Ultra Clean Holdings, Inc. (UCTT) Q1 2020 Earnings Call Transcript

Good afternoon, and welcome to the Ultra Clean Technology Q1 2020 Earnings Conference Call. Please note, this event is being recorded. I would now like to turn the conference over to Rhonda, Rhonda Bennetto with Investor Relations. Please go ahead.

Thank you, Ian. Good afternoon, everyone, and thank you for joining us. We hope that you and your families are safe and healthy. With me today are Jim Scholhamer, Chief Executive Officer; and Sheri Savage, Chief Financial Officer. Jim will begin with some prepared remarks about the business, and Sheri will follow with a financial review, then we'll open up the call for questions. Today's call contains forward-looking statements that are subject to risks and uncertainties. For more information, please refer to the risk factors disclosure in our SEC filings. All forward-looking statements are based on estimates, projections and assumptions as of today, and we assume no obligation to update them after this call. Discussion of our financial results will be presented on a non-GAAP basis. A reconciliation of GAAP to non-GAAP can be found in today's press release posted on our website. And with that, I'd like to turn the call over to Jim. Jim?

Thank you, Rhonda, and good afternoon, everyone. Thank you for joining us. Today, I will be speaking mostly about the global COVID-19 pandemic, UCT's response to date, our current situation and our near-term outlook. Then I'll turn the call over to Sheri for a financial review before opening up the call for questions. As an essential global company tackling a worldwide pandemic, UCT has done an extraordinary job proactively managing through these unprecedented times. We recognized the potential impact in Asia early and initiated global site readiness in other regions where our facilities are located before the virus spread. This enabled us to maximize capacity at our factories and manage our suppliers with minimal disruption to meet customer demand. I say this not in a boastful way and certainly without any complacency, but more to explain what actions we have taken and share some insights on how we delivered our highest revenue quarter-to-date with improved profitability and strong earnings. The first and most important way we measure our success is by the health and safety of our 4,700 employees around the world. We conducted an internal survey earlier this month, and among other positive responses, we found that the vast majority of our employees said they felt safe or very safe while working at our facilities. We are sincerely grateful for their hard work and dedication and their relentless drive to deliver the best possible results for our customers, suppliers, company, community and shareholders. An equally important measure of our success is customer satisfaction, which is only possible with a committed workforce. Every significant product and service customer has provided feedback citing the excellent job we have done with respect to transparency, on-time delivery, flexibility and the thoroughness of our business continuity planning. In addition to meeting the majority of the product orders in the quarter, some customers have shifted additional work to UCT to cover shortfalls from other suppliers. Where possible, UCT is working hard to help fill those deficits. This is where UCT's global footprint and ability to flex to meet demand provides a distinct competitive advantage, and we are capitalizing on these opportunities. Our service facilities operated at high capacity throughout the quarter with minimal disruption. We saw an increase of business across the customer base, including an improvement in memory wafer starts. All UCT products and services facilities are operational. So how has UCT successfully navigated the crisis to date? It started with a detailed business continuity plan already in place, designed by a top executive and included a worldwide pandemic as a possible scenario. UCT's business continuity team is comprised of many uniquely talented people with decades of experience in all manner of crisis situations. Having operations in China helped us understand early the depths of the crisis, and we took prescient actions, assuming the virus would spread worldwide. The business continuity team quickly began to secure the necessary personal protective equipment to ensure the health and safety of our employees. We were also one of the first to introduce a work from home and travel restriction policy. As the virus spread across the globe, we stayed one step ahead utilizing our playbook for each facility in advance of governing body directives. Our playbook was so successful that it was cited as a model for other Asian manufacturers to follow by a prominent Chinese official. More recently, we secured temporary housing in Singapore for the majority of our Malaysian workforce prior to Malaysia introducing its new border closures earlier this month. The BCP team continues to work diligently 24/7, applying our preventative measures to stay in front of the developments that seem to arise daily. With regard to our supply chain, UCT was prepared with alternative suppliers not yet qualified by the OEM. When the approval process was expedited by many of our customers, we acted quickly, and we were able to source from a variety of suppliers. We believe that this initiative will have long-lasting benefits to the health and competitiveness of our supply chain. Our ability to accommodate demand resulted in revenues and earnings above expectations despite some temporary closures at a few of our sites throughout the quarter. All of our factories are operational, and we are working closely with our customers to understand any changes they may see regarding demand outlook and are planning ahead to find creative solutions. Having said that, the environment for our guidance has many unknown potential caveats that could impact our end markets, our manufacturing capability and our supply chain. While we don't know exactly how things will unfold longer term, we see continued strong demand through the second quarter and are confident that our team will continue to perform at a high level. Our hearts and thoughts go out to all those affected by this tragedy, and we look forward to a day when the virus is contained and manageable. We remain ready to react as the situation evolves and are very proud to play an essential role in this global fight against COVID-19. And with that, I'll turn the call over to Sheri for a financial review, and then open up the call for questions. Sheri?

Thanks, Jim, and good afternoon, everyone. Thanks for joining us. In today's discussion, I will be referring to non-GAAP numbers only. We continue to see strong demand from ongoing industry momentum in the first quarter, resulting in record revenue for UCT despite some facility disruptions due to COVID-19. Operational efficiencies, together with higher volumes resulted in the improved profitability and increased earnings quarter-over-quarter. Total revenue for the quarter was $322.9 million, up 12% from the prior quarter. Our products division grew 12.7% to $259.4 million on increased demand from our largest customers. Our services group contributed $61.5 million, up 9.4% as wafer fab utilization returned to more normalized run rates. Gross margin was 20.9%, up from 20.3% last quarter. Higher volume brought our products gross margin to 17.4% from 16.4% last quarter. Service gross margin was 35.9% compared to 36.5% last quarter. Margins can be influenced by customer concentration, geography, product mix, volume and expenses related to COVID-19, so you should expect to see variances quarter-to-quarter. Operating expenses were $35.4 million, up from $31.4 million in the prior quarter, primarily due to the increases typically seen in the first quarter, such as audit fees and employee-related taxes. As a percentage of revenue, operating expenses were 11%, flat with the prior quarter despite the 12% increase in revenue. Total operating margin for the quarter improved to 9.9%. Margin from services was 11.9% compared to 15% last quarter due to higher audit fees. We anticipate that service operating margin will return to a more normalized range in the second quarter. Products margin improved to 9.5% versus 8% in the prior quarter due to increased volumes. Based on 40.7 million shares outstanding, earnings per share for the quarter improved from $0.40 to $0.52, with a net income of $21 million compared to $16 million in the prior quarter. Our tax rate for the quarter was 18.7% compared to 20.8% last quarter. We expect our tax rate for 2020 to be in the high teens. Turning to the balance sheet. During the March quarter, we increased our cash and cash equivalents from $162.5 million to $208.1 million. Cash from operations was $15.7 million, and we drew down $40 million on our revolving credit facility. While we have a very healthy balance sheet and flexibility in our cost structure, we feel it's prudent to preserve cash during this unprecedented time. While demand remained strong in the near term, we are risk adjusting our guidance to account for the numerous uncertainties surrounding the COVID-19 pandemic, including unexpected changes in demand and supply chain interruptions. We anticipate revenue for the second quarter to be between $290 million and $330 million, and EPS in the range of $0.40 to $0.56 per share. And with that, I'd like to turn the call over to the operator for questions.

And the first question today will come from Quinn Bolton with Needham & Company.

This is Charles on behalf of Quinn. Congratulations on the strong results. I have two questions for now. The first question is about SPS. Again, congratulations on the 13% sequential growth. And I just wonder, I think you mentioned that some of your OEM customers shifted some volumes from your competitors to you. I wonder whether natural demand increased quarter-over-quarter. And some of the advanced purchase, maybe of your OEM customers, to secure safety stocks could also play a role, if yes. And how should I think about which one of these three factors are really playing the biggest contribution here? And I have a follow-up on SSB.

Yes, Charles. Yes, the majority of the increase was due to natural demand. We don't believe it was advanced purchases because we saw these bookings before a lot of the crisis hit. Basically, we were able to mitigate a lot of the shortfalls that we had seen as issues when we went into the quarter. So the majority of the increase was kind of already expected from the ramp that we came out of in Q4.

Got it. So let me address the question about service. You pointed out that particularly in memory, some of the fab utilization decreased sequentially. I recall that your service business significantly benefits from OEM demand, as they utilize your services when shipping new tools. Can you elaborate on the contributions of these two factors, OEMs and fabs? Additional details would be appreciated.

The majority of the increase in the services group was attributed to the fabs. We observed ongoing growth with Intel, similar to what we've seen in recent quarters. Additionally, the memory fabs, particularly Samsung, have continued their recovery that began in Q4 and showed significant improvement in Q1. The OEM business has also increased, but that was likely a lesser contributing factor.

Regarding fab utilization, what are your expectations for the next quarter? We understand that in Q1, there was demand from data centers, largely driven by global work-from-home initiatives. What do you anticipate as we move into Q2? Is fab utilization increasing, or are there any challenges you foresee?

Yes. It'd be difficult to call it up. I mean, they've recovered to a significantly higher level, so I think they'll continue to be. We expect and included in our guidance, this data for the second quarter, so continue to be at the high level that it is returning to, but it's very difficult to call whether it's going to continue to go up or from there, but we see it continuing strong through the second quarter right now.

The next question will come from Patrick Ho with Stifel.

It's great to hear that everyone is doing well, and congratulations on a successful quarter. Jim, to start off, with all the disruptions and ongoing constraints, are you still experiencing any supply chain issues or customer delays, especially considering that some of your larger clients may still be struggling with getting parts or tools delivered? How are you managing this on your side, given that you've performed well operationally, while also addressing the challenges your customers are facing?

Yes. In our forecast for the second quarter, we have accounted for the reflow based on their constraints already reflected in our detailed forecast. The issues are included in our numbers for Q2. At this point, we hope for improvement. If it occurs, we are prepared, and we are actively addressing any shortfalls where we have the capability and capacity. We are making efforts to alleviate some of these issues as well. We have already factored this into our second quarter forecast. However, we remain uncertain about future developments. New issues arise weekly, but we have managed to mitigate most of them.

Great, that's helpful. And maybe as a follow-up question. In terms of the food chain, you're getting inventory building across from the OEM consumers all the way at the top, to the chip makers, to the equipment companies. From your business continuity plans, given how well you operated during the quarter, how are you managing inventory and maybe building some inventory on your end in case there's any future disruption? Longer lead times, how are you managing that?

Yes. We're definitely still keeping an eye on inventory. As we just add another company, one foot on the gas and one foot on the brake. We definitely keep trying to manage our inventory to keep our liquid assets liquid. But obviously, there's a handful of certain components which are constrained. And obviously, where we can get an additional buffer, it's in those constraints. We work to do that while balancing to make sure that we don't tie up too much cash. We did a very good job, I think, on managing our inventory. Our turns actually increased in the first quarter. Inventory went up but not as much as revenue.

Great. And final question for me. On your services side of the business, obviously, that's driven by utilization rates and we have seen wafer starts across the board pick up, heading into the June quarter. Are there any other types of new offerings or services that you can give your customers on that end to keep revenues at a more, I guess, elevated level given a lot of the uncertainties there are right now going into the second half regarding demand?

On the short term, that revenue is very difficult to replace by being flexible by offering different services. Obviously, we're always working on new opportunities and penetrating in other areas, but those tend to be longer term. So we still, in that business, we basically follow wafer starts and to a smaller degree, new equipment shipments. But yes, that's not something we can easily flex and have a different service offered in the immediate future to fill in any gaps. But we're always working on expanding our presence and growing that, but those are more longer-term programs.

The next question will come from Karl Ackerman with Cowen.

Jim and Sheri. Congrats on the results. I mean, clearly, first half results have been healthy, I think largely driven by foundry and logic spend. Memory investments look to be more weighted toward DRAM in the first half of the year. I'd love to hear your view on how you see the mix of end market demand in the second half of the year, particularly given, I think, your services business is a bit more lower toward memory. So your thoughts there on just kind of end market dynamics would be helpful.

I wish I had a view to help you with, Karl. I think as you see everyone report, including those companies which are even closer to it than we are, the second half is really unknown. There are winners and losers in the chip area, as you know, depending on whether you're in the cloud or telecoms or computers versus automotive or smartphones, right? There's a whole mixed bag going on. And in the second half, we really have no additional insight beyond what you're reading, as Samsung reported this morning, and others.

Sure. Got it. No, that's fair. Maybe a different tact. Your ability to accommodate last-minute customer demand has certainly been very beneficial for you in the first half of the year. Oftentimes, in recessionary periods, larger and more nimble companies tend to outperform peers as market dynamics accelerate. I'm curious how you think about your design win funnel for the second half of the year on an organic basis. And given your larger liquidity position, how are you thinking about inorganic activities in the current environment towards less financially healthy localized suppliers?

We have many organic design win opportunities with our existing customers as well as new customers. We have not seen any changes to those programs. In fact, the programs that are ongoing, while not at customer sites, are continuing within the OEMs, allowing them to focus on those opportunities as they face some restrictions in the field. We are optimistic about our pipeline for new wins, and so far, the virus pandemic has not impacted that. Regarding inorganic opportunities, we remain opportunistic but also conservative. As you noticed, we utilized some of our revolver. Given the uncertain macroeconomic events that may arise toward the end of the year, we are prioritizing cash retention to prepare for any potential economic fallout. However, we continue to seek opportunities and evaluate what makes sense, all while maintaining a cautious approach in light of the increased likelihood of macro events.

And the next question will come from Christian Schwab with Craig-Hallum Capital Group.

Congratulations, guys, on a fabulous quarter. I just wanted to follow up on the second half kind of outlook and commentary, potentially, if we can. I know it's the largest memory as you said despite some unknowns regarding handset demand. Ultimately, they still think memory should be relatively strong again in the second half. So if we get through this on the backside without a relapse in the COVID-19, can you give us a range of potential outcomes about how strong the second half could be for you?

Yes, that would be challenging. If there were no significant macroeconomic impacts and considering the delays with products like the Apple phone, we would have expected the growth that began in the fourth quarter of 2019 to continue, leading to revenue increases similar to what we experienced this quarter in the upcoming quarters. This is how things could have naturally progressed without the effects of the virus. On the lower end, I can't provide a clear answer. We've observed delays with Apple's phone, but we also see solid investments in servers and other areas that remain important and should continue. As I mentioned previously, some aspects are performing well enough to support the lower end of projections. I don't believe anyone has clear insight into the second half of the year. However, if you remain optimistic, it is reasonable to envision a quick recovery, which could lead to continued growth rates similar to what we have seen this quarter.

The next question is from David Duley with Steelhead.

Yes. You mentioned that your global manufacturing capability enabled you to meet customer demand, which seemed to indicate market share gains. Could you clarify which geographic regions contributed to this achievement? Additionally, which areas did you refer to where you might have taken business from competitors who were unable to fulfill demand?

The pandemic initially impacted China, where we have a presence that many of our competitors do not. While they primarily operate in Southeast Asia, specifically Malaysia, we were able to recover quickly. When the pandemic reached Malaysia, our competitors faced challenges there, whereas we managed to shift operations to Singapore and our smaller site in the Philippines. As a result, we could relocate activities back to China and Singapore. This included both major modules and smaller components like weldments, which we could move efficiently. Having sites in these locations allowed us to implement strategies based on our early experience in China, giving us a significant advantage as the situation evolved globally. Our lighter footprint in Malaysia compared to many peers played a role in our ability to adapt and take advantage of the circumstances.

Okay. That's great. Now as far as the OEM business goes, I think you addressed it a little bit, but if you could just talk a little bit more in detail. In times of difficult outlooks, they might build inventory. And how do you measure that? Or do you know if your OEM customers have built inventory because they're worried about COVID supply chain issues? Or if you could just give a little bit more color on this topic, that would be great.

Yes. During our ramp-up phase, our customers haven't had much chance to build inventory. Another point is that what we manufacture is more customized rather than standard components like power supplies or mass flow controllers, which are more typical shelf items. In our role as a contract manufacturer, we deal with items that are not typically stocked. I don’t believe there’s any significant inventory between us and the OEMs. Their timelines and schedules depend on when they need the tools based on their capacity to procure everything necessary to complete the tools, rather than on a strategy of stocking inventory items between us. Therefore, this isn't a major factor for us.

Okay, great. I have a couple more questions. I know you ship to the OEMs, who then sell to the customers. Could you share any observations regarding the situation in China, especially since their economy is recovering from COVID? Are you noticing an increase in demand from Chinese companies? Lastly, while it's challenging to predict the overall revenue for wafer fab equipment this year, what is your current planning range for that?

Yes. In response to the first question, we're observing continued strength in China. They are past most of the COVID wave, which contributes to their ongoing robustness. Additionally, there are concerns among Chinese fabs regarding new export controls being discussed in Washington. Despite this, we see the China fabs continuing to invest, focusing on both technology and capacity improvements, particularly in the memory space. We anticipate this strength will persist, especially during the current pause. Regarding wafer fab equipment, various analysts suggest that the market could either remain flat at best or experience a single-digit decline at worst. For our planning and next quarter's guidance, we focus on real orders and the surrounding circumstances rather than WFE projections. However, we acknowledge the potential range for WFE could be a single-digit decline compared to 2019 or flat. We do not plan for more extreme scenarios but have contingencies in place if needed. These expectations seem reasonable, particularly since WFE has been somewhat insulated, though not completely unaffected, during the first half of the year. We'll need to monitor developments in the second half.

And the next question will be from Dick Ryan with Doherty.

So Jim, one of your longer-term goals has been to increase contributions from other key customers. Has the current environment shifted any of that potential sorts of market share gains, your ways, or is it still too early to tell on that?

No. To date, particularly in our growth efforts, we are seeing strong performance from about one-third of our customers at a 10% reporting rate, and those are performing very well. We have experienced several significant wins with one of the OEMs that is not among our top two. We are continuing to see a lot of success in this area, and many of these projects and products are set to launch next year, which should remain unaffected by current events. These are new product lineups. Thus far, we have not observed any impact on our roadmap to grow our market share.

Okay. I heard the guidance for Q2, but did you mention your expectations for each of the segments, the products and services for Q2, and how they will mix?

No. We didn't break out by product line. But I think, as you can see, the revenue is nearly flat than we're projecting, so you can expect a similar mix.

The next question is a follow-up from Quinn Bolton with Needham & Company.

Regarding the OEM shifting some volumes your way in the first quarter, can you let us know whether those market shares have changed? Are they permanent, or do you think they will return to the original supplier? I just wanted to understand how we recognize that there are fluctuations in share dynamics. But for what has already been shipped, will those volumes leave or will they remain with you?

Yes, sure. Yes, obviously, some of them are clearly temporary shifts just around the situation, but I think it'd be reasonable to expect that some of the shifts would continue based on continued uncertainty around the supply chain and our strong performance that we've had to date, that we could see a portion of those continue. And it's always difficult to predict, long term, how that will play out as that becomes the normal battle. But definitely, some of them are just temporary fill-ins, but some of them could definitely play into a more permanent situation based on how reliable we've been to our OEMs.

Got it. In the first quarter of 2020, you indicated that you expected to be at the high end of your guidance, around 5% above the midpoint, and mentioned a potential impact from COVID of 5% to 10%. However, it seems your Q1 results reflected no COVID impact at all. This indicates the strength of your global presence in supporting results and customers. I also noticed that Lam Research announced a new manufacturing facility in Malaysia, and I trust your global manufacturing and supply chain can accommodate this. Are you anticipating any changes to your manufacturing footprint or supply chain network? I realize this is a recurring question, but any insights would be appreciated.

Yes. Regarding the first point, we did anticipate some delays pushing into Q2, and that occurred due to shifts in customer timelines as well as our inability to meet some original dates. However, we managed to mitigate many of those delays and delivered more in Q1 than we initially thought possible. Q1 was characterized by addressing more pushouts than expected, alongside additional revenue from products that emerged in response to demand, where we stepped in to assist when others could not deliver. Bridging these changes is complex, but it's a combination of addressing original delays and constraints, while also securing last-minute business to compensate for the OEM. As Lam continues to expand its presence in Asia as our largest customer, we are expected to increasingly shift our manufacturing operations there. Over the years, we have steadily moved more production from our North American plants to our facilities in Asia. For instance, our Singapore facility has grown significantly, increasing from a few million dollars a quarter to around $100 million. We will continue to expand in Asia, and this growth might accelerate once the new plant is fully operational, as we are prepared to support that transition.

Ladies and gentlemen, this concludes our question-and-answer session. I would like to turn the conference back over to Jim Scholhamer for any closing remarks.

Well, thank you for joining us today, and I hope everyone stays safe and healthy until we speak again in the second quarter. Thank you, all.

The conference has now concluded. Thank you for attending today's presentation. You may now disconnect.