Ichor Holdings, Ltd. (ICHR) Earnings Call Transcript & Summary

I'm Diana Chang from UBS semiconductor and equipment research...

I can't hear, Diana.

You can't hear me. Can you hear me now?

No.

Is it better?

A little bit. Okay.

Okay. Hi. Sorry for the technical difficulties. This is Diana Chang from the UBS semiconductor research team. I would like to welcome everyone this morning to the fireside chat with the management team of Ichor. We have Jeff Andreson, CEO; and we have Larry Sparks, the CFO, here with us. It's our pleasure to have you here with us today. Before we start, just need to read through the disclosures. As a research analyst, I'm required to provide certain disclosures relating to the nature of my own relationship and that of UBS of any company on which I express a view on this call today. These disclosures are available at www.ubs.com/disclosures or alternatively, please reach out to me and I can provide them to you after the call. I would also like to remind everyone on the call, we do have Q&A for the later part of the call. You can submit questions through the Ask a Question tab in the upper right-hand corner of the screen, and we'll get those questions asked for you.

So we've got a pretty straightforward fireside chat today with management, so I'll start things out. Maybe just when you think about the growth outlook into next year, I'm just wondering if you'd talk about what do you see in terms of growth opportunities and how much visibility do you have given all the supply constraints people have seen within the industry.

Yes. Thanks, Diana. Yes, we continue to have very good visibility into next year. Obviously, we're all, and I'm sure we'll come back to this, dealing with some supply constraints, but the unconstrained demand visibility is very good. I'd say over the last 2 years or so, our customers and us have kind of expanded the horizon that we received. So we get pretty good visibility for at least out 6 months and directionally for the rest of the year. We look at that plus other analysts. And our belief, next year is going to be a growth year. I might put a number of around probably 10%. Though I think that's pretty close to what the consensus is in the marketplace today. And so we are managing the company for another year of growth. That would be the third year now of this cycle that we're seeing. And so our confidence level is pretty high that we're going to see growth next year.

I guess when you think about the visibility when you talk about being better, are you like seeing how -- conversations with customers haven't changed, like customers are talking to you a bit much more earlier. Or like when they negotiate contracts, are the terms becoming like longer-term agreements or just anything you could shine a light on customer engagement?

Yes. I think as an industry during the last ramp, which ended at the middle point of 2018, I think there's been a lot more collaboration between outlook between our customers and what they ask us to plan for in growth and the details of what they give us. So that has changed. That's not been specifically associated with the pandemic, but I would say it's even closer collaboration as we work through the pandemic. Because for us, the majority of what we do is build to print. So we're integrated with our customers, our engineering teams and with our suppliers and our manufacturing team. So we do need good visibility. It is good, strong. I would say directionally good in the second half of an outer year. So our customers are communicating to us more frequently and with a longer horizon.

So when you think of the broader industry environment, how should we think about the competitive landscape for you? Are you seeing more competition? Or because with the supply constraint, some of the things could be, demand could be undermined. So just like do you see like market consolidation or more competition coming out of the market?

I wouldn't say that we're seeing new entrants in our space. The largest part of our business is gas delivery or gas panels for the process tools. There's a few large companies that deal with it. Obviously, there's another one in the U.S. There's one in Japan. And then beyond that, they're much smaller entities that might do a little bit, but we're not seeing new entrants on that side of the business. I wouldn't say we're seeing it on the component side of the business. Everybody is trying to add capacity to support this growth, but we're not seeing new entrants or competition from that angle. We're different than a traditional contract manufacturer in the fact that we're truly kind of high mix, low volume compared to what a typical contract manufacturer. So that's kind of our operational model, and you can see that we carry a lot more inventory than a traditional contract manufacturer. We turn inventory 5 or 6 times a year. They might be looking to turn at 10 or 12 times a year. So that's a different model for them and much more difficult. We've seen them try and enter. It hasn't been tremendously successful over the last, say, 10 years or so.

And then, can you talk about the IMG deal, like what is the strategy behind the deal? When you think about their product offering, what do you think they offer? And why did you do it? And why do you think it's a good use of your capital?

Yes. Well, our M&A strategy, if you look at some of the deals that we've done over the last 4 or 5 years has really been kind of focused on the component side of the business as opposed to the integration, assembly side of the business. So our strategy has really been to look for margin accretive acquisitions that can expand that side of our business that carry a little more of IP-centric and that will drive improved margins. And I think with the IMG deal, we talked about adding 100 basis points to margin and 40 basis points to operating margin. It will be instantly accretive. The deal closed a couple of weeks ago or a week ago. And so it's been kind of what we've been looking for. It's been a very good fit. It's very complementary. There is no overlap truly with our machining. They do larger format machining. They also have positions in industries that are not necessarily semi. But primarily, their largest market is still semi. So that overlaps nicely into our kind of served available markets. And so we see it as a, from a valuation perspective, I'd say it was a reasonably good valuation. And what you see in machining businesses can be much higher than what we paid for this, and so it will add to the accretive nature of this as well. So from a use of capital, while the, say, the EBITDA multiple was higher for their business, but it carried a higher margin than our kind of overall business, but it wasn't that far apart.

So when you talk about their primary market, I guess, also, at the same time, they get you into some of the new end markets. Can you just elaborate what are the new market opportunities that you're seeing from this deal? And what are the offerings you potentially see you could be able to grab more opportunities over there?

Yes. Some of the markets that they're in there outside of semi are defense, aerospace, medical, very unique proprietary product that they manufacture in the medical space. It's for a radiology-type piece of equipment as well. And in defense, they manufacture parts. I can't be specific who the customers are, but they manufacture parts for commercial airlines and other, I'll call them, aerospace applications. That side of their business has been growing fairly nicely, along with the growth in the semi side of the business. And uniquely enough with this acquisition, it brings a little more of a recurring revenue stream with it because some of the products they manufacture, they actually need to be replaced. They're not put in the tool onetime. Whereas a lot of what we manufacture today on the component side, its life is very, very long. So it doesn't have a truly good service spares kind of revenue. Plus, they do services such as e-beam welding, laser welding, brazing, things like that, where we actually get the parts in from customers and then we provide that service. So there is a recurring revenue stream with this, too, which was very intriguing to us.

Will you be able to quantify how big is the recurring part of the business?

I couldn't hear you, Diana, say that again.

Sorry. Just asking if you will be able to quantify how big portion of it is for the recurring revenue.

No, because we're not going to split that out on every call, but it's a sizable double-digit piece of their percentage of their business so.

Got it. So when you think about the whole industry, how much has supply been an issue for you? Like are you concerned about additional shutdown given the new variant coming up? What are your contingency plans when thinking of that?

Yes. Good question. So we, as a company, we kind of manage this every week, every day. I don't know what the new variant will bring us, but we're not changing any protocol, safety first for our employees. So yes, we do obviously worry about it. And as you know, in our quarter 3, we were impacted, started at the end of Q2 when Malaysia started to reduce the workforce that could work and then shut us down for about a couple of weeks. And it's been, taken a while for us to dig out of it. So we do have to think about that. I think in the short term, it's not that easy to shift a lot of supply between geographic regions. So what we've done is, like, for instance, in Malaysia, we worked really hard to get the vaccination of our employee base. It's nearly 100% there. So that helps with that. And we're not immune from other challenges in the supply chain, just like everybody else. We don't have a tremendous amount of content of what you would call semiconductors, but there are semiconductors in some of the products that we purchase and assemble in the gas panels. But what we really do is we spend a tremendous amount of time kind of on the blocking and tackling to address these wide range of issues that come up, which are not necessarily all systemic. They come up in different areas and different times. One could be a freight delay. One could be, we've dealt with paints, latches, parts and delays in shipments. And so everybody is in the same boat, at least in our industry or in our business so.

Are you seeing any changes like during your negotiations with your customers, we're kind of seeing people or at least from what we're hearing from the industry in general, customers are willing to engage maybe in longer-term agreements. So just wondering what you're seeing over there.

Yes. No, I think that contractually, we generally, since most of what we do is build to print, we have long-term agreements that are multiyear anyway. They're based, the pricing's all set, lead times, et cetera. So what has changed is just the visibility and the detail of the visibility that they provide. They're working to make that a tighter and tighter communication with us. And so that helps us plan longer term with our supply chain. So we're going down each sub-tier and extending the horizons. We've extended PO horizons up to a year for certain suppliers so they have plenty of visibility. And so we've been doing that for well over a year so.

When you think about lead times, I would assume lead times have definitely extended with some of your customers just given the supply constraints that we just talked about. Historically, I believe like products which have gas delivery products have been very low inventory since they're more customized. So just curious like what are your cycle times today for those products compared to maybe the typical average, probably 4 to 6 weeks in general for your other product?

Yes. I mean, our cycle time to manufacture hasn't really changed. Unless we get impacted by a supply chain shortage or something, it could extend our cycle times. We've had to extend on the component side of the business, obviously, to address some of the longer lead times we're getting from our suppliers. But in general, I think the inventories are very, very -- most of us are trying to build up inventories to support the growth in that business, and you'll see that across. But in the channel, I'd say the inventory is pretty lean. But most of the inventory you're seeing is either a result of trying to purchase more safety stock or inventory that can help you buffer these lead times for our customers. And our focus is to make sure that we're meeting all their critical deliveries as best as we can.

So when I think about one of the positive features of your story is your ability to continue to outperform the market on a very consistent basis and particularly in your gas panel delivery system business is where we see the outperformance. So can you just detail like what are the opportunities you are seeing over there? What's driving above-industry growth and any areas you would like kind of like to highlight for potential share gain opportunities emerging?

Yes. I think we've done a pretty good job. When you kind of look back over, since 2019, you can see our revenue growth has outgrown. This year, a little more challenging versus WFE driven by some of the supply constraints and just the timing of how everything has come together over the years of the pandemic. But in general, if I was to give you, obviously, from an organic side, deposition and etch is really outgrowing WFE. We all know that. Our customers are the leaders in that particular space. So they've outgrown that, the dep and etch markets themselves as well. So that's a benefit to us. We also have a position in EUV. EUV, as you know, is growing year over year over year and really getting really close to kind of higher volumes now, and so that's helped our growth rate. We've won market share gains. As you go back to 2019, we talked about exiting that year with about $100 million in gains, and those are built into the revenue streams today. And so that's helping as we look out. And our focus is continuing to, we've added IMG recently, and that's an acquisition that will help us look like growth again in revenue. We did a couple of other ones on, one on weldments and one in precision machining prior to that, that we're largely focused on one of our largest customers. And we're continuing to try and get share on the other side. And so those are all opportunities that have helped us outgrow WFE kind of over this cycle.

Maybe just to touch a bit on that a bit into more detail. So when you think about new architectures, such as gate-all-around, which are very materially intensive, will kind of like increase the intensity for the etch and deposition process you just talked about. So when you think about your new market opportunities within the gas delivery systems business, can you just discuss like where do you see the growth potential coming from, from these new architectures? Perhaps like if EUV lithography adoption could be one of the growth drivers going forward?

Yes. I think that I can take a long time to answer this, but in light of time, I'll just give you an example is that, one, we totally agree that the more complexity structures become, they become more and more dep and etch-centric. And so you're going to see that part of the market continue to outgrow, I think, overall WFE for sure. And then when you look at it, as an example, in the 3D NAND, for example, if you look at a 64-layer die back a couple of years ago and now we're working towards 256, you almost need twice as many tools per wafer start. And so that's capital intensity increasing. And you're seeing that also in foundry/logic. There's nearly a doubling from 14, 16 to the 5-nanometer. When you get to 3, you start introducing some of these new technologies that you talked about. And DRAM, to a lesser degree, is about a 50% increase in capital intensity from kind of 1x to the 1b node. So all of this, I think, is beneficial for Ichor because we address those. And then you're seeing, when we talk about etch and deposition, it's really etch and CVD applications primarily and PVD applications. But you're seeing other novel deposition applications that are coming to light, and we have a position on one of those as an example today around several of them actually. So those are going to be areas where I think you're going to continue to see those type of applications outgrow kind of just the general WFE growth.

Just to clarify that a bit. When you think about the WFE, obviously, industry is trending to a more like material-based engineering process, more complicated architectures. And those are clearly benefiting to where you're exposed to. But there's also talks about potentially intensity couldn't be as high or WFE could roll over a bit maybe in 2023. Just like do you think that's the right way to think about your business or do you think you're vulnerable if any of these cyclical factors kind of like take out after that?

I'm not a technologist so difficult to answer the question around specific impacts of material-based engineering type applications. My understanding is the more materials, provided they're gases and/or we have a chemical side of the business as well, those all will be net beneficial for us. An example is, if you went back probably 5 years, the number of gas sticks on an etch gas box has probably gone up by, I don't know, 30% to 50%. So there's either more and more gases or different flow rates needed and precision needed. So as you get to these smaller and smaller line widths and geometries, you need more precision. And I think that's going to increase capital intensity, and that's all net beneficial for us.

In the recent earnings call, I believe you mentioned you are seeing steady growth from your Q4 into Q1. So some of that might be muted or really capped by the supply constraints. So just wondering like where are things trending right now versus then? Are you seeing any improvements or how should we think about the supply situation in the next couple of quarters?

Yes. I mean, I definitely think we're starting to see improvements in supply constraints. We won't know what we don't know, whether a new one comes up or things such as that. But I think in general, the ones we see today, they're starting to improve either through -- a lot of it is just you've got in the sub-tier sometimes not everybody ramps at the same speed. So you get suppliers where they get to capacity quickly. We've talked about adding capacity. We've added a bunch of capacity this year. We'll probably add more into next year, probably more around the machining space. So we have to stay in front of it. And so those folks are catching up and that helps. I think we're going to continue to have to do this blocking and tackling through the first half of next year. Hopefully, it ends sooner rather than later, but I think we are starting to see things improve a bit. The magnitude, we'll just have to say. But I would say that as we exit this year, I think it's pretty clear that there's going to be some demand that isn't fulfilled because of these issues so.

If we look closely on the margin side, you're modeling or expecting 10 basis points to 20 basis points improvement as we go into next year. When you think about your gas panel absolute business or some of the component side and generally, overall product mix, one of the biggest components is really about precision machining and growing that piece of the business as a percentage of your overall revenue profile. So just like when you think about your gross margin potential as the business continue to grow sequentially, what are the puts and takes you want to highlight over here?

I'll let Larry jump in here. Go ahead.

I'll take that one, Diana. So as you mentioned, the expectation is to continue to improve gross margin 10 to 20 basis points quarter-on-quarter as we move into 2022. It's really through a combination of, we'll get some volume leverage and then continued market share wins in the components part of our business, especially in precision machining. Our long-term financial model of 19% to 20% assumes a higher mix of new higher IP-based content for gas panel and liquid delivery products. And really the ability for us to accelerate gross margin improvement beyond the 10 to 20 basis points quarter-on-quarter is really dependent on the speed at which these new products are accepted in the marketplace and then also some easing with the COVID costs, which we've talked about in our earnings call. And as Jeff mentioned, one thing that does help us from an incremental perspective is the IMG acquisition, which does add 100 basis points to the baseline this year into 2022. So I think that combination of IMG and some of the growth items that Jeff mentioned, plus our continued quest for 10 to 20 basis points a quarter as we kind of go into next year is really what's going to drive the improvement.

Maybe on the cost side because you've talked about, besides the product mix that we just talked about and the IMG deal, you also did some cost reduction activities. Do you see room for more cost improvement across your business? I mean, you've talked about closing the Union City business and changing your cost profile over there. So just anything you could shine a light in terms of where you see opportunities for more cost improvement?

We continue to look for ways to improve our cost profile, either through effective material cost sourcing or we do some new factory automation, direct labor training. And we also will get some leverage from the implementation of our new ERP system. So we are, from a cost perspective, every year, we have programs that we put in place and we execute on. In addition, we are focused, very focused actually on COVID and the impacts, especially in the area of logistics and freight. It seems that these cost headwinds have been there for a while and looks like they're going to continue into 2022. So we're looking at new and creative ways to kind of offset that. It's true that when you look at our margin, the largest contributor is the product mix and putting more new IP content, but cost reduction programs are an important part of the equation as well.

Let me just circle back a little when you talk about IMG deal probably brings more recurring nature. Just like is there a way you could or just like strategy-wise, you're thinking about moving your revenue base more toward recurring in nature? Just can you talk about any efforts you're spending on there or like what do you expect in terms of those basis?

Yes. So the largest part of our business, as you can tell, is the gas delivery side of the business. You can do the math, but it's probably around 60-plus percent of our business. And so you're not going to get a bunch of recurring revenue layered on top of that. Most of what is recurring has just been, this has been an industry for 30-plus years, and our suppliers carry most of the service inventory or our customers do through their network. We're developing some new products that will have some recurring revenue. But other than the IMG side of it, it's very little within the company. But IMG will help us. We'll learn from it. We'll look for other applications that can do it. Most of it because of the machining nature of that business, it will be parts replacement. But with e-beam welding and things like that, there is a kind of a service. In other words, the parts are supplied to us and we do the processing. And we have 3 or 4 areas where we do that. And so we can grow that if we can continue to penetrate other customers for those services. So it is an area of focus. I would say also, from an M&A perspective, we're not opposed to looking at companies that are more service-centric. We haven't found one that fit yet, but there are some areas that are interesting in that space as well.

I have a question from the audience. Investors are wondering, when you think about the IMG deal, when you think about their product offerings, how much of the business is precision machining and how much more capacity does it provide going forward?

Their capacity, I'd probably say, what do you think they have? 15% more capacity?

Yes, 15% to 20% probably.

15% or 20% or so above the kind of, we talk about next year being in the $70 million to $80 million range in our press release. So there is some incremental machining. I would say a fairly large, more than half of their business is probably just pure machining. And so even the medical application that I talked about is largely machined as well, even though there is some assembly to it, things like that. So it's pretty heavily. It's large format machining. In other words, most of what we do through the acquisition that we did 4 years ago, I guess now, that's very small form factor machining, kind of fit in the palm of your hand kind of machining. And these guys, these are, some of the stuff that they machine is 3, 4 feet tall. So it's a much larger format.

And I have another question also related to IMG. Like how do you see the growth of your semi business compared to the non-semi area that you just talked about? Do you think the fastest growing will probably come from medical or defense? Can you just like give specific examples like in the areas that you think will be well positioned to grow into next year?

Yes. We haven't had it for that long, but I think the medical application is a relatively small piece of their business today and that probably will be. That and the aerospace application could likely be the fastest-growing components of their business. Having said that, if we were able to win some new positions at another customer on the semi machining side, that could actually be a pretty fast-growing opportunity as well. But we've just got our hands on it. We're working the integration plans, getting our sales teams involved, et cetera, to go do this. But those are kind of the areas that I think that, that business can outgrow the industry.

I guess like when you think about the proprietary technology over there, which of the product groups have the most potential for synergy like IP-wise, like could be applied to your current like existing customer footprint?

Yes. I would probably say from an IP perspective, we probably have similar capabilities between our precision machining engineering group and their engineering group, 2 very strong groups. But I think the uniqueness in spaces we don't operate in, I think the application is called LINAC. It's a linear accelerator for radiology application. That is highly proprietary. And I would say that's the most proprietary thing, but that wouldn't overlap with us. But what will overlap with us is their business is mostly, it's virtually all in California, most of it in the Bay Area. And their level of automation in the machining, kind of lights out machining is higher than ours in our Minnesota operation. And so as Larry talks about margin improvements, if we can kind of continue to invest in the automation side, you just end up with lower costs and higher output. So that will be an area of focus that we learn from them and bring into our current operations.

I have a modeling question coming over the queue. Could you provide the revenue growth rate had been for IMG or the industry for like 2020 or 2021 in terms of industry growth? And then also did you indicate the implied gross margin is probably mid- to high 30s? Is that the right range to think about the model?

Yes. I think the margin is the right model. The growth rates we haven't truly provided, and we probably won't provide them specifically. So I would see they're, at a minimum, I think they'll grow with the market on the semi side of the business. I think the medical, because we're starting from a very small position, it could outgrow overall general medical and aerospace. And then actually, aerospace has held up pretty well if you're in a specific place. And part of what they do manufacturing is something that is a recurring part that has to be routinely replaced.

So maybe just talk about more broadly what are the key elements you expect in your financial contribution into the next year? What are in your models? And what are the primary metrics you're looking at?

You're talking about us and looking into next year?

For IMG specifically.

I think they have positions that they've earned, I'd say, in the second half of the year that will add to growth outside of semi. I think semi right now, unless we penetrate, and these are long qualifications. So if we start working on it now, there won't be new qualifications at new customers for probably 6 to 9 months, and those are areas that we're just getting our hands on the business to go work on that can get it to grow over and above. Remember, it has a recurring revenue stream. So some of the parts are new, first time that go into a tool and some are parts that get replaced as the tool, as they wear out on the tool. So that growth rate for service type parts is not necessarily the same as WFE.

Are there any balance sheet items as related to the deal you could share like the cash since acquisition and how the company is thinking about that?

Yes. That was a cash-free, debt-free brought from a private equity firm, very typical. So we basically bought their businesses but cash-free and debt-free. So we added some debt to the balance sheet to do the deal we noted, $130 million?

$130 million.

$130 million. We refinanced the debt somewhere in late October as well, very, very good interest rates and stuff. So we're pretty happy with the balance, our capital allocation here, using some cash off the balance sheet, which was really, that came from the secondary we did about a year ago, maybe today, and then some more debt. So balance sheet is in really good spot, even the EBITDA multiple post acquisition is quite reasonable.

I guess to that end, when you think about your overall capital allocation strategy going forward, what would you highlight would be the company's focus? How are you thinking about shareholder return since you don't need to like deleverage a lot? So just like what are you thinking about the priority in terms of that?

Yes. That's a good question, Diana. Obviously, we're moving into more and more component development, so capital allocation into R&D and our capacity adds is probably the first that we'll fund. And after that, we're looking to add additional kind of accretive acquisitions. From a strictly shareholder return, I wouldn't say that in our 2022 outlook things could change that we have any kind of share buybacks planned or anything like that. Obviously, that would be something that we have done in the past. We're not opposed to it, but we kind of want to continue to kind of build the top line and the margin accretive acquisitions, and the market is still reasonably good for those so.

We don't have any further questions online. So I just want to see if you guys have any closing remarks you'd like to let investors to take away from the conference.

No. Well, first of all, anybody who's online, appreciate your attendance today. I think that Ichor is unique in the fact that we've got a pretty good track record of outgrowing the market. We do a pretty good job of acquiring acquisitions and things like that and building the business. The revenue growth has been good, very strong management team, and we really think we're in a good place right now. Obviously, with the pandemic and other challenges, there's a lot of tactical focus right now to manage through all of that. But these things will get behind us, and we'll come out a stronger company on the other side.

Thank you, Jeff. Thank you, Larry. And thank you, audience, for being with us today. Operator, I think we can conclude the call now. Thank you so much.