of the sales were in our specialty devices and advanced packaging markets, which continued to strengthen from the previous quarter and increased 21%. That increase was driven by RF, MEMS, and power customers as well as growth from the OSATs. The advanced node markets represented 33% of sales with strong memory sales being partially offset by weaker logic foundry sales in the quarter. Finally, software and services increased slightly and represented 19% of revenue. We continue to maintain strong gross margins at 55% in both the third and fourth quarters. Higher revenues, including stronger software sales, were offset by supply chain and logistic cost increases in the quarter. We continue to work on product margin improvement programs and supply sourcing programs to mitigate the impact from the supply chain on our gross margin. The fourth quarter operating expenses were $54.9 million, an increase of $3.3 million from $51.6 million in the third quarter. The increase is primarily due to onboarding of new headcount to support the growth we're experiencing and variable compensation plan adjustments. We continued our quarterly operating margin improvements each quarter since the merger with a record fourth quarter operating margin of 31% well within our published long-term operating model on a quarterly run rate basis. We also published a new long-term operating model just after the quarter closed with revenue targets of $1 billion to $1.4 billion, operating margins of 31% to 36% in those revenue ranges, and earnings power north of $8 per share at the high end of that model. Net income increased in the fourth quarter and was $61.2 million or $1.23 per share, above the high end of guidance. In the third quarter, we reported net income of $48.7 million or $0.98 per share. Moving to the balance sheet, we ended the quarter with a cash position of $511 million, up $50 million from Q3. Our free cash flow for Q4 was $51 million or 23% of revenue. For the year, we generated $163 million of free cash flow. Accounts receivables decreased to $177 million in the quarter, and our days sales outstanding declined to 72 days. Our inventory increased to $243 million in the quarter on higher planned sales for 2022, and continued acceleration of inventory deliveries as a hedge against supply chain disruptions. Now turning to the first quarter guidance. We currently expect revenue to increase from the fourth quarter and be in the range of $226 million to $240 million. As noted last quarter, we currently have several of our new lithography systems which have shipped or are shipping in Q1, with the revenue being deferred awaiting acceptance from the customer. It is currently unclear whether those systems will be accepted by the end of the quarter and recognized as revenue. The high end of our revenue guidance anticipates inclusion of those lithography systems. Earnings per share in the revenue range are expected to be between $1.13 and $1.20 per diluted share, which are partially affected by a reset of our effective tax rate for 2022. We also expect our gross margins to be between 53.5% and 55.5%. As we previously discussed, our new lithography systems will put some pressure on our gross margins during 2022 due to manufacturing inefficiencies as we ramp our production throughout the year. For operating expenses, we are aggressively hiring to support our growth and typically have higher operating expenses in the first quarter as payroll taxes and other compensation plans reset. Therefore, we're currently anticipating our operating expenses will increase in the first quarter and be in the range of $55.5 million to $57.5 million. And with that, I'll turn the call back to Mike for additional insight into Q1 and the remainder of 2022. Mike?

Michael Plisinski, CEO

Thank you, Steve. Looking broadly at the industry, we see a growing number of end markets being enabled by advances in semiconductor technology for wireless communication, high-performance computing, power devices, and sensing. These new end markets are simultaneously increasing the need for additional chip capacity as well as advances in manufacturing process technology to make future devices faster, smaller, and greener. At Onto Innovation, we are collaborating closely with leaders across the semiconductor value chain to deliver the manufacturing solutions needed to accelerate their road maps and fulfill expanding end market demand. These partnerships strengthen our ability to serve core markets while also opening the door to new markets. We estimate an increase of $650 million in new addressable markets spanning substrate, device, and packaging. This should provide additional tailwinds independent of projected industry growth over the next several years. Zooming into the first quarter guidance Steve just outlined, we project revenue from memory customers in both DRAM and NAND will increase by over 50% in the quarter. As we mentioned earlier, our integrated suite of metrology is providing important value to our customers. As an example, we're contributing to yield improvement at one of our largest 3D NAND customers by aggregating Atlas OCD with integrated and films metrology data. This aggregation is providing a more complete view of deposition, etch, and CMP process steps, again, it's speed suited for high-volume production. For the year, we see NAND continuing to be strong with capacity expansions for 128 to 176 layer NAND devices. We also see technology ramps to 192 and above increasing during the year. We expect similar strong demand from several DRAM customer expansions, which we also believe will remain at elevated levels throughout the year. The strength in DRAM memory this year is being driven by the positive impact the work-from-home trend is having on cloud and server markets as well as the growing number of memory-hungry AI applications. Simultaneously continued 5G handset and device adoption creates a 2x increase in NAND demand over prior generations, and the increase in mobile workforce is pushing up demand for reliable solid-state drives. Within our specialty devices and advanced packaging markets, we expect to see demand for our advanced packaging solutions grow by over 40%, primarily from the top IDMs. In addition, we see solid traction in the advanced image sensor market with revenue in the first quarter from 3 leading customers in 6 manufacturing sites. We do see a reduction in spending in the first quarter from advanced logic and compound semiconductor manufacturers after each contributed so strongly last quarter. Our positive outlook for the first quarter reflects our best understanding of the risks presented by global supply chain shortages in COVID. So far, the Onto team has been managing admirably through the unpredictable nature of these challenges. However, we are certainly not immune to these challenges, and so they remain an ongoing risk. We expect this uncertainty, especially in the supply chain, will continue to be a factor through at least the first half of 2022 and possibly the entire year. However, if we look more broadly at the year, we see demand across several end markets continues to be robust. In response, industry estimates for semiconductor equipment spending continue to increase across all of the markets we serve. As a result, it appears 2022 will be another double-digit growth year for the industry. And with the solid demand we see today for our products in our core markets and from new served markets, we feel we are well-positioned to outperform industry growth. With that, we'll now open the call for your questions. Keith?

Operator, Operator

We'll take our first question from Craig Ellis with B. Riley Securities.

Craig Ellis, Analyst

Congratulations on the very strong performance in the quarter and the outlook, guys. I wanted to start just understanding a little bit more about panel litho, really a 2-part question. I believe there's $100 million in backlog there. And if you could provide any color on the pacing of how that backlog might ship through '22 and '23, it would be helpful. And then Steve, with the commentary on gross margin, in the near term being impacted by revenue recognition of that product in a 53% to 55% range. The question is, is that impact something that's in the initial part of the manufacturing ramp? Or is that something that would persist through the period where we have the $100 million in backlog?

Steven Roth, CFO

So Craig, I'll answer that one first. Yes. So I think we're going to see the manufacturing impact throughout the year. I mean, we're not shipping a lot of systems; we're going to ship only several systems each quarter. And so that $100 million, as we said, will go through 2022 and into 2023. I would say maybe a little less than half of it going this year and then going into 2023. I think some of it might be driven into 2024 now. The margin thing, as we ramp, I think is going to be a full-year event in 2022. I mean we obviously some efficiencies as they get better at building the systems as well as that's the manufacturing side of it, as well as we continue to work on cost downs from the engineering side and quantity buys and things like that as we grow. So I think it's going to be a pretty good impact throughout 2022, and then you'll see improvement in 2023, the impact of the litho business on our business.

Craig Ellis, Analyst

Got it. And then combining that with a longer-term question related to the target model, and I'm not sure if this is better for you or for Mike. But with the target models, $1 billion, $1.2 billion, and $1.4 billion points. Were those anchored either in points in time or specific levels of WFE? How should we think about the way the executive team and the broader Onto team is looking at some of the underlying drivers to attaining those different levels and over which time period?

Michael Plisinski, CEO

Yes. So Craig, what we look at is pretty conservative estimates for WFE. So we look at industry growth and we consider growth as well as potential contractions. But the bulk of the model is based on the tailwinds that we can create through SAM expansion, through new product introductions, through some of the solutions that we have either recently introduced or in the pipeline, where we know where the customers' demand drivers are and what their needs will be. So our model is really a combination of the market, but mostly what we're trying to drive and have a little bit more control of, if that makes sense. And if you want to look at timing, we don't have a set time, but you could guess that based on the last models, we achieved that in this relatively quickly in this industry, kind of a 5-year time frame would be a reasonable 1 plus or minus on either side, more to the play.

Craig Ellis, Analyst

Yes. Well, certainly, the annualized level of the first quarter's earnings guide is making very robust progress towards the $1 billion model. So good for you. But clearly, there are some gives and takes with gross margin based on some of the things that Steve said about panel litho. Okay. Very helpful, guys. I appreciate it. And congratulations again, I'll hop back in the queue.

Operator, Operator

We'll take our next question from Quinn Bolton with Needham.

Quinn Bolton, Analyst

Let me echo my congratulations on the results and outlook. I guess, in '21, you saw a number of product lines growing at rates well above the WFE industry, and it looks like you guys expect to do that again in 2022. Wondering if you might rank order for us or if not rank order, just give us your thoughts on which segments of the business you think will be the fastest growing in 2022? I mean it sounds like you've got good tailwinds in litho, you've got good tailwinds in advanced packaging, but also in metrology. So kind of hitting on a lot of cylinders. So how would you rank the growth drivers in '22?

Michael Plisinski, CEO

From a percentage perspective, lithography would be at the top due to its small base. Putting that aside, we believe the metrology products, particularly in advanced node metrology, will experience the strongest demand, driven by the overall strong market demand. We see opportunities for market share growth with new products and the progress we are making through our hybrid metrology approach, which utilizes AI to enhance our software. Following that, there is significant demand for Dragonfly in advanced packaging, mainly to support initiatives aimed at achieving smaller and more densely packed interconnects, with bumps approaching $500 million per wafer. This requires not only inspection but also metrology and reliability solutions through our Clearfind technology. The Dragonfly platform has multiple growth drivers, including CIS, which has shown notable traction over the last two quarters. Advanced packaging will likely follow closely behind lithography. Next, we have the compound semiconductor market, which will incorporate our overlay metrology and inspection software. Although this market is smaller, we have seen strong growth in the past four to six quarters, and we anticipate this trend to continue into 2022.

Quinn Bolton, Analyst

Great. I wanted to follow up on Craig's question regarding gross margins. Steve, do you expect that the litho pressure will remain throughout most of 2022? Should we anticipate gross margins to stay relatively flat during the year? Or do you think that growth in other product lines, cost reductions, and potentially lower COVID-related and logistics expenses might mean that Q1 could be the lowest point for gross margin, with modest improvements in the subsequent quarters?

Steven Roth, CFO

Yes, it depends. In Q1, we have several litho tools that, if accepted, will likely set the lower end of my margin guidance. Without those tools, we're above 55%, which represents the upper end of my guidance. The margins will depend on how the litho tools are distributed each quarter. We've been hovering around 55%, so there is a possibility to reach 55.5% at most. If we maintain a consistent level of litho throughout the year, we can expect to be in the range of 53.5% to 55.5% for the entire year if the litho distribution is uniform. However, if it becomes uneven, it will have a more significant impact.

Operator, Operator

And we'll take our next question from Brian Chin with Stifel.

Brian Chin, Analyst

Congratulations on the nice results and execution in the quarter and thanks for letting us ask a few questions. Maybe just fine-tuning maybe the question or 2 that was just asked. Mike and Steve, why don't you get beyond the revenue recognition acceptance and maybe that happens in Q1 for a customer to maybe happens in Q2. But from there out, it should be pretty much your revenue against sort of your linear shipments. Is that a fair way to place that dynamic?

Michael Plisinski, CEO

Yes. That's for sure. Yes.

Brian Chin, Analyst

Okay. Great. And then again, looping back on the substrate opportunity, it sounds like there is some room over the next, say, 12 to 18 months to drive litho margins up. But are you more focused on wrapping higher-margin Firefly inspection and software around the litho tools replacing the customers? Is that really the bigger focus, and that will obviously drive a good margin point for that sort of blend?

Michael Plisinski, CEO

I wouldn't say one focus is more important than the other; both are priorities for us. We see opportunities in both areas and are actively pursuing them. Our organization is capable of handling multiple initiatives, so everyone is held accountable in that regard.

Brian Chin, Analyst

And maybe kind of a bit of a technology question, but hybrid bonding, it certainly enables significant interconnect density. And I realize we're still a ways out from broader industry adoption. But given that systems are hitting your backlog now vis-a-vis your press release, can you describe the impact hybrid bonding will have on inspection intensity in the years ahead?

Michael Plisinski, CEO

Yes, I believe this will lead to a major change in the metrology and inspection needs. When you're bonding wafers together, even a single interconnect or the level of coplanarity between these interconnects is crucial. If they don't align properly, it can ruin not just one chip but several. Both the coplanarity and the surface roughness and shape of these interconnects are essential. We are currently developing technology to address these upcoming challenges as hybrid bonding progresses from its current applications in CMOS image sensors, which have larger interconnects, to what we anticipate for advanced packaging in logic and other complex computing devices.

Operator, Operator

We'll take our next question from Mark Miller with the Benchmark Company.

Mark Miller, Analyst

Let me add my congratulations on another very strong quarter. I'm just wondering what type of pressures are you seeing from your component suppliers in terms of pricing and how are you handling that?

Steven Roth, CFO

Well, we've started to see some price increases being passed through. The key issue for us is that, for critical components, we have relatively long lead purchase orders. So we've observed a bit of that so far. We've been able to leverage higher revenues to balance it out. However, I believe this will continue to pose a challenge for everyone throughout 2022.

Mark Miller, Analyst

Are you starting to see any orders for the new fabs ramping next year, or do you expect to see them late in the year or early next year?

Michael Plisinski, CEO

We are definitely starting to gain better visibility through our backlog. While we’re not seeing a large number of orders for 2023, we are receiving some inquiries from customers who are looking to understand our slotting plans and wish to reserve slots for next year. So, visibility is certainly improving. However, our main focus right now is to ensure we can meet all the demand we have for 2022.

Operator, Operator

We'll take our next question from David Duley with Steelhead Securities.

David Duley, Analyst

I had a couple. I guess in reference to the $100 million lithography backlog, I think you've mentioned, Steve, that just under half of it might ship this year with the balance in 2023 and '24. I'm assuming that's just the lithography systems. Could you help me understand since you're kind of packaging these with inspection or metrology and software what the total opportunity might be for that $100 million? Is the other tools adding another $100 million to that opportunity? Or is it less? Or maybe help me understand how the bundling of things impacts the $100 million of lithography backlog?

Michael Plisinski, CEO

Yes, that's a great question, David. I'll provide some additional context. We have established use cases for panel-level fan-out applications and have developed a comprehensive integrated solution that addresses specific process issues in this area by combining inspection, lithography, and software. The X500 targets a different panel market, specifically the substrate market, which presents its own unique challenges. Therefore, the solution we developed for panel-level fan-out does not apply directly, although we believe several aspects of it may be useful. As we begin to install these systems and gain a deeper understanding of the processes and challenges, we will better identify which additional components from our technology portfolio can enhance productivity and yield for our customers. There is definitely a significant need for improved yields among our X500 customers, as their yields are currently well below 90%, and they are under substantial pressure to increase production capacity.

David Duley, Analyst

Can you clarify how the $100 million is allocated between the fan-out and substrate markets?

Michael Plisinski, CEO

It's nearly all X500. So it's nearly all for the substrate market.

David Duley, Analyst

Okay. You mentioned in your prepared remarks about how you've worked hard to enter the power device markets. I was wondering if you could help us understand the total revenue exposure to the power markets, specifically the silicon carbide market. Additionally, which product lines are the biggest drivers of your revenue and exposure to that sector?

Michael Plisinski, CEO

For power, we have a broad exposure to customers involved in manufacturing GaN and silicon carbide. Although these customers are smaller compared to our other clients, they have significant growth projections. Our product lines serving these power customers include the Dragonfly inspection and our IVS or iVision overlay metrology systems. Additionally, we provide software that several power customers have also adopted. Despite the power market being somewhat smaller and categorized under specialty devices and AP, it is expected to see decent growth in percentage terms this year. We believe our compelling combination of technologies will provide a strong opportunity to gain market share in this sector.

David Duley, Analyst

Okay. Great. Final one for me is, I think you mentioned you thought the overall WFE market would grow double digits and that I think you also mentioned that you would outperform that. So the suggestion is that whatever WFE is that your revenue should grow a bit faster. I guess I'm trying to figure out, above 10% is kind of a big range. I'm wondering what you think the WFE market will grow in 2022?

Michael Plisinski, CEO

We've noticed that estimates have fluctuated significantly and have changed since our last call. Initially, the range was between 8% and 12%, but now we've observed estimates as high as 15%, even reaching 17% or 18%. We believe that if the estimates hold true, we are confident that we will outperform within that range.

Operator, Operator

We'll take our next question from Hans Chung with D.A. Davidson.

Hans Chung, Analyst

Congratulations on strong results and outlook. I have a couple of questions. First, I want to follow up on the lithography topic. The $100 million backlog, I believe, pertains to the first customer, correct? Additionally, you've already provided clarification regarding the third customer. My question is what kind of revenue opportunity can we expect for the second and third customers moving forward? Could that be benchmarked to the $100 million type of revenue opportunity going forward?

Michael Plisinski, CEO

That's a good question. Within the $100 million backlog, there are actually several customers involved; it's not just one. Our ability to increase production and expand our capacity in a timely manner is currently limiting us in meeting market demand. I’d estimate that there are about three to five customers included in that $100 million, each with different levels of systems allocated to them. Great. Thank you, everyone, for joining us today. We know it's a busy time for earnings, and we really appreciate your time today. I'm sure we'll be catching up with some of you at the Morgan Stanley conference on March 9, and we'll be looking forward to catching up with many others throughout the quarter. With that, I'll turn the call back over to Keith to wrap it up.

Operator, Operator

Thank you. Ladies and gentlemen, this does conclude today's conference. We appreciate your participation. You may now disconnect.