Advanced Energy Industries, Inc. (AEIS) Earnings Call Transcript & Summary

Great. All right. So thanks, everyone, for joining. I am Jacob Wheeler. I am part of our global semiconductor and electronics investment banking team at Morgan Stanley. Thanks for taking the time to meet today. We have Paul, CFO of Advanced Energy, and Edwin, who is Head of Strategic Marketing. So look forward to the discussion. Before we get started, I need to read one piece of disclosure. Please note that all important disclosures, including personal holdings, disclosures and Morgan Stanley disclosures appear on the Morgan Stanley public website at www.morganstanley.com research disclosures or at the registration desk.

So Paul, Edwin, as we kick this off, maybe for those in the audience who are potentially less familiar with the Advanced Energy story, it might be helpful if you could just kind of go through a little bit of the background on the company, what you guys do, and how you fit into the overall ecosystem?

Yes, great. Thanks. Thanks a lot, Jacob, and we're really glad to be here today. I appreciate everybody's attendance. And maybe I'll just add our own disclosures to those at that time. We're subject to a number of risks and you can have a further description or see a further description of those risks on our filings with the SEC. But we're really glad to be here. There's a lot of exciting things going on with Advanced Energy. Advanced Energy, if you're not familiar with this, is a company that's been focused on electrical power conversion. In fact, we are the leader in precision electrical power conversion and our roots have been in the semiconductor equipment industry, and our products have provided the catalyzing energy that drives plasma processes, etch and dep. We're the #1 supplier to those -- to the -- to our customers in that area with roughly 2x the market share of our nearest competitor. And that's formed the core of the company. We've been very successful over many years. We're a 40-year-old company. We've been historically very profitable and generated cash. And that's given us a strong foundation. But a few years ago, we looked at our strategy and said, look, there's an opportunity to grow faster than the market and to grow earnings faster if we take our core competence and power and extend beyond just the semiconductor equipment market. If you think about it, power is ubiquitous. It's in everything and power conversion is in everything. And we felt like there was a very large market for precision electrical power conversion products, where we can apply our capabilities and, in some cases, acquire more products or access to customers and leverage what we're doing to grow into bigger set of markets. Now in that, we have focused on precision power. So we're not focused on commodity activities like your cellphone charger or a radio charger, we focused on markets where there are highly engineered products. They are designed into critical applications, and they're staying power in what we call regulated markets where they're sticky, whether that's in semi with Copy Exact or it's in areas like medical, where there is FDA or defense applications or even in areas like telecom or a data center where customers want to work with known companies, and you have to be embedded well with their design organizations and have the flexibility and staying power to be in those markets. So we focused on precision electric power conversion. And as we focused on that over the last 5 years, we've made 8 acquisitions that have allowed us to get into a broader set of markets, including most recently in the fall, we acquired Artesyn Embedded Power products, which was a part of a company called Artesyn Embedded Technologies. And that's been a very transformational acquisition for our company. As a result of that acquisition, we now address not only the semiconductor market, where we're a leading player, but we also have a very strong presence in industrial and medical markets, where we provide equipment, not only for thin-film deposition for the advanced material deposition, similar to semi, but for non-semi materials as well as a whole array of embedded power products, products that are critical to the piece of equipment being able to operate correctly, whether that's a piece of medical equipment, life sciences equipment, analytical equipment. These products require clean, stable power. You can imagine a medical laser. If you have a disruption in the power while you're performing a surgery, that could be a problem. In addition, we've entered with part of this acquisition, the data center and computing market, and we have a very strong position, not only with traditional server and storage companies, but also, we have a growing position with hyperscaler companies where we're seeing good growth in that area as we've had new design wins. And finally, we sell -- we're a leading provider of power supplies to the telecom and network environment. And our power supplies are in base -- are used in base station, the remote radio head. And these are extremely rugged power supplies that are able to perform in extreme weather conditions, both hot and cold and are very, very reliable. What we really like about these 4 markets as we've extended beyond semi, so as we look at telecom and networking data center and storage, and we look at sort of smart medical and industrial, these are all markets that are right at the heart of the Fourth Industrial Revolution of this whole new interconnected environment and part of the data economy. And as we see growth in the need to collect data, to generate data and to transfer data, we now have critical products that go into all elements of that supply chain. So it's a very exciting time for us as we're able to leverage our core competencies in this broader set of markets. And this strategy, we believe, is one that we can continue to replicate. We can still have a very good balance sheet. We're still very profitable. We expect very good accretion from the acquisitions that we've done. And we're very excited about the future.

Got it. Got it. And then so you've been pretty public about -- and I have to do the obligatory coronavirus question, but you've been very public about the potential impact from the coronavirus as well as potential implications of the trade situation on certain customers such as Huawei and the base station market. Could you maybe just give us an update on where -- how you're feeling about those situations?

Sure. So we had both maybe the advantage and disadvantage of having a timing of our earnings release, which was a little later in the cycle, which put us right in the middle of the coronavirus. And so we were able to be, I think, more open about how we see the impact of the coronavirus. And clearly, in the near term, it's having an impact on our operations. If we look at our business, the demand is strong. In fact, following a very strong Q4, we expect demand to sequentially increase in Q1. But because of disruptions in our factories due to the extended Lunar New Year, how fast people are coming back to work, and more importantly, in the supply chain, which we have a large supply chain in China, we are seeing some impact to our operations. The result of that is we did guide down for Q4 from revenue -- for revenue to be down about 8% to 10% from Q1. Now that's despite an increasing demand environment. So it's clearly impacting us. We think it's a temporary impact. Our factories did open up the day after the extended Lunar New Year was completed. We have had people coming back to work. I think if you look broadly, the news since then around China has been improving. You see large companies coming back to work like Foxconn earlier this week announced. And those trends are trends that are -- I think, are benefiting us as well. So in the near term, it's kind of the supply chain disruption and operating disruption. But we came into it, I think, relatively well prepared on a couple of fronts. One, very tactically, we were able to respond very quickly. We put in place an executive-led response team so that the day that people could come back to work, we had masks and goggles and gloves. We had rethought about workflow to not have concentration of workers. And we were able to come up relatively quickly compared to everyone else. But I think more broadly, thinking about business continuity and how we diversify risk and optimize our business, we had already put in place some strategic investments that have helped us. For example, about 18 months ago, we announced that we were going to put in place a dual factory that would supplement our China factory with the factory in Malaysia. We've been investing in that capability. We started pilot production early in Q4. We announced that, that factory is fully operational just about a week ago. And we're seeing the volume ramp there. That gives us some diversification in this case from the impact in China. And over time, that factory will continue to grow in its output. More broadly, if you look at our footprint, post the acquisition we made this fall with Artesyn, we have 6 major factories or major hubs, 3 in China, now 1 in Malaysia and 2 in the Philippines. And as we look forward a couple of years from now, we expect to be able to consolidate that down to 1 in China, 1 in Malaysia and 1 in the Philippines. That will give us the advantage of both a more consolidated footprint and a more diversified place -- set of places where we can manufacture our products.

Got it. That's helpful. And then so when you look at the now 4 markets that Advanced Energy serves, right, you're really in a leadership position in each of those. Could you just touch on some of the key differentiators in maybe each of those markets or a few select markets where you think Advanced Energy has a real advantage?

Sure. Maybe I'll start with our core market of semiconductor. We have been the leading share provider of RF generators and matches and components that go around providing power to the chamber for many years with roughly 2x market share. The things that differentiate us there are our ability to control and to bring next-generation technologies to the table. In fact, as we look forward, obviously, as you have more complex designs and more layers, you need both more power to be able to do the processes, but you also need better control of that power. And you need to deliver what we call the right power to the work surface. And there's a lot of investments we've made, both beyond using just RF but other technologies as well as to how we control the frequencies and have integrated solutions between the generator and the match. As well as recently, we've introduced some capability that we call power insight that leverages the same IIoT-type technologies of big data to make the power supply more of a smart power supply. So it can do predictive maintenance, it can help you do optimization and even yield improvement in some cases. So we're very excited about our capabilities in semi. In addition, we're expanding our content in semi as there's new parts of power applications within the semi market that we can bring, products, some of which we're developing ourselves like our remote plasma source. And others that we've acquired in Artesyn, for example, they provide auxiliary power to things like the robots, the computer, even the equipment itself. These are products we've not had in the past. But our relationships in semi, their products are now giving us a window to expand our SAM even within semi. So we're very excited about that. And in fact, we've had our first order already for auxiliary power products in semi, a very natural synergy we hadn't countered on. In the industrial and medical markets, we have probably the broadest set of products. We have an expanded distribution channel, and we have highly configurable platforms, which we think will give us a lot of opportunity to expand our content and our presence in industrial and medical applications. In the data center and telecom, and I'll say broadly in our embedded power products, we have 2 real advantages. One, we're very good at power efficiency. And the higher efficiency you can get in the products means a lower energy usage, the lower heat dissipation. That's very important to customers, especially in data center and storage. And secondly, we have the industry's best, what we call power density or footprint. Our footprint is as much as 30% smaller than other competitors, which gives us an advantage when you think about rack space and how you're going to deploy this power supply. And then finally, in the area of telecom and network, and one of our key differentiators is the ruggedness of our power supplies. We have proven capability to have highly reliable, highly rugged power supplies that can sit in these remote towers in all kinds of weather in the Arctic and in Dubai. And you need these things to work constantly, to do a truck roll to replace the power supply, it's very expensive. And so we are known for that capability. Those are the advantages we bring to those markets. And if you think about them, they really work together across all areas where we can leverage those competencies, really a collection of competencies across all of our markets.

Got it. That's great. That's great. And you've touched on some of this, but there are obviously a lot of really interesting inflection points in the various industries in which you're playing. Could you maybe connect the dots to some really exciting applications, whether it's in the semi -- the core semiconductor business or otherwise, where Advanced Energy is really enabling some of these developments and progressions in each of those markets?

That's a great question because technologies continue to evolve. And we've always been a leader in innovation. That's been the core of our company. So maybe I'll ask Edwin to talk a little bit about some of those applications we're excited about and some of the technologies we're bringing to market.

Sure. So for example, let's go to semiconductor first, that's our core, right? In general, as semiconductor device evolves, right, either you go down to the technology in the logic side or in the memory side. We're talking about 3D stacking, right? One of the -- 2 things that we have seen, right? One is that requires increased precision of how the power is being delivered onto the wafer, right? And also, in some cases, like as you increase the stack, increase -- require increased amount of power that's delivered on to do the etching process or amount of stack that you try to stack up, right? So that precision as well as increased power is kind of almost offset each other, right, because as you try to pump more power then it's hard to become more precise, right? And I think that's where we believe our technology is enabling our customer to be able to deliver that, right? Beyond that, we talk about this beyond power technology, which we call eVoS, right, which is basically called we have delivered this groundbreaking technology to try to change the way that our customers think about delivering power, right? At some point, you'll be pumping too much power into the chamber to cause other issues like the power supply become too big or too much heat and other things, right? So we can't see that long term, not today, but longer term as you move down N plus 1 and N plus 2 nodes, right, and find anyone else to grow, no, right? There is a risk for -- increasing power just couldn't get you there anymore, right? So that's why we have new solution, what we call right power and one that we have recently talked about is eVoS, right? So that drives the potential new inflection point on power delivery system, which we believe we're in the forefront of it and it will lead the industry to that. Beyond that, I think we can talk about data center as in that example, right, that we talked recently how about some share gain with one of the hyperscale customer, right? It ties to one of the things that Paul was talking about, power density, right? As the data center evolves, right, more and more investment upon to like AI-related process or high-performance computing, where people are using GPU or their own customer design processor. It turns out this processor is very power hungry, so you want a lot higher power supply. But the data center from the box maker to even the hyperscaler, they don't want to, like, complete -- add more rack, right? They want to be able to fit more GPUs into a single rack, right, which in fact could lead -- step up the power requirement on the rack level, right? We deliver power shelf that has power supply embedded into it that power the whole rack. And we have programs for our customer where we discuss how we can increase that level power each shelf can deliver. In one case 1 program to work on with almost doubling the power in the same amounts that we're talking about, right? Obviously, that require not just simply put more boxes in there. There is some -- there is technology that needs to be developed around that, right? And we're very excited about it.

That's great. That's great. Paul, you mentioned -- you touched on manufacturing a bit, right? And post Artesyn, you've talked about the importance of vertical integration, and how that has evolved for Advanced Energy as part of some of these acquisitions. You also put out an aspirational target model back at the Analyst Day that shows 5%, 6% points of gross margin improvement. Can you kind of talk about some of the opportunities, both on the manufacturing side and improvements in gross margin, whether that's through more selective product introductions, et cetera? Can you just touch on that piece of it?

Absolutely. In fact, we're very excited about the Artesyn acquisition and the opportunities for synergy because the 2 companies are very complementary. Our strategy as we've acquired companies is to stay a pure-play power provider, right, not to branch off into other things or buy companies that we think we can run better. But rather, the synergies are created by the natural combination of the 2 companies. And in Artesyn, that's really the case. Artesyn brings a lot of capabilities in both technology and operational excellence that have been very beneficial to AE. And AE brings a lot of capabilities and control and scale that are very beneficial to Artesyn. And one of the areas we think we can make a lot of improvements in is in gross margin. And there's 3 things that will drive that. First of all, there's very natural synergies amongst our footprint. And I already talked about that over time, we believe we can go from basically 6 major factories or hubs down to 3. That will just create savings in itself, more revenue per square foot, more revenue per employee. The second area is when you look at the supply chain, there's a lot of overlap in the supply chain in terms of the actual components we buy. So the opportunity to move to common vendors, to leverage our buying power, to think in a more leveraged position, we believe we can actually take out material cost. And think about if we could just reduce material cost by 1%. It's huge value to us. But you mentioned vertical integration. One of the things that Artesyn brings is they bring a more vertically integrated structure because of the more cost-sensitive nature of our products. We've historically had more of a outsourced structure where we just do final assembly and test. We can take a lot of the parts, products, PCBs that we've outsourced in the past and actually now in sourced them to ourselves, leveraged the fixed cost structure that we have, and therefore, actually reduced cost of even our more advanced products or our higher-priced products, which we think is very exciting. And then finally, we do believe that as a combined company as we focus on areas where there's technology and capability, we can actually shift the portfolio of products that we address to continue to shift the things to -- that are even more differentiated and have more capability and, therefore, more value to our customers and effectively improve what we call price, not because we're raising prices, but because we can actually deliver products with more value. And that from -- again, from the combination of the 2 companies. So our goal, if you look today, as a combined company, as we're running about mid-30% gross margins, and we feel very comfortable that over the next 2 to 3 years, we can bring that to around 40% or a little better. That contributes quite a lot of, I'll say, incremental leverage to our operating model, which is part of how we will accelerate earnings growth as we go forward, which is the whole point of expanding our SAM, leveraging the acquisitions that we've made and growing as we think we can grow earnings significantly, not only margins, but earnings. And if you look at operating margins, we think we can go from today around the low teens to over 20%. That will drive EPS today from around $2.40 to our 3-year target of $6.50, which is substantial EPS growth on relatively modest sales growth. So we're very excited about that. And I guess the one thing I'd add to that is, it's not just growth at kind of a bunch of capital cost, we have a very efficient capital structure. We only spend 2% to 3% of revenue today on CapEx, and we have a good working capital structure. The result of that is we believe that we can drive return on invested capital from kind of the low teens today to over 20%. And if we do that, we'll be almost 3x our cost of capital, and we believe we'll be best in tier in terms of return on invested capital amongst semiconductor, a company -- equipment companies, our customers, semiconductor subsystem suppliers, our peers, power supply providers, again, another set of peers. And even what we would think of is best-in-class diversified industrial companies, people like the Danahers and AMETEKs and IDEXs and Emersons of the world. We think we'll be best-in-class with return on invested capital. So we are very excited because these opportunities of around expanded SAM, the synergies that it brings. Our own organic growth strategy, we think, will drive accelerated earnings growth over the next 3 years and best-in-class return on invested capital.

That's great. That's great. And maybe one more question from me and then we can open up -- open it up to the audience. But on capital return, you've mentioned a leverage target of 1 to 1.5x, but you're already in a net cash position, which is great. And you also mentioned -- you highlighted the fact that M&A has been an important driver of the business in the past. More medium term, as you continue to bring down the debt, what part will M&A play in the overall strategy going forward? How does that change post Artesyn?

Yes. It's a great question. And M&A has played an important part of our strategy as we continue to diversify our end markets and become more of a diversified technology company. And going forward, that's going to continue to be important. Look, the precision power market today the SAM we address is about $9 billion, but you could argue that, that SAM is even a little bit bigger than that. And we play in a fraction of it, and it's a very fragmented market. And so there's a lot of opportunities to continue to add scope, continue to add product, continue to add customers inorganically. So from a capital-allocation perspective, the model that we've been on the last 5 years, we think, is a very repeatable model. There's a lot of runway. So we want to position ourselves to have the capability for the right opportunities to be in a position to continue to grow the company inorganically. That means that we are going to keep our normal target of about 70% of our cash and I'll say, cash resources available to grow the company. And then about 30% for shareholder return. And today, we've used an opportunistic buyback program for that. We've executed pretty well against that. If you look at the last 3 years, we've spent almost $600 million on M&A to acquire about $750 million of annualized revenue, and we've bought back almost $200 million of our stock, not at all at once kind of opportunistically. I think we've been pretty successful with that over time. But it's illustrative of what we want to do as we go forward. Now in the near term, part of that 70%, you're right, we're going to use to do some deleveraging. We have 0 net leverage today. And we have about 2x EBITDA to debt leverage. We'd like that to be more like 1 to 1.5. I think that's a nice level that gives us opportunity to reload and look at other opportunities if we needed to do that. So we want to maintain good balance sheet strength. That's where we saw cash. We want to bring down debt a little bit, that will give us continued credibility with the debt markets. And look even within our current structure, we have opportunity to maybe look at other opportunities down the road.

Got it. That's great. Any questions from the audience? Sorry, microphone.

Maybe a more elementary question, but in your -- the 4 to 5 market that you mentioned, what's your rough market share and who are the major peers in those respective 4 to 5 markets?

Edwin, do you want to talk about that?

Yes. So we can talk about that. So historically, we have the highest position in semi equipment, right? We've disclosed that. If you do the math based on what we report on our revenue, right, our share in that market is probably in the 30% range, roughly around 30% range, right? We are the #1 player in that space. The second largest player, we believe, is a Japanese competitor, right, based in Japan. And you can go to -- actually, if you go to our analyst event deck there is a slide that shows all the competitors, so you can look that up ourselves, right? And that's our market share position. The other 3 markets, which is data center computing, telecom networking and industrial and medical, right, in all those markets, if you do the math, it's -- we have roughly around 10% or 10% to 15% share around in those markets, right? It depends on the time frame. Okay? And actually -- yes. And then we are #2 in all of those markets, every one of them.

Got it. We have time for probably one more quick question. Any takers? All right. Then maybe we close it out.

Very well, Jacob, thank you very much, and thanks, everybody, for your interest in Advanced Energy.

I appreciate you. Thank you.