Earnings Call Transcript - ONTO Q3 2022

Operator, Operator

Good day and welcome to the Onto Innovation Third Quarter Earnings Release Conference Call. Today's conference is being recorded. At this time, I would like to turn the conference over to Michael Sheaffer. Please go ahead sir.

Operator, Operator

Thank you, Cynthia, and good afternoon, everyone. Onto Innovation issued its 2022 third quarter financial results this afternoon shortly after the market closed. If you haven't 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 Mark Slicer, Chief Financial Officer. As always, I'd like to remind you that the statements made by the management on this call will contain forward-looking statements within the meaning of the federal securities laws. Such statements are subject to a range of changes, risks and uncertainties that can cause actual results to vary materially. For more information regarding the risk factors that may impact Onto Innovation's results, I would encourage you to review our earnings release and our SEC filings. Onto Innovation does not undertake the obligation to update these forward-looking statements in light of new information or future events. Today's discussion of our financial results will be presented on a non-GAAP financial basis, unless otherwise specified. And 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?

Mike Plisinski, CEO

Thank you, Mike, and good afternoon, everyone, and thank you for joining our call today. We'll begin with a brief review of the new US trade restrictions and their impact on Onto Innovation. We'll then cover business and financial highlights from the third quarter and close with our outlook for the fourth quarter and calendar year 2023. So let's begin. On October 7th, the Commerce Department announced new regulations essentially restricting US semiconductor equipment suppliers from selling to and supporting facilities in China fabricating logic devices below 15-nanometer design rule, DRAM below 19 nanometers, and V-NAND with over 127 layers. Specifically Onto Innovation, packaging and specialty device customers account for over half our year-to-date revenue in China and those customers are not directly affected by these new rules. Furthermore, several multinational corporations that produce advanced products have already been granted licenses, which extend to key suppliers such as Onto Innovation. So in total these new restrictions negatively impacted our revenue guidance for the fourth quarter by about $10 million. The estimated impact to 2023 revenue is roughly $80 million. And our closing remarks will provide a preliminary view of 2023 accounting for China, market headwinds and memory and the opportunities we see to continue to outperform the industry. Now turning to the third quarter. We're happy to report the Onto Innovation team delivered another strong quarter of $254 million in revenue, an increase of 27% over the prior year. More importantly, margins were at the high end of guidance resulting in record net income for the company. Contributing to that strong financial performance was our Atlas metrology, which set a quarterly revenue record with nearly all of the revenue supporting process nodes at 5-nanometer and below. We are projecting our metrology business to grow over 40% this year, well ahead of current wafer fab equipment growth projections. We believe this outperformance is a result of establishing early leadership positions in several technology transitions including the adoption of gate-all-around transistor structures and high stack V-NAND. For new gate-all-around structures, materials concentration is of growing importance for accurate etch and deposition control. Some customers' X-ray systems moving into fabs from labs are too slow for this high sampling application. Recently, we demonstrated the capability to provide accurate composition metrology while simultaneously measuring critical gate dimensions, all at volume production speeds. If adopted in production, we expect this unique capability to increase our attach rate of Atlas metrology by over 10%. We also see attach rate expansion in the high stack V-NAND market where shipments of our Atlas metrology and powerful AI to frac software are on pace to triple the shipments made in 2021. In addition, we're expanding the adoption of high aspect ratio metrology and acoustic metrology for V-NAND with over 200 layers. By year-end, we expect these systems to be qualified in four of the top five NAND manufacturers. This increases our attach rate for the eventual market ramp of this memory, which will deliver data center edge compute and mobile devices, a 40% increase in bit density and a 28% smaller form factor. Wrapping up our highlights for advanced nodes, our expansion into planar films continues with three new Tier 1 customers taking delivery of five evaluation units in the quarter. This year, we're on track to exceed $50 million in revenue, a 34% increase over 2021 with additional growth projected in 2023. Now turning to our specialty and advanced packaging markets. Revenue contracted in the quarter primarily due to the revenue recognition of multiple lithography systems in the prior quarter. Inspection revenue increased over the second quarter, led by a 30% increase in demand from the rapidly expanding compound semiconductor power device market. The global transition to electric vehicles is driving the need for more productive process control solutions to both improve yield and factory output. Our Dragonfly G3, with production-proven sensitivity below 1/4 Micron, coupled with new software algorithms to accurately separate critical defects from nearly identical, but acceptable process variation is essential for automotive applications where defect control is not simply a matter of profit, but is essential for human safety. Another secular trend we've been highlighting is the shift to heterogeneous systems and packages. Our opportunities to date centered on the JetStep X500 for substrates, and the Dragonfly G3 for inspection and micro bump metrology on the wafer. We now see interest expanding to higher resolution fan-out packages on panels and have received orders for four JetStep 3500 systems. This customer purchased our connected StepFAST technology, which integrates our die placement metrology and Discover Analytics to provide a fully integrated lithography solution to address overlay challenges inherent to the fan-out process. We expect to ship the first system in the fourth quarter, and additional systems in the first half of 2023. Finally, I'm pleased to announce in the third quarter, we delivered a JetStep 3500 to a customer in Korea, to support R&D for next-generation foldable OLED displays. Our stepper was selected due to the performance benefits and flexibility of our lithography platform. If the R&D effort is successful, it could open an estimated $300 million to $500 million TAM in 2025. Now I'll turn the call over to Mark for a review of the Q3 financial highlights and our Q4 guidance.

Mark Slicer, CFO

Thanks, Mike and good afternoon everyone. As Mike highlighted, we had another strong quarter with third quarter revenues of $254 million, up 27% over the same period last year and $4 million above the midpoint of our previous guidance. Breaking down the revenue by market, advanced nodes revenue of $111 million grew 57% year-over-year and represents 44% of total revenue. Specialty device and advanced packaging achieved $101 million in revenue, up 14% year-over-year and represents 40% of total revenue. Software and services of $42 million grew 8% year-over-year and represent 16% of total revenue. Our gross margin increased to 55%, our highest quarterly performance year-to-date. We are pleased with the team's ability to execute a quick sequential quarter recovery, driving a 300 basis point improvement compared to 52% in the second quarter. Our product mix was certainly a factor driving this improvement. However, we continue to experience supply chain disruptions and inflationary cost pressures within the quarter. We have active programs working with our suppliers and logistics companies to manage these gross margin headwinds and to minimize the impact in future quarters. Third quarter operating expenses were $61 million at the midpoint of our previous guidance. We did see an increase sequentially by approximately $2 million from the second quarter, primarily from further R&D investments and programs critical to our customers' road maps. However, we continue to drive operating expense leverage, as on a year-over-year comparison operating expenses as a percent of revenue decreased by 200 basis points. Our record level of operating income of $78 million or 31% continues to demonstrate the leverage in our operating model as our operating margin increased approximately 200 basis points both sequentially and as compared to a year ago. Our record level net income in the third quarter was $67 million or $1.35 per share, up 38% over the same period last year and $0.03 above the midpoint of our previous guidance. Now moving to the balance sheet. We ended the third quarter with cash of $553 million, up $41 million since the start of the year, generating $87 million of year-to-date cash flow from operations, representing 12% of revenue. Inventory increased to $308 million in the quarter to support increasing certain safety stock levels as a hedge against ongoing supply chain disruptions and to prepare for 2023, given the long lead time nature of our components. However, as Mike noted earlier, with approximately $80 million of our projected revenue for 2023 being impacted by the recent China restrictions, we are now reassessing our optimum levels of inventory and would expect to return to the mid-$200 million range for inventory levels in 2023. Accounts receivable remained relatively flat at $236 million in the quarter and our days sales outstanding increased one day to 84 days, primarily due to the timing of revenue within the quarter. As commented on during previous quarters, we continually assess our capital allocation strategy, which includes the balance between internal investment, M&A and share repurchases. All three continue to be a primary strategic focus for the company. During the quarter, we repurchased approximately 172,000 shares of common stock resulting in a return of capital to shareholders of approximately $11.5 million. The share repurchase was executed under our existing $100 million share repurchase authorization. This repurchase reflects our confidence in the strong earnings potential, our ability to generate strong cash flow and our commitment to delivering value back to our shareholders. Now turning to our outlook for Q4. We currently expect revenue for the fourth quarter to be between $244 million and $256 million, reflecting the impact of approximately $10 million in projected China revenue, Mike had mentioned earlier. We expect our gross margins will be between 54% to 55%. For operating expenses, we expect to be between $60 million to $62 million. For the full year 2022, we expect our effective tax rate to be between 12% to 13%. We expect our diluted share count for Q4 to be approximately 49.3 million shares. Based upon these assumptions we anticipate our non-GAAP earnings to be between $1.25 per share to $1.40 per share. And with that, I will turn it back to Mike for additional comments on the remainder of and further insights into 2023.

Mike Plisinski, CEO

Thank you, Mark. In the fourth quarter, we expect another increase in demand for our process control solutions from power device manufacturers. We project this will be our second largest market in the quarter, marking the first time a specialty device market reaches this level of relative revenue. Our largest market in the fourth quarter will be advanced logic, which we expect will grow 30%, including initial shipments to a logic factory in Arizona. We expect DRAM to be down slightly and revenue from NAND customers to be down significantly after growing in the third quarter. In addition, we expect to ship a record number of NovusEdge tools to support wafer capacity demand for EUV process nodes. Based on our healthy backlog supporting commentary from customers and ASML's guidance on EUV demand, we forecast revenue for both NovusEdge and Element metrology will increase again in 2023. Stepping back from the quarter, over the last two years global wafer fab equipment revenue has increased 50%. During that same period, Onto Innovation revenue is projected to nearly double, growing twice as fast as the industry. We achieved this performance by not only focusing on the growing share in our served markets, but also by successfully expanding into new markets with innovative connected solutions tied to secular trends in artificial intelligence, edge computing and new power devices. We expect many of these trends to drive growth next year in several of the segments we serve such as panel packaging, bare wafer and compound semiconductor manufacturing. We believe this will reduce the impact Onto Innovation of a projected 20% decline in global wafer fab equipment spending next year. At this level of global decline, we expect our revenue in 2023 to decline about 10% to 15%, including the negative impact of about $80 million from new restrictions on equipment sales to China. Though still early, we currently see the first half of 2023 will be the bottom, followed by an incrementally stronger second half. While maintaining the pace of innovation our customers rely on, we will take advantage of this pause in the market to focus on untapped product supply chain and operational synergies further strengthening our business foundation to support the next wave of growth, which will surely follow. With that, we'll open the call for your questions. Cynthia?

Operator, Operator

Thank you. We will take our first question from Craig Ellis with B. Riley Securities. Please go ahead.

Craig Ellis, Analyst

Yes. Thanks for taking the question. And Mike, thanks for providing some color on how you see calendar '23 shaping up for the company. I just wanted to start with a clarification on the comments on the China BIS impact. So it sounds like the impact is really inside of the advanced node segment. Is that correct or is it touching some of the other segments as well?

Mike Plisinski, CEO

Correct. It's within the advanced node segments and primarily the domestic manufacturers in China.

Craig Ellis, Analyst

Got it. Got it. Okay. And then the second question really relates to some of the color you provided for calendar '23. It seems like the SAM expansion that's been a strength of the company in 2022 has good momentum into 2023 with planar films panel on compound semi. Can you just talk a little bit more about what you see happening there? And to what extent is customer expansion or other things that play in each of those areas?

Mike Plisinski, CEO

Sure. A couple of our advancements are driven by artificial intelligence. The constraints in high-end chips largely stem from packaging issues related to IC substrates. We anticipate continued growth in panel packaging to support artificial intelligence. On the front end, wafer manufacturers are using EUV technology and have been cautiously increasing their capacity over a multi-year cycle, planning for significant expansions to support EUV specifically. This requires higher levels of process quality control, which our NovusEdge and Element products are exceptionally suited for. We currently have a robust backlog for both of these extending through 2023 and into 2024, driven by this demand. Regarding compound semiconductors, the growth is primarily linked to the automotive sector and the electrification of vehicles, as well as the push for renewable energy and the necessary changes to the power grid to support distributed energy sources. In 2022, despite the growth, we faced some constraints due to limited access to lithography equipment, which affected several customers' capacity to expand. As the market cools in some aspects, we expect this will ease demand pressures and allow our customers in the compound semi space to continue their expansion plans. I hope that clarifies things.

Craig Ellis, Analyst

Yes, that helps. And then the last one before I hop back in the queue Mike, I think towards the end of the year the company has in the past engaged with volume purchase agreement type of activity with its customers. And so the question is as you get to the end of the year and look ahead to 2023 what's the indication you're getting from customers in terms of the company's share of wallet and share of new programs that are going out there?

Mike Plisinski, CEO

It's a good question. I would say it's a combination of factors. Customers are engaging at different levels when it comes to volume purchases. Memory sales are definitely down, while logic is down but not as much. This is reflected in the numbers we are discussing. Regarding share gains, the indications are quite positive for us. As I mentioned, we are expanding into new markets, such as planar films, where we are competing against established rivals. Additionally, we are seeing positive results from using the Atlas platform for compositional metrology, which also competes with another player in the market. Our value proposition has been strong since the merger, emphasizing our ability to exceed the capabilities of our competitors in optical CD metrology, while they struggle with X-ray solutions that are often too slow for our customers. By expanding the range of applications on our platform, we believe we are capturing a larger share of the overall market spend.

Craig Ellis, Analyst

Got it. Thank you, Mike.

Operator, Operator

We will take our next question from Mark Miller with The Benchmark Company. Please go ahead.

Mark Miller, Analyst

Congratulations on another record quarter. In terms of the rebound in the second half of next year, what do you see driving it? Is that some of the new fabs that are just starting to come up?

Mike Plisinski, CEO

So, it's different. Overall, we're seeing a down year for next year, but I think in some areas, we're seeing strong growth. So panel-level packaging, planar films which is really around just spreading our technology into more of the customer base. So even though that market may be down, our ability to grow revenue within it is going to grow because we're gaining share. And then in the power devices, the electrification of vehicles, we still see that compound semi going up next year. That said, we certainly see DRAM or memory coming down both NAND and DRAM. And we see logic coming down as well. So some of the advanced nodes are coming down a bit.

Mark Miller, Analyst

You have five Irish tools, so how many total email tools do you have out there?

Mike Plisinski, CEO

It's likely a little over five. However, it's important to note that we've already generated approximately $30 million in revenue from these tools in 2021, and we're expecting to reach another $50 million this year. These tools are primarily intended for evaluation, not just to demonstrate the technology but to show that we can measure against their baseline. They are very specific evaluations tailored to our fabrication process. As we continue to bring in more customers, the initial step they usually take involves an evaluation unit to validate the technology before implementing it across our factories.

Mark Miller, Analyst

Thank you.

Operator, Operator

And we will take our next question from Hans Chung with D.A. Davidson. Please go ahead.

Hans Chung, Analyst

Thank you for taking my question. First, I want to discuss the gross margin. Can you provide some insights for 2023? We're expecting a ramp in the software reel product, which has a lower margin, but we also have new products with higher margins continuing to ramp up. Additionally, the leasing supply chain dynamics may help on the cost side, although we might also see lower revenue scale. How should we view the gross margin trend for next year considering these factors?

Mark Slicer, CFO

Yeah, I won't go into specifics about the gross margin rates, but as we approach 2023, it's definitely a focal point for us. We are looking at the mix and its impact on gross margin. We've mentioned that the margin profile for litho tools is expected to improve throughout the year. We're committed to optimizing this to enhance gross margin further, and we'll incorporate this into our models for next year. In terms of the overall gross margin, we're examining operational efficiencies and our plant network to create better alignment and leverage. This should ideally lead to gross margin improvements. Currently, we aren’t observing any reduction in headwinds or a decrease in costs. Labor costs are increasing among our suppliers, and while freight costs have decreased from their peak, they haven’t returned to pre-COVID levels. We still face significant challenges with pricing and price increases. These factors are all at play as we collaborate with our vendors and logistics partners to secure better contract terms and pricing that could alleviate some of the pressure on gross margin.

Mike Plisinski, CEO

Yeah. So Hans, to provide some additional insight, you covered all the factors. Mark mentioned the various steps we're taking regarding those factors. If you examine our history, even with reduced revenue, we've consistently managed to maintain gross margins and take necessary actions to uphold those margins. So, I believe you will see more of that as we look ahead to 2023.

Hans Chung, Analyst

Got it. Can I follow up on the overall cost structure? What percentage of COGS and OpEx is variable versus fixed? I'm trying to understand how a revenue decline of 10% to 15% might impact the overall operating costs.

Mark Slicer, CFO

We don't have the specific details on that right now. Currently, we are evaluating our annual operating plan for next year. We are looking at costs throughout the company and seeking areas where we can make reductions without affecting our innovation. We aim to maintain a balance in what we cut or reduce. While I can't provide an exact breakdown of what is variable and non-variable, we are definitely focusing on variable costs first and assessing our operating structure to ensure it continues to align with our financial commitments outlined in our long-term operating model.

Hans Chung, Analyst

Got it. And then lastly, can you elaborate a little bit more on the acoustic metrology, it seems like it's very a strong value proposition for the V-NAND, just how strong is the value proposition for like more than 200 there like you highlight? And then at kind of the revenue opportunity are we looking at?

Mike Plisinski, CEO

Yeah. So as we discussed, it would be about a 10% increase in attach rate. And so I would say, maybe it's two to three tools per 20,000, 30,000 wafer starts. Again, this is still early. So customers are still optimizing their lines and working out their sampling strategies and things like this. So, it's an incremental improvement. It's an incremental attach rate on an already strong position that we have in NAND. But it is a unique capability. So you're right to call out both the Echo acoustic metrology for hardmask layer. It's very unique in being able to measure the hard mask glare critical for etch control and then the aspect of metrology for high aspect ratio metrology basically those bit channels going vertically across those layers that become very difficult to measure over 200 layers or 200 stacks.

Hans Chung, Analyst

Got it. Thank you.

Operator, Operator

We'll take our next question from Trevor Janoski with Needham. Please go ahead.

Trevor Janoski, Analyst

Yeah. Hey, Mike. Hey, Mark. This is Trevor on for Quinn Bolton. Thanks for letting me ask the question. Can you provide any more color on the China impact, specifically what is causing the quarterly impact to pick up in 2023 versus the $10 million in fourth quarter?

Mike Plisinski, CEO

Quarterly impact to pick up in 2023. So, I don't think we said it was going to pick up –

Trevor Janoski, Analyst

Sorry – like the run rate – if you just take the $80 million in run rate it?

Mike Plisinski, CEO

Yes. So then I think it would still be a pretty – a bigger impact than the $10 million, right?

Trevor Janoski, Analyst

Yeah, yeah exactly. Exactly. Yes. Okay. So when you said pick up, I thought you meant growth.

Mike Plisinski, CEO

No. I think it's just the orders. So the customers that were ordering in Q4 wasn't going to be the same mix we expected, and that actually had booked throughout next year. So we've gained some share in some of the other areas. I'm not going to give details, but we had expanded our customer base and share within our customer base, which would have been reflected in nice growth in 2023, which now will not be there. Does that make sense?

Trevor Janoski, Analyst

Yeah. Definitely. Thank you for that. And for my second question it's about your backlog. Have you seen any cancellations yet or a pickup in order delays over the recent months?

Mike Plisinski, CEO

We've seen some pushing around of orders for sure. No cancellations due to market. We had one single tool cancellation due to basic something unrelated to markets. So, a financial issue with that particular company. But outside of that, there's been no cancellations, just some movement on orders and that's about it.

Trevor Janoski, Analyst

Okay. That's helpful. Thank you, Mike.

Operator, Operator

And at this time, there are no further questions. Mr. Sheaffer, I would like to turn the conference back to you for any additional or closing remarks.

Operator, Operator

Thanks, Cynthia. And we'd like to thank everybody for joining us today. A replay of the call is going to be available on our website by about 7:30 p.m. this evening. We'd like to thank you for your continued interest in Onto Innovation. Cynthia, please conclude the call. Thank you.

Operator, Operator

Thank you. This does conclude today's call. We thank you for your participation. And you may now disconnect.