Ultra Clean Holdings, Inc. (UCTT) Q4 2022 Earnings Call Transcript

Thank you, operator. Good afternoon, everyone, and thank you for joining us. 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 the financial review, and 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 section 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 for our fourth quarter and full year 2022 conference call and webcast. First, I'm going to highlight a few financial results that Sheri will expand on in her commentary. I'll follow this with an overview of what we are seeing in the semiconductor market in the near term and summarize our plans as we play a more critical, meaningful role in the value chain. Solid execution from our global teams in 2022 resulted in a record year for UCT with revenue growing 13% year-over-year and operating income reaching a new high of $260 million. Looking back on this extraordinary three-year industry ramp, UCT's annual revenue grew almost 123% and earnings per share surged 243%. That's a compound annual growth rate of 31% for revenue and 51% for earnings per share compared to the industry CAGR of 22% in the same period. Late in the fourth quarter, it became apparent that the industry was headed into a downturn as our customers quickly pushed out and canceled orders in rapid response to their customers doing the same. Reductions in end market demand have been felt throughout the value chain and has prompted suppliers and service providers like UCT to make immediate adjustments to near-term production, operations, and financial forecasts. Because our customers and their customers are taking actions to bring surplus inventory into balance as quickly as possible, we believe the major step down of orders are reflected in our Q4 results and Q1 forecast. We expect the order stream to stabilize around these new levels. We have not changed our optimistic view that the fundamental drivers of our industry will propel significant growth over the long term. Not surprisingly, after three consecutive years of record WFE growth accelerated by pandemic-related demand for technology, we have entered a correction period. Every semiconductor cycle has its own unique characteristics, in this one, in addition to supply, demand and inventory imbalances, today, the industry is also grappling with lingering effects from the pandemic, inflationary pressures, unsettling geopolitical events, and notable macroeconomic influences such as trade wars and export restrictions. All of these factors combined, supported by what we've recently heard from IDMs and OEMs and our internal marketing intelligence, we believe weakness may continue through 2023. While the lower equipment investment will primarily impact our products business, there are pockets of opportunities we will be capitalizing on. We will be ramping products in markets like lithography, which are anticipated to grow in 2023. And while not yet at the level to offset declines in other segments of WFE in 2023, over time, our position in this space will continue to expand as a percentage of our revenue. In our Services Group, where revenue is more closely tied to wafer starts, we see a decline in business, but at this point, it is less than what we expect for WFE. While we hope that a recovery begins to materialize sooner, we are restructuring our business to maintain flexibility and optimize profitability, just like we did during the 2018-2019 downturn that lasted five quarters. We are taking immediate action within our variable cost model, including sharp reductions in overtime, a significant decrease of temporary workers and utilization of normal attrition. To prepare for the next ramp and support our growth strategy, we are consolidating our footprint and making improvements within our supply chain to enhance cost and delivery performance, among many other actions. We are balancing our cost reduction activities with key strategic investment programs, such as proliferating our single ERP solution, ramping Malaysia, adding fluid solutions machining capabilities, and expanding capacity at some of our service sites to support new chip fabs in the U.S. in 2024 and beyond. UCT has a proven playbook to successfully manage through industry cycles and emerge a much stronger, more profitable company each time. While our focus over the past few years was primarily on meeting demand, today, we are taking the opportunity to transform our business processes and global operational footprint, so we have the services, products, and capacity to scale quickly and efficiently to meet customer demand when the industry rebounds, because the industry always rebounds. In summary, while the chip industry is notoriously cyclical and experiences fluctuations, we view current business conditions as an opportunity to improve our bottom line in the next up cycle while ensuring that we protect our revenues and optimize our capabilities to secure long-term growth. By working closely with our customers today, we are increasing our strategic relevance within this value chain and expect to continue to outperform the market on an average over the long term. I would like to thank our employees and our shareholders for their continued support, and I look forward to updating you on our next call. With that, I'll turn the call over to Sheri.

Thanks, Jim, and good afternoon, everyone. Thanks for joining us. In today's discussion, I will be referring to non-GAAP numbers only. As Jim noted, 2022 was a record year of UCT for revenue and operating income. During the year, we paid down our debt by $40 million and spent $12.1 million repurchasing shares and prudently invested in projects to support our long-term growth strategy. Total revenue for the fourth quarter came in at $566.4 million compared to $635 million in the prior quarter. Products division revenue was $499.5 million compared to $556.3 million last quarter. And revenue from our Services division was $66.9 million compared to $78.7 million in Q3. The strong demand we saw in the first three quarters of 2022 led to a record revenue of $2.4 billion for the year, up 13% from the prior year. Products generated revenue of $2.1 billion, up 15% year-over-year, and Services contributed $299.6 million, flat with the previous year. Total gross margin for the fourth quarter was 19.5% compared to 20.6% last quarter. Product gross margin was 17.7% compared to 18.3% in the prior quarter, and services were 33.5% compared to 36.9% in Q3. Margins can be influenced by fluctuations in volume, mix in manufacturing region as well as material and transportation costs. So, there will be variances quarter to quarter. Total gross margin for the year was 20.2% compared to 21.4% last year. Operating expense for the quarter was $53.8 million compared with $56.5 million in Q3. As a percentage of revenue, operating expense was 9.5% compared to 8.9% in the prior quarter. For the year, operating expense as a percentage of revenue was 9.3% compared to 9.2% in the prior year. Total operating margin for the quarter was 10% compared to 11.7% in the third quarter. Margin from our Product division was 9.9% compared to 10.8% in the prior quarter. And Services margin was 11.3% compared to 18.2% in the prior quarter. The reduction in margins was mainly due to decreased efficiencies for both divisions on lower volume. For the full year, operating margin came in at 11% compared to 12.2% in the prior year. Based on 45.7 million shares outstanding, earnings per share for the quarter was $0.93 on net income of $42.6 million compared to $1.06 on net income of $48.6 million in the prior quarter. For the full year, earnings per share were $3.98 on net income of $181.9 million compared to $4.20 on net income of $186.1 million in 2021. Our tax rate for the quarter was 13.7% compared to 17.9% last quarter. For the full year, our tax rate was 15.9%. We expect our tax rate for 2023 to stay in the mid-to high teens. Turning to the balance sheet. Our cash and cash equivalents were $358.8 million at the end of the fourth quarter compared with $453.5 million last quarter. Cash from operations was an outflow of $38.8 million compared with an inflow of $71.7 million in the prior quarter due to lower shipment volume and timing of cash collections and payments. For the full year, cash flow from operations was $47.2 million compared to $211.6 million in the prior year. In the fourth quarter, we made an additional debt payment of $13.4 million, bringing our total debt payments for the year to $40 million. In the third quarter, the Board initiated a three-year $150 million share repurchase program. In the fourth quarter, we repurchased 343,000 shares at a total cost of $12.1 million. Subsequent to year-end, we repurchased an additional 389,000 shares at an aggregate cost of $12.9 million, leaving $125 million remaining on our three-year purchase program. Given the current global macroeconomic and geopolitical uncertainty, we are keeping our guidance range wide and including a negative adjustment of $30 million related to a cybersecurity event recently announced by one of our suppliers. We expect this revenue to flow into the second quarter. We project total revenue for the first quarter of 2023 between $395 million and $445 million. We expect EPS in the range of $0.12 to $0.32. And with that, I'd like to turn the call over to the operator for questions.

The first question will be from Quinn Bolton from Needham & Company. Please go ahead.

Congratulations on a record 2022. I know the environment has changed, but it's great to see those results. Jim, I wanted to get your thoughts. In your remarks, you mentioned that the majority of the decrease in orders likely occurred in Q4 of 2022 and this quarter in 2023. You also indicated that you expect orders to stabilize. Looking ahead to 2023, how do you view the revenue outlook for the year? I know there's that $30 million expected to come out of Q1 and likely be recognized in Q2. Should we consider that the first quarter level, without the $30 million, would be around $450 million at the midpoint? Is that the revenue level where you see stabilization, or do you foresee a different level?

Hi Quinn, you have it exactly right. Yes, that's true. We would have been projecting around $450 million. I think we see it stabilizing at that level or potentially slightly higher, with fluctuations around those numbers throughout the year. We're hopeful that the second half could be more positive, as some of our customers and peers mentioned they are looking for improvements then. However, our current assumption is that we will hover around the number you proposed, with some recovery in the second quarter, provided the supplier issue affecting us and many others also recovers. So yes, that's the correct way to think about it.

Perfect. You mentioned, Jim, the number of actions you're taking to streamline operations now including sort of reduced overtime, getting rid of some of the variable employee costs. But where do you see OpEx sort of shaking out in the near term as you take those actions? And then you also mentioned facility consolidation. Is this downturn giving you the opportunity to bring more business into Malaysia from some of the other sites around the world?

Yes, I think there are several parts to that, Quinn. Yes, we've been through multiple of these cycles. And so, taking down the variable cost, especially in the COGS area, we're pretty experienced at that. And I think you'll see us sustain higher gross margins through this cycle than we have in the past also with our broader company portfolio that we've assembled since the last downturn. So, on the OpEx side, there are a few headwinds. I'll let Sheri talk about that in a second. Those take a while to really move down. And some of the consolidation actions, of course, those are consolidating where you have two sites relatively to close proximity or business has moved from one region to another and a site is kind of unbalanced as a result of the last surge of the industry where we rebalance that and consolidate those sites. Those actions take roughly a year to put in place before you start seeing the benefit of those. We won't see a lot of that impact of those longer-term cost reductions until next year. But those will obviously help us become leaner and hit better numbers in the next upturn, just like we did in the last one. But Sheri, maybe you can talk about some of the other specifics?

Yes. So, we came in at 9.5% for Q4. We will see that go up in Q1 and partially in next year as we move through it. But we do have quite a few reduction initiatives in place, especially surrounding controllable spending within OpEx, whether that be travel or other discretionary spending as well as looking at our headcount and obviously, looking at footprint that does play into that as well. So, we are continuing to look at that quite heavily and see that cost hopefully come down as we move through the year as well.

Sure. Should we be thinking maybe OpEx somewhere between, say, 10% and 11% of sales? Or do you think it could go even higher just given the magnitude of the quarterly change in revenue in March?

We've observed that in previous downturns, the decrease has typically been between 10% and 12%. Therefore, I expect it to be within that range based on the revenue level. Q1 has seen a decline, partly due to the recent cyber-attack and also because of the overall industry downturn. I anticipate that the percentage of revenue for Q1 may be a bit higher. However, as we progress through the year, I believe it will return to a more normalized level.

Hi, thank you for taking my question. This is Stephen calling on behalf of Krish. I guess, Jim or Sheri, just a quick question first on Q4 and some of the impact from, I guess, production limitations in China that you guys previously highlighted. I guess relative to that $60 million delta between what you reported for Q4 and your original guidance midpoint, how much of an impacted production restriction have? And how is that situation here in Q1 so far?

Yes. In Q4, the major impact was actually the industry downturn and a lot of canceled and delayed orders. The COVID impact turned out to be much smaller than we first feared. I think it was roughly $8 million or $5 million. And that factory is up and operating normally right now. What was the second part of your question on that?

Is there any follow-on impact here in Q1? Is that correct?

No. The only unexpected impact in Q1 was one of the key suppliers for the industry, and the issue that they're having with the cyber-attack. Those components are used in multiple areas of the tools by many of us.

All right. Got it. My follow-up question is regarding sort of your, I guess, your memory exposure. I think in your slide deck, you show your exposure on a revenue basis from your largest customer is holding steady around 40% in Q4 relative to Q3. Just kind of wondering, just given some of the talk in the industry over the past couple of weeks about memory makers or suppliers potentially not cutting CapEx significantly this year as originally expected, I guess, how do you see that, if any, at this time flowing through to your outlook for the second half of the year?

Yes, it's difficult to forecast the impacts. We are noticing that Samsung intends to invest a bit more throughout the cycle compared to some other memory or foundry manufacturers. Therefore, it's challenging to determine what the situation will resemble or if there will be additional cuts from memory producers. That's why we are adopting the perspective of not anticipating a recovery in the latter half of the year, although a pleasant surprise could occur.

Great. Jim, after you take the variable cost of COGS out, I'm just wondering what your utilization rate of labor is. More importantly, as we look to the eventual recovery at a $450 million run rate business quarterly, what is your utilization rate then on tools and facilities?

Yes. The utilization on labor with some time lag, we tend to keep up not at 100%, but pretty close to even through the down cycles when we're not able to achieve it through normal means of overtime, and we carry a large temporary workforce sometimes up to 35%, 40% during the upturn. So, when we're not able to meet those utilizations and we utilize other things like shutdowns, which we're doing in this quarter and other methods as well. So, we keep the labor utilization very high. So, we expect to be able to keep the gross margins up. Obviously, the footprint and the tools and the costs and COGS is harder to cover. I couldn't give you an exact number on the utilization, but I think if you assume we were 100% utilized at the 630 million, do the math on the number, which is 65% of that, I think you'd be somewhere roughly around there. We were not 100% utilized in the Malaysian footprint, but we were 100% utilized in the workforce there. So, we maybe put it at around 60% or so.

Okay. That's great. Can you remind us about the product mix and the end markets you serve, specifically regarding memory, mature and advanced logic? Where do the majority of your shipments to your two leading customers end up being used by the end customers' fabs? Does that make sense?

Yes. It's actually hard for us to track on a running basis is when we ship a tool to our customers, again, that same tool can go or the same module can go to any application. So, it's not something I can really forecast. But I think you'd expect it to follow exactly where the capital is being spent right now. So, memory is clearly going to be down as more of the tools are going to foundry and Samsung as well. So, I think you'll see a shift that way. But I couldn't give you a new pie chart on memory versus logic foundry at this point. But definitely, it's going to be moving towards less memory, as you would expect.

Great. And then should we assume that gross margins improve sequentially in Q2 and then the kind of flat line at those type of levels given labor will be fixed quickly. And then is that the way we should be thinking about that?

Yes. I would assume that it would be able to level out at the Q2 level. And then hopefully, depending upon what happens in the second half, we would see it stay around that range as we move through the rest of the year.

For years leading up to the most recent up cycle, we observed a demand that didn’t require supply adjustments across the industry. During that time, we experienced an unusual pattern in fourth quarter bookings that were relatively easy to predict. Now, we have returned to a more typical situation where we can see one quarter ahead clearly, although certain unexpected events like COVID and cyber incidents have created some uncertainty. Currently, we have more variability in our outlook because we generally maintain low inventory levels with our customers. However, as orders sharply decreased at the end of 2022 and into the first quarter, some inventory accumulated between us and the customers, which is not the norm. Therefore, we need to analyze both the end demand and the situation to better understand our order book.

Yes. And then just a follow-up on that. It will be my last question. Do you have an idea of how much aggregate dollar amount of inventory is sitting between you and the customer that historically is not there?

No, we don't fully own every module we produce; sometimes our share is 50%, 60%, or 70%. Therefore, we aren't aware of what competitors may have in terms of similar products. What we do know is that many of our customers have significant inventory levels, to the extent that in some cases we may need to hold onto products for them. This situation is substantial right now, which helps explain why they may report less significant drops in revenue. Several factors contribute to this; firstly, they are working through deferred revenue for items already shipped, and secondly, they have a considerable amount in inventory at the moment. However, I believe that inventory will eventually decrease. Overall, when we consider both the challenges and benefits, the figures discussed make a lot of sense.

Sheri, I have a quick follow-up for you. If we consider revenue decreasing by approximately 25% or around $600 million compared to last year, and I'm arriving at the $1.8 billion by annualizing the $450 million quarterly run rate we've been discussing, could you provide some insight on what you expect the incremental margin will be for that reduced revenue? Should we be anticipating an incremental margin around 25%, or is there a more accurate figure we should consider as we evaluate the gross margin trend for the year?

I don't anticipate a significant decline in gross margin. There may be a slight drop, but it won't be as pronounced as what we've experienced in past downturns. The product mix might vary a bit, and we've effectively shifted certain assemblies to lower-cost regions and reduced direct labor costs rapidly, so the impact there is minimized. Adjusting operating expenses is more challenging due to the fixed costs involved, but I believe we can manage that and aim for stabilization. Ultimately, we want to ensure we are prepared for the next upturn across all areas.

Got it. So, a trough gross margin in the 7.5% range feels like a decent place to be.

Yes, I think that's probably a low point probably.

Thank you, everyone, for joining us today, and we look forward to speaking with you at our next earnings conference next quarter. Thank you.

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