Earnings Call Transcript - PLAB Q2 2022

Operator, Operator

Good day and thank you for standing by. Welcome to the Photronics Q2 fiscal year 2022 earnings conference call. At this time, all participants are in a listen-only mode. After the speakers’ presentation, there will be a question and answer session. As a reminder, this conference is being recorded Wednesday, May 25, 2022. I would now like to turn the conference over to John Jordan, Executive Vice President and CFO. You may begin.

John Jordan, CFO

Thank you, Tanya. Good morning everyone. Welcome to our review of Photronics fiscal 2022 second quarter results. Joining me this morning are Frank Lee, our recently appointed Chief Executive Officer; Chris Progler, our Chief Technology Officer; and Eric Rivera, our Corporate Controller and Chief Accounting Officer. The press release we issued earlier this morning along with the presentation material which accompanies our remarks are available on the Investor Relations section of our webpage. Comments made by any participants on today’s call may include forward-looking statements that include such words as anticipate, believe, estimate, expect, forecast, or in our view. 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 Frank.

Frank Lee, CEO

Thank you, John, and good morning everyone. I would like to begin this morning by stating how honored I am to be with you today as the new CEO of Photronics. Since joining the company in 2006, I have helped create and lead our operation and strategy in Asia, including the formation of two joint ventures with Dai Nippon Printing Company and also the recent geographic expansion of our operations into China. Turning to the financial results, we once again delivered record revenue in the second quarter, improving 8% sequentially. Our strong end market demand, further price realization across the IC segment, and also the continuous production ramping up of our Xiamen and Hefei operations contributed to this result. In addition to top line growth, we expanded our gross and operating margins. Gross margin was 36% and operating margin was 25%. The end result was EPS of $0.49. Cash generation was also strong as we ended the year with $247 million in net cash, which positions us to continue investing in profitable growth opportunities. As CEO, I fully commit to continuing our organic growth strategy, revenue growth, margin expansion, and also we’ll keep exploring additional growth initiatives. Our revenue growth is achieved by winning more share in a growing market. We have been working closely with our customers to meet their needs in technology and capacity. We are building partnerships with several key customers, and we also signed many long-term purchase agreements with our key customers. This kind of approach serves us very well to make critical investments, and it helps us to quickly get a return on our investment. Our recent IC and APD operations in China are very good examples of this approach. As the market leader, Photronics has become a trusted partner and key supplier for our customers in both IC and APD. In addition to revenue growth, our profitability has been continuously improving. This is achieved through the execution of three major key items: product mix optimization, effective cost management, and operational efficiency enhancement. As part of these actions, we have implemented some pricing adjustment strategies based on the current market supply-demand imbalance situation. My firm commitment is to explore new strategies to further our growth initiatives. I’ve been very involved in this process since joining Photronics. We have a very good relationship with our customers, vendors and various partners throughout Asia. With the emerging trend of global supply chain restructuring, including IC manufacturing localization such as made in the USA, Photronics will solidify our footprint and relationships in these other geographies. I’m very certain that with our strong existing global footprint and our successful experience in Asia, we will be successful in our business. We have performed very well through the first half of 2022 and we are on track to have the best year in the history of the company. I’m very proud of our team, and together we will continue to outperform beyond 2022. Thank you very much, and at this time I’d like to turn the call back to John.

John Jordan, CFO

Thank you, Frank. Good morning again everyone. The second quarter was another record quarter for Photronics, our fifth consecutive record quarter. Revenue improved 8% quarter-over-quarter and 28% year-over-year as demand across the board remained strong. We’re executing on our growth strategy by investing in technology aligned with market drivers and partnering with customers by establishing long term purchase agreements that enable us to quickly and profitably ramp new tools while maintaining high utilization on existing tools. This quarter is another proof point that our approach is working. IC revenue grew 12% sequentially and 30% year-over-year, driven by strong global demand for our photo masks. High end demand was driven by foundries in Asia and the U.S. as semiconductor content in consumer goods continues to increase. With more chips in electronics, automotive, appliances, and many more applications, new designs continue being released to satisfy this demand. Advances in communication infrastructure such as the rollout of 5G are another catalyst for demand growth. This proliferation of chips drives photo mask demand for Photronics. As the use of semiconductors continues to proliferate and demand growth continues beyond our capacity to supply it, it creates a change in pricing environment primarily in trailing edge masks but also in the high end business, helping us to further expand margins, which I’ll discuss in more detail later. FPD was down slightly quarter-over-quarter primarily due to a decrease in mainstream LCD. High end was slightly higher thanks to continued strong mobile demand. Growth in displays for mobile applications offset a decline in G10.5 larger mask demand. We expect demand to remain strong for AMOLED and LTPS displays used in mobile applications, some increase in G10.5, and continued reliable demand for mainstream LCD displays. Revenue from products shipped to Chinese customers achieved another record quarter, improving 8% sequentially and 58% year-over-year. We are the clear market leader in this growing region. Our past business development and operational expansion initiatives are reaping the benefits we anticipated. Gross and operating margins improved during the second quarter, benefiting from the high leverage in our operating model and demonstrated discipline in keeping costs low. Gross margin of 35.7% and operating margin of 25.5% are both well within the long term ranges we communicated in February. We fully expect this business environment to continue well into the future. We have based our investment plans on that expectation and we anticipate that the increased margins will be sustained by the demand-supply imbalance due to limited trailing edge capacity. Our target model, which will take us into fiscal 2024, has been updated to reflect these new growth opportunities and is included in the supplemental slides posted to our website this morning. Our approach to these target models is to be realistic without being aggressive, although in retrospect, consistently improving business conditions in the photo mask space and our execution have suggested that the model should be updated. The updated target model layers in only the revenue increments anticipated from our currently planned capex investments, and the pricing opportunities provided by the continuation of the current business environment, with consideration at the low end of the target that, at three years into the strong semiconductor business cycle, the risk of a downturn is increasing. Income tax provision increased due to the increased earnings, and net income to non-controlling interest increased with the strong performance of our joint ventures in China and Taiwan. Changes in foreign exchange rates resulted in an $8 million gain in other income equivalent to approximately $0.07 a share. As a result, diluted earnings per share were $0.49. We strengthened our balance sheet during the quarter with cash and equivalents increasing to $329 million and debt decreasing to $83 million, resulting in net cash of $247 million. We generated $44 million in cash from operations and received $10 million in contributions from our JV partner for IC capacity expansion in Asia. Capex in Q2 was $16 million and we received a little over a million in government subsidies for investments in China. This brings our total capex for the year, net of subsidies, to $33 million. We still expect capex of $100 million in 2022 as we increase our mainstream IC capacity and increase the size of our facility in Taiwan. Before I provide guidance, I’ll remind you that our visibility is always limited 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 and, 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. Given those caveats, we expect third quarter revenue to be in the range of $205 million to $215 million, driven by a continuation of favorable end market demand trends across both IC and FPD. Based on those revenue expectations and our current operation model, we estimate adjusted earnings per share for the third quarter to be in the range of $0.45 to $0.55 per diluted share. As Frank said, we’re on track to deliver the best year in the company’s history with strong end market demand, strategic capacity expansions, higher profitability, and a strong balance sheet to support further growth initiatives. Business conditions and execution by our team across the organization brought us within the ranges of our previous target model and support new projections. Achievement of that new target model will continue to create and deliver more value for our shareholders. I’ll now turn the call back to the Operator for your questions.

Operator, Operator

Our first question comes from Patrick Ho of Stifel. Your line is open.

Patrick Ho, Analyst

Thank you very much; and Frank, first off, it’s good to hear your voice and congratulations on the job, and best of luck going forward. Maybe a first question on the demand environment - obviously that looks very healthy moving forward in both mainstream and high end IC. Are any of the recent Chinese market volatility changing your outlook, at least in the near term in terms of potential pull-backs in that region, or are you still seeing continued strong demand in the IC market in China?

Frank Lee, CEO

Thank you, Patrick. The Shanghai city lockdown initially slowed down all the business activities in China, especially in the Shanghai area. Though we do see some new product introductions slow down initially, however the situation has been gradually recovering and recently we see new orders and new product introductions starting to come in, so I think there’s an impact, however it’s short and it should be fully recovered already.

Patrick Ho, Analyst

Great, that’s helpful. Maybe as a follow-up question for John, obviously the operating leverage was excellent this quarter as well as it was a nice pleasant surprise to see the new target model. What gives you confidence, because you were looking at some new target model metrics of over 40% gross margins, 30% operating margins, numbers we’ve never seen from the photo mask industry as a whole. Is it more the pricing aspect or is the demand and just the revenue growth that’s driving this improved margin leverage?

John Jordan, CFO

Good question, Patrick, and essentially yes to all of the above. I refer to it as the business environment, which presents us with significant pricing opportunities that we haven't experienced before. As Frank mentioned, we have long-term purchase agreements with many customers, some of which we've renegotiated, and others that are due for renewal. Some agreements are for one year, while others extend beyond that. As these contracts come up for renewal, we still have the chance to implement price increases. Many of our locations are operating at full capacity, so the operational leverage from those sites is exceptional. Additionally, the favorable business environment allows for improved pricing, which we anticipate will continue well into the future. I think you have seen the same information we have, and most of what you've read supports that outlook.

Patrick Ho, Analyst

Great, thank you very much.

John Jordan, CFO

Thank you, Patrick.

Frank Lee, CEO

Thank you.

Operator, Operator

Our next question comes from Hans Chung of DA Davidson. Your line is open.

Hans Chung, Analyst

Hi Frank and John. Thank you for taking my question. Congratulations on the strong results. Our first question, can you elaborate more on the pricing adjustment during the quarter, like was it across the board or what kind of magnitude, and then where are we now in terms of the pricing, how much further room do we have to increase going forward?

John Jordan, CFO

Hi Hans, nice to meet you, and thanks very much for the question. We don’t generally talk about the specific amounts of pricing adjustments because it’s really competitive information, but we’ve been able to increase prices in the mainstream primarily because there’s such limited capacity and the mainstream demand is expanding so ubiquitously just because of the use of non-leading edge chips in everything we do. But we’ve also had an opportunity to increase our high end pricing as well for similar reasons and because of our technology leadership, so without talking about specific amounts or percentages, the environment is there, and we’re able to take advantage of it, and we expect it to continue going forward. I hope that answers your question.

Hans Chung, Analyst

Yes, that helps, thank you. Then I guess a follow-up is as we move to our new target model with further higher margin, that would also be assuming further price increases over time. Just to give a sense, to what degree that in terms of pricing we might start to see that our customers may start to consider turning to the captive options? I know this might be a difficult question at this moment, but just trying to get a sense, like how far are we to there if we can keep our target model margins?

Frank Lee, CEO

Yes, right now the capacity issue we believe will last into next year at least. The main reason, of course, is the long lead time of the equipment, same as wafer fab equipment. Our photo mask equipment delivery time has become very, very long, so the demand increased a lot, however on the supply side it will take time to provide some capacity to the customers, to the market, so we believe the price increase has a very high possibility of continuing into next year.

Hans Chung, Analyst

Okay, thanks.

John Jordan, CFO

I might also supplement that with a comment about the captive photo mask business as well. With the amount of investment and resources required for the leading edge chips these days, the captives are reluctant to invest in mainstream capacity, and they’re also inclined to start outsourcing more of that mainstream demand, the mainstream photo mask business. We haven’t incorporated any of that into our model, but we fully expect that to also be an upside to the model.

Hans Chung, Analyst

Got it, that’s helpful. Then last question just regarding the capacity as well, we continue to expand our capacity, so what would be the capacity run rate in terms of revenue by the end of this year, and then I guess just assuming, let’s say, by the end of this year, what would be the level of capacity to market demand this year?

John Jordan, CFO

Our guidance for the next quarter is based on the capacity additions incorporated into our capital expenditure budget for this year. As we bring new tools online, we have included the incremental revenue those tools will generate in our guidance and target model. We foresee capacity growth as we continue to expand. While some locations are not running at full capacity due to geographic demand, most are operating at full capacity. We expect capacity to grow as we introduce these new tools this year and high-end tools next year. I want to highlight that our long-term target model is based solely on this year's capital expenditure budget, with some of the benefits expected next year. We do not plan to increase capital expenditure for next year beyond what is already ordered. Therefore, while we anticipate capacity to rise from these budgeted projects, these are not reflected in our target model.

Hans Chung, Analyst

Got it. Thank you guys.

John Jordan, CFO

Thank you, Hans.

Operator, Operator

Our next question comes from Gus Richard of Northland. Your line’s open.

Gus Richard, Analyst

Yes, thanks for taking my questions. Great quarter. Could you just give a little color on the sequential increase in revenue? Is that mostly price or was there some volume component to that?

John Jordan, CFO

It was both, mostly price but some volume.

Gus Richard, Analyst

Okay, and then in terms of the long term purchase agreements, is that still primarily FPD or is it starting to spread out into the IC business?

Frank Lee, CEO

Actually, it started with IC because we do have this kind of agreement with certain key foundry customers for several years, but right now we are expanding the customer base to sign the contracts, so at this moment it covers both the IC and FPD customers.

Gus Richard, Analyst

Okay, got it. Just roughly, how much of your revenue is under long term purchase agreements?

John Jordan, CFO

Yes, we don’t really report that number, Gus. It’s a pretty substantial amount, especially in Asia.

Gus Richard, Analyst

I believe this is the first time you mentioned that high-end pricing is improving. Is that accurate? Are the price increases in the high-end starting to align with mature markets? Can you discuss the two segments of IC and how they are performing?

Frank Lee, CEO

Yes, the price increase actually started last year in the mainstream market; however, the capacity shortage situation started to migrate into the high end IC area also, so in this year, we started negotiations with a key high end IC customer and the new price started to become effective at the beginning of Q2.

Gus Richard, Analyst

I understand, thank you. That’s very helpful. Then in terms of capacity utilization in IC mature versus mainstream, are you basically both of those running flat out now or do you have incremental capacity in the mainstream?

Frank Lee, CEO

We are building the incremental capacity step by step; however, as I mentioned, the tool lead time is becoming an issue, so the capacity incremental has to be done quarter by quarter but not at the same time.

Gus Richard, Analyst

I see. Then last one from me, in terms of the foundry outsourcing, I’m sure they’re busy with the EUV masks, sort of are they outsourcing 14 nanometers and above, so where is the break point on what they outsource and how do they think about what they put out into the merchant market?

Frank Lee, CEO

The amount of outsourcing from captive has increased year by year, and with the growing demand in the high end, the captives are also short of mainstream and middle end capacity. We do have a customer talking about some kind of long term outsourcing agreement, so we are in the process of talking to customers about this kind of outsourcing strategy.

John Jordan, CFO

And keep in mind, Gus, the outsourcing by the foundries is not limited to mainstream. We also do high-end work for foundries.

Gus Richard, Analyst

What I was trying to express is that I believe you can produce 14 nanometer products, and I'm curious if outsourcing can match that capability.

John Jordan, CFO

Yes.

Gus Richard, Analyst

Is there any plan to be able to produce a 10 nanometer mask set, or certain layers?

Chris Progler, CTO

Yes, I can make a comment. The 14 nanometer logic is performing well in terms of outsourcing among foundry captives and IDMs, positioning it strongly in commercial mask making. The 7 and 8 nanometer nodes are beginning to approach qualification, with some processes starting last year and continuing this year, and we are equipped to handle these nodes as well. We have an EUV process in place, and since 2017, we've maintained a joint development agreement with IBM in New York, where we produce all of their EUV masks. While this is primarily a pilot line, it involves full device demonstration and reach yield down to 28 nanometer pitch, which corresponds to a 5 nanometer node class mask. Our EUV front-end capability at Photronics is solid, and although we are not delivering huge numbers, we are increasing our output each month. However, the broader transition to commercial EUV mask making is still a few years away. We are noticing that tier two companies are beginning to adopt EUV tools, specifically single unit EUV systems, which signifies gradual growth, but the application remains largely limited to a few designs. The major players, TSMC, Samsung, and Intel, continue to produce most of their EUV masks internally. We are monitoring the market closely and enhancing our capabilities through our partnership with IBM. That said, it may still take approximately three years for EUV to achieve full commercial status.

Gus Richard, Analyst

That makes complete sense. Thanks so much.

Chris Progler, CTO

Yes, sure.

Operator, Operator

Ladies and gentlemen, there are no further questions at this time. I would now like to turn the call over to Frank Lee for closing comments.

Frank Lee, CEO

Thank you. Thank you for joining this morning. Photronics is in a great position and we are continuing to move forward, and we will achieve our long term goals. I’m very confident that Photronics employees across the world will continue to exceed expectations by delivering quality products and outstanding service, helping us to achieve our long-term targets. I am looking forward to meeting and speaking with many of you in the near future. Have a great day and thank you very much.

Operator, Operator

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