Earnings Call Transcript - PLAB Q1 2021

Operator, Operator

Good morning, ladies and gentlemen, and welcome to the Photronics First Quarter Fiscal Year 2021 Earnings Conference Call. At this time, all participants are in a listen-only mode. Later, we will conduct a question-and-answer session, and instructions will follow at that time. As a reminder, this conference is being recorded, Wednesday, February 24, 2021. I would now like to turn the conference over to Troy Dewar, Vice President of Investor Relations. Please go ahead.

Troy Dewar, Vice President of Investor Relations

Thank you, Joan. Good morning, everyone. Welcome to our review of Photronics 2021 first quarter financial results. Joining me this morning are Peter Kirlin, our Chief Executive Officer; John Jordan, our Chief Financial Officer; and Chris Progler, our Chief Technology Officer. The press release we issued earlier this morning, along with the presentation material which accompanies our remarks, are available on the Investors section of our web page. I would like to note, the press release had inadvertently omitted the bottom half of the balance sheet. The version on the page is correct, and we will be correcting the press release. Comments made by any participants on today's call may include forward-looking statements, that include such words as anticipate, believe, estimate, expect, and forecast. These forward-looking statements are based upon a number of risks, uncertainties, and other factors that are difficult to predict. Actual results may differ materially from those expressed or implied, and we assume no obligation to update any forward-looking information. At this time, I will turn the call over to Peter.

Peter Kirlin, CEO

Thank you, Troy, and good morning, everyone. We achieved sequential growth in the first quarter, defying seasonal trends as demand improved across many sectors. The most notable improvement was observed in the high-end FPD, with strong AMOLED demand for new mobile displays leading the increase. High-end IC was modestly lower, with slight improvements in mainstream IC and FPD. Typical seasonality indicates that Q1 revenue would decline sequentially. So an increase of 2% demonstrates solid performance by our global team. John will offer more insights into the details shortly, but I’d like to make some general observations on what we’re seeing in our markets. Over the last 18 to 24 months, there have been tremendous supply chain disruptions, driven by a combination of trade policies and economic lockdowns resulting from COVID-19. In our view, these government mandates moved the market in ways that were not easily anticipated. In some cases, the impact has been positive for the industry, such as the trend to do more of what we do every day remotely, spurring demand for work-from-home electronics. Conversely, many automotive manufacturers suspended or severely curtailed vehicle production last spring. When automobile manufacturing recently returned to normal levels, some of the capacity had shifted to work-from-home applications, resulting in chip shortages. The semiconductor industry is quickly reacting to these demand dynamics, creating what we believe to be an inventory-driven semiconductor upcycle. Pending the installation of additional capacity, particularly at the high-end logic nodes, semiconductor manufacturers are focusing their resources on increasing output of needed chips, and not on releasing new products. Therefore, new design activity has been constrained, resembling the semiconductor industry cycle of old, where the upturn in our business lags the capital equipment suppliers by one to two quarters. Once the new tools are installed with the resulting capacity online, as inventory levels are replenished, the dam breaks and a wave of new design flows. Shifting gears to FPD, the trade policies implemented by the US over the last few years have clearly impacted the electronics industry in China. Up until late last year, these policies had little impact on our business. However, that changed when Huawei was placed on the deny entity list last fall. As the leading manufacturer of smartphones in China, Huawei had its own ecosystem of suppliers. When their ability to purchase leading semiconductors was severely constrained, it effectively froze their new product roadmap. The impact on us was a dramatic drop in demand for photomasks to build their new display panels. Fortunately, the end market demand for those phones did not disappear. As we moved through Q1, we started to see a resurgence in new designs from alternative phone manufacturers. Furthermore, significant amounts of new AMOLED display manufacturing capacity are being brought online by our customers in China this year. Looking ahead, we expect a significant rise in AMOLED photomask demand that should continue throughout 2021. Returning to our first-quarter results, gross and operating margins were lower for this period. There are several reasons for this, and John will provide details during his commentary, but the bottom line is, we must do better. We have positioned our operations behind market needs that are critical for the production of leading-edge devices. Based on these sectors, our margins need to improve. We know well what is required to accomplish this, and we are committed to delivering the results that investors as well as we expect. Moving to the bottom line, earnings per share were $0.13. Our cash balance was steady, and our strong balance sheet continues to provide superb flexibility in managing our value creation strategy moving forward. We held our investor Analyst Day in December. If you attended the live event or listened to the archived webcast, thank you for your interest, and I truly hope you found the presentation helpful. If you have not yet listened, I encourage you to do so. During that event, we reviewed the comments made during our 2018 investor day, and how we performed against them. We also looked ahead as our investment focus evolves to maintain alignment with market trends. The two areas we highlighted were advanced display technologies and growth in the Chinese market. We have three new FPD measuring tools that will be installed during 2021. These will bring us additional capacity to serve our customers who manufacture advanced panels. These investments should provide us with sequential growth in capacity and therefore revenue during the second half of 2021. As stated before, we have entered into three multi-year purchase agreements that collectively represent a business commitment in excess of $40 million annually to support these investments. We often comment that the display market is very dynamic. This includes the development and adoption of new technologies. The increased penetration of AMOLED displays within smartphones is one example, as manufacturers combat plateauing sales by offering premium options such as upgraded displays. Similarly, the introduction of 5G requires a premium display, consistent with 5G capability and feature set. The resulting transition from LTPS to AMOLED requires masks with more layers. The most basic rigid AMOLED mask has only 12 layers, while the most advanced can have up to 25. Not only does the number of layers increase, but there are more critical layers within each set, further enhancing the value we provide. Similarly, high-end technologies are expanding into the large screen TV market. We are seeing the ramp of G10.5 plus form factor, which has come to dominate the production of standard LCD panels for large-screen TVs. With this transition largely behind us, we are currently seeing the commercialization of various OLED displays intended to capture the premium sector of the TV market. Our targeted approach combines a conventional LCD with a mini LED backlight to create a similar visual experience. These technologies are good for mass demand, as they require more mass layers and more critical layers per set, putting more complexity and higher value. As the display for the mass market and technology leader, we are well positioned to benefit from these trends. Shifting to the Chinese IC market. We're in the process of qualifying the funnel tool from our initial phase of investment in Xiamen. The installation of this tool was delayed six months because the supplier self-imposed travel restrictions in response to COVID-19. The tool is targeted at the production of high-end photomasks. Our expectation is that we'll begin to generate revenue by the end of the second quarter, ramping through the back half of the year. China remains a key region of expected growth for the semiconductor industry, and our presence there should position us well to grow with the market. Over the last three years, our IC revenue of products shipped to China has grown at a compounded annual growth rate of 60% and is currently running slightly above $100 million annually. We anticipate that our business there will continue to grow and we will remain the merchant photomask market leader in China. We are off to a strong start, and I would like to thank all of our employees for your good work during the first quarter. Looking forward, I continue to believe that 2021 will be one of the best years ever for Photronics, as we invest to support growing end markets, expand our business in advanced display technologies, enable our global customers to meet their product roadmaps, and improve profitability and cash flow to facilitate continued investment in projects that enhance our return on capital. At this time, I will turn the call over to John.

John Jordan, CFO

Thank you, Peter. Good morning, everyone. Revenue improved 2% compared with the fourth quarter, as growth in FPD was partially offset by a decline in IC. FPD growth was driven primarily by AMOLED displays for advanced smartphones. We've communicated over the last few quarters that the US ban on Huawei had an impact on our display supply chain, as design activity stopped while they reacted to the new restrictions. This affected our fourth-quarter FPD results, as panel suppliers had not required new masks for Huawei phones. During the first quarter, we saw this disruption ease and AMOLED demand return, as new phones produced by other manufacturers made their way to the consumer. I also want to note, FPD demand for LCD masks, including G10.5 plus, remained depressed as panel producers took advantage of favorable markets and the dynamics by maximizing output of colored product and not releasing new panels. IC revenue was down slightly compared with the previous quarter, as an increase in mainstream and memory growth was offset by reduced high-end logic demand, partially due to the industry dynamics Peter mentioned earlier. In addition, one of our high-end writing tools in Taiwan was down for an extended period as travel restrictions delayed the repair and return to production. On a year-over-year basis, many of the trends we saw were similar to the sequential trends for the larger decline in high-end logic and a smaller increase in smartphone displays. Looking forward, there's a plethora of positive data points for our industries that suggest photomask demand should increase in 2021. That, combined with the additional capacity we plan to bring online during the second half of the year, gives us confidence in our outlook for 2021 of high single-digit percentage revenue growth and operating profit growth, similar to the 23% growth we achieved in 2020. Gross profit for Q1 was 20% lower than the previous quarter and previous year, driven primarily by unfavorable product mix, which we expect to improve as high-end logic demand returns. Operating expenses were higher sequentially, which is not unusual for the first quarter and is within our expectations as a percentage of revenue. Below the operating income line, net effects of other income, tax provision, and non-controlling interest were more favorable than comparable periods, resulting in earnings per diluted share of $0.13 for the period. Our cash balance at the end of the first quarter was $279 million, essentially unchanged from the beginning of the quarter. Operating cash flow was $26 million, and we spent $18 million on CapEx. For the full fiscal year 2021, we're still forecasting approximately $100 million in CapEx, as we execute on the next phase of FPD capital investments. We repurchased 1.2 million shares of our common stock for $13 million during the quarter, leaving approximately $69 million remaining under our current share repurchase authorization. On the balance sheet, total debt increased by a net of $33 million, which includes a new equipment lease. Before I provide second quarter guidance, I'll remind you that our visibility is always constrained, as our backlog is typically only one to three weeks, and demand for some of our products is inherently uneven and difficult to predict. Additionally, the ASPs for high-end mask sets are high. As this segment of the business grows, a relatively low number of high-end orders can have a significant impact on our quarterly revenue and earnings. Geopolitical risks related to government actions to address health concerns and trade policy may impact our operations, the operations of our customers and suppliers, or end market demand, resulting in an adverse impact on our industry and therefore our results. Given those caveats, we expect second quarter revenue to be in the range of $153 million to $162 million. We are encouraged by demand trends in our markets and overall positive commentary by others in the industry. High-end logic recovery is anticipated, but timing is uncertain. Other markets should continue to grow, and we're on track to deliver on 2021 targets. Based on our revenue expectation and our current operating model, we estimate earnings for the second quarter to be in the range of $0.14 to $0.20 per diluted share. We have begun 2021 on an encouraging note, growing revenue in a seasonally soft period and meeting supply chain challenges. We are pleased with our performance, but there is room for improvement. Margins should improve as we grow revenue, further benefiting from fixed cost absorption and continued focus on removing costs from our supply chain and operations. During our investor day in December, we presented our three-year target model that establishes operating margins in the high teens, earnings in excess of $1 a share, and free cash flow of approximately $100 million. We are confident that these targets are achievable and look forward to updating you as we move forward. I will now turn the call over to the operator for questions.

Operator, Operator

Your first question comes from the line of Tom Diffely with D.A. Davidson. You may now ask your question.

Tom Diffely, Analyst

Yes. Good morning. I guess I first wanted just to look into the mainstream market for you. Obviously it's still a big part of your revenue. What are you seeing as far as industry capacity, and what are the pricing trends and growth trends you see there?

Peter Kirlin, CEO

Yes. Our mainstream market right now, particularly in Asia, is very strong. So our capacity in Korea, Taiwan, and China was sold out in the current quarter, while in the US and Europe it was not. But throughout Asia, we're in an oversold situation. If you look relative to historical behavior, this is probably the first time in my 35 years that I've seen significant investment being made in legacy nodes. The market is oversold for photomasks, and there's more capacity coming online. This also sets the stage to do things that we have effectively never been able to do in the mainstream, which is to start to nibble at raising prices. So we're in a dynamic now where we expect to see pricing move up instead of down in the mainstream market segment. And that should start to happen in the current quarter. And as we step through the year, we'll see how far we can take that. It won't have a big impact on revenue necessarily, but it will have a disproportionate effect on profitability.

Tom Diffely, Analyst

Okay, great. Thanks, Peter. And then maybe as a follow-up, you talked about $40 million of annual contracts with a few large flat panel customers. When you look at phase two, do you typically get into those contracts ahead of time? And so they're kind of in place for when you spend the money to put in another line or what are the dynamics there for a new line going in?

Peter Kirlin, CEO

Yes. It's a mix of the two. As far as our FPD business is concerned, just remind you that for a couple of years running, we were sold out in our FPD business. On the Q3 call, we said we expected Q4 not to be sold out, and indeed it happened as we expected it would. Then when we got on the Q4 call and then our Analysts Day a day or two later, we noted that November was a month of grim market. Fortunately, by December, we were able to sell our capacity. Our FPD revenues this quarter reflect one month of a weak market and two months that were not as strong, but strong for us because of our position, particularly in AMOLED. Projecting forward, we expect a significant amount of AMOLED capacity to come online, particularly in China. This year we estimate for our customers a doubling from the beginning to the end of the year. We're bringing this capacity online right into the ramp of capacity and I think it will serve us very well. The tools are being delivered this quarter with expectations to ramp in the third quarter.

Tom Diffely, Analyst

Okay, great. Maybe if I just squeeze one more in for John. When you look at the single-digit revenue growth, but the 23% or so operating leverage, is that just kind of normal operating leverage for you? Or is it some special things going on this year that creates a little higher leverage than you would normally see?

John Jordan, CFO

No, Tom, we should see OpEx improve as a percentage of revenue through the year. First quarter is generally a tough one with OpEx, due to employer taxes, etc., reinstating. Our normal operating leverage through the rest of the year should fit comfortably within the range that we discussed, the low to mid-20% range.

Tom Diffely, Analyst

So the increase of these new tools doesn't ramp up your COGS meaningfully?

John Jordan, CFO

We only start depreciation as we qualify and start generating revenue from those tools. We have a fairly close match of depreciation with revenue, and it's a smaller portion of the depreciation coming on. So our operating leverage will still be 50% or better.

Tom Diffely, Analyst

Great. Okay. Well, thanks for your time today.

Operator, Operator

Thank you. Your next question comes from the line of Patrick Ho with Stifel. You may now ask your question.

Patrick Ho, Analyst

Thank you very much. Peter, maybe first off in terms of the high-end IC business that you talk about recovering, where specifically are you seeing signs of this potential recovery? And could it be a steep ramp when it does finally recover?

Peter Kirlin, CEO

Yes. So, Patrick, we have a really strong global team that has reacted quickly to shifts in the markets, and they continue to do so. If we look at our memory business, for example, it snapped back just as you would expect in a normal upturn. The logic business, however, is a different story. We've talked about the mainstream market, which over the last few years and continuing into the next, sees new capacity coming online. So the mainstream market is oversold, which is unusual. On the other hand, I think now it's well understood that there is a shortage of high-end logic capacity. The capital equipment suppliers are selling significantly, with bookings of $3 billion in January, which is unprecedented. These tools are largely being installed in Asian foundries, which are now utilizing their existing designs significantly to keep customers happy. So we expect to see a significant uplift in our business as a result of this high-end logic recovery. The new designs that had been shelved will be released, and we anticipate that 2021 will show continuous improvement each quarter. We believe we are well-positioned with the capacity we invested in when we made our purchase decisions.

Patrick Ho, Analyst

Great. That's helpful. Peter. And maybe as a follow-up question, you talked about the strength in the mainstream IC business, which again, is not a major surprise given the market environment. Given the comments you made about high-end ICs and how historically it's been driven by new design and wins, aside from the strong demand and the need for new masks in keeping up with current trends out there, are you seeing any new designs on the mainstream IC?

Peter Kirlin, CEO

Yes. The answer is yes. Most of the automotive applications are not high-end. The high end of automotive might touch the 28-nanometer node, but in general, it's older nodes. This is a market where historically, when you saw an upturn, the business would get better, but there wouldn't be new capacity coming online. However, over the last year or two, there have been investments being made in mainstream sets. This is being fueled by increased demand at those nodes, both for existing and new products. A new car today has an average of $800 in silicon content, with high-end cars having much more. As we shift from internal combustion engines to hybrid and electrification models, there will be a considerable increase in demand for power electronics, which all fall within the mainstream category. This shift in the automotive industry will create unprecedented dislocations in our industry, and you can already see CapEx being adjusted in advance for it.

Operator, Operator

All right, your next question comes from the line of Gus Richard with Northland. You may now ask your question.

Gus Richard, Analyst

Yes, thanks for taking the question. Just in terms of the gross margin in the first quarter was down to 130 bps sequentially, and you had some tools down. I know it was a weaker mix. Could you parse those out and just give us a little bit of guidance as to which was the bigger impact or the mix between those impacts?

John Jordan, CFO

Yes. I don't know that we would say one is bigger than the other. We had the decline in the high-end IC and a slide moving to a lower geometry product, up to a higher level machine. In FPD, we had some unabsorbed overhead. I don't know that I'd weigh one effect on the margin more than the other.

Gus Richard, Analyst

Okay. And then in terms of it sounded like some of your competitors are adding capacity for mature markets. Given most of the equipment in the market is fully depreciated, can those new assets be competitive at current prices and be profitable?

Peter Kirlin, CEO

No. To clarify one of John's comments, we saw high-end logic demand leap. We moved capacity strategically where we needed to maximize our market share. As the high-end demand resumes, we'll push that all back down. You can see the effect on our margins. Anyone attempting to do the same will face similar outcomes—using more expensive tools to build lower ASP products will compress margins. Today, it’s not feasible to buy a new mainstream line and operate it profitably at current pricing. However, as the high-end fills up in the back half of the year and designs are released, we anticipate a significant uplift in utilization and an upward trend in pricing.

Gus Richard, Analyst

Got it. So what you're painting a picture of is, as the high-end fills up in the back half and designs are released, you're going to see a significant uplift in utilization in both mature and high-end and prices should go up, and this should be a very favorable trend for margins as we walk through the year.

Peter Kirlin, CEO

Yes. We will effectively fly the mainstream business down off the high-end tools and refill those tools with the high-end logic in Asia. Additionally, prices are starting to rise, and we started to negotiate increased pricing with select customers after the Chinese New Year. I have never been able to raise prices before, but we can do this because everyone is sold out.

Gus Richard, Analyst

Got it. And then last question regarding climate change. There was this cold snap in Texas, a lot of water damage, power outages, etc. I think you have a plant in Round Rock. Was that plant impacted? Is it back up and running? Just any color there?

Peter Kirlin, CEO

Yes, both we and our largest competitor have factories in Texas. We were impacted, but our factory downtime was limited to about a day's outage due to loss of power, while their factory was down for a week. Our output was depressed for about a week due to the dislocation in the power grid. We were still affected, and this impact was factored into our guidance. Fortunately, we outperformed our competitor significantly, who faced more severe disruptions. We also have several significant customers in Texas which were offline for about a week.

Gus Richard, Analyst

Got it. And then just last one for me. You’ve had some issues getting things installed and repaired due to quarantine and COVID. Are those issues behind you at this point, or are you still struggling to get vendors in to do stuff?

Peter Kirlin, CEO

Yes. The installation problems we faced, we hope, are behind us. However, there are still challenges related to travel constraints imposed by COVID. Not every vendor in the photomask industry has fully capable personnel in all regions where we operate. This will continue to be a challenge for a quarter or two, but with vaccination rates increasing and infections decreasing, we are hopeful for improvements. The installation and qualification of our high-end e-beam tool in Xiamen were delayed, but we believe it will ramp in time for the anticipated high-end logic market recovery. So, while we've managed to mitigate impacts well, we do see a tail end of challenges lasting a bit longer.

Gus Richard, Analyst

Yes. Got it. Okay. Thanks so much.

Operator, Operator

Ladies and gentlemen, there are no further questions at this time. I will now turn the call over to Peter Kirlin for closing comments.

Peter Kirlin, CEO

Thank you for taking the time to join us this morning. We truly appreciate your interest. Photronics is well positioned to grow revenue, earnings, and cash flow this year, extending our marketing and technology leadership positions, and moving us towards our long-term financial targets. I look forward to updating you on our success as the year progresses.

Operator, Operator

All right. Ladies and gentlemen, that concludes the conference call for today. We thank you for your participation, and ask that you please disconnect your lines.