Keysight Technologies, Inc. (KEYS) Earnings Call Transcript & Summary

Welcome. Thank you for joining us for this morning's session for Keysight Technologies Corporation (sic) [ Keysight Technologies, Inc. ]. I'm Rick Eastman, Managing Director and Senior Analyst here at Baird. I follow the advanced industrial equipment sector and test and measurement and certainly, Keysight Technologies are core components of our coverage. So I will just like to introduce Keysight here, and then we'll hand it off -- hand the presentation off to Neil Dougherty, who -- CFO, who will give us a quick overview. With that, Keysight Technologies is the largest global electronic test and measurement solutions provider, which includes hardware, services and expanding portfolio of software. This expanding solutions portfolio is a significant competitive differentiator for Keysight in a market most appropriately defined as an oligopoly. One insight investors often do not appreciate about test and measurement is that the high electronic measurement tools, like those brought to market by Keysight, are enabling tools essential to bringing next-generation technologies to market. Keysight solutions are used to upstream for design and simulation, in which case the funding is through R&D budgets. They also use midstream for validation and manufacturing tests. Those tools are funded through capital budgets. And then downstream from monitoring of network or quality assurance, and that's funded through operating budgets. So various budgets are at play here in terms of Keysight's revenues. So with that, I will hand the presentation off to Neil Dougherty, Chief Financial Officer of Keysight Technologies, and he'll provide us with an overview. [Operator Instructions]. Okay. With that, Neil?

Yes. Thanks, Rick. I appreciate the introduction. So I'm Neil Dougherty. I'm the Senior Vice President and Chief Financial Officer here at Keysight, and I have been the CFO of Keysight since the inception of the company when it spun out from Agilent back in November of 2014. Prior to this role, I was the Treasurer at Agilent and have well over 20 years of experience in the industry. Keysight, as Rick has said, is the market leader in electronic design and test. We also -- we've achieved that market leadership position through leading with technology. We have a highly diversified, the most -- the broadest portfolio of design and test solutions in the market. As I mentioned, we've been an independent public company since November of 2014 and the time of our spin, and it was that spin-off that was truly an inflection for the company, enabling us to increase investment in our business and winning in our end markets and really allowed us to transform the business to drive growth. We believe -- we're a market leader. We're #1 in each of the end markets in which we participate, including commercial communications, aerospace defense and electronic industrial end markets. We're the recognized leader in technology with a broad portfolio of software, hardware and services solutions. We've gained share in each of the years since our spin starting in 2014. And we have a strong operating model as with -- at its foundation, something we refer to as the Keysight Leadership Model, which is how we communicate with our employees about what's expected of them and allows us to deliver strong financial results and strong operating results in any economic circumstances. We have an increasing base of recurring revenue as mentioned -- as Rick mentioned. At the time of our separation, our software revenues were in the mid-$300 million kind of range. And then at the end of our most recent fiscal year, they were north of $800 million, so a substantial and growing portfolio of software as part of the solutions that we're bringing to market. We have an extraordinarily broad set of end customers selling to over 32,000 end customers annually. We do not have a single customer that even represents 5% of company revenues. And so we service a diverse set of end markets. We have highly differentiated solutions. And we have a highly durable operating model, which we -- unfortunately, we've got an opportunity to prove here this most recent quarter with our top line under pressure as a result of COVID but still being -- enabling the business to deliver 19% operating margins. Since our separation, we've been investing in key growth areas of our end markets, including 5G, software, services, automotive and defense modernization. We've made significant progress on our multiyear strategy and continue to deliver industry-leading operating margins and profitability. We believe there's a long runway in front of us. There are a number of secular tenants that will continue to drive our end markets, the migration from 4G to 5G, the migration towards next-generation auto, particularly electronic vehicles and autonomous driving, all of which will require significant investment in electronic design and test solutions. Globally, there's a trend towards defense modernization and moving towards more electronic means of defense. And all of that bodes well and aligns well with our key strengths. So with that, Rick, I think I'll hand it back to you, and we can move to Q&A.

Very good. Thank you. Thanks for the overview. [Operator Instructions] Neil, I want to just spend a few minutes. I mean it's very topical, and I realize there's a lot of moving parts here, but there's 2 recent efforts by the Trump administration as well as the Commerce Department to tighten up on technology trade with not just Huawei but also kind of military users, end users who have an ownership in most companies in China. But can we just kind of talk a little bit about where is this going to take us here? Big picture, Keysight has 20% of its revenues that come from China and maybe just try to tighten the risk around that 20%. Is all of that at risk? Or -- so I'm going to just kind of let you run with the question, but I'm trying to just get my arms around the risk here.

I mean there's no doubt that China is an important market for Keysight. I would start by saying that at the core level, we have an extraordinarily strong relationship with our customers in China, right? The company has been operating in China since the early 1980s, and we have a very significant local presence and have built deep relationships with our customers in China. And our business in China is really a mirror image of the broader company. We sell our entire portfolio of solutions into our Chinese customers. I mean people tend to think about commercial communications and manufacturing, but there's a big auto industry there. They're making a big push in towards EV and AV themselves. Obviously, what you just mentioned, there's the defense industry, where we don't sell the most cutting-edge technology, but we sell older technologies into the defense industry in China. And then there's the broad kind of consumer electronics, electronic industrial end markets, which also have a significant presence. So we really do sell the full portfolio into China. Obviously, we're watching the China trade situation very carefully. But with all of the interactions that's happened to date, right, with multiple rounds of tariffs; with specific trade restrictions first on ZTE, more recently on Huawei, and now with this most recent U.S. Department of Commerce restrictions on defense and used applications in China, our China business has continued to grow. It's continued to be a bellwether, really, in many ways for the company, leading from a growth perspective. And so from that perspective, the business has been extraordinarily resilient. If we look specifically at the most recent set of actions, we do believe this most recent U.S. Department of Commerce action around defense end use will likely create a headwind for us of 1 to 2 percentage points of growth as we look forward over the course of the next 12 months. But we're not going to sit stagnant. We will redeploy our sales force and continue to look for other opportunities. We've done this in the past. It's a big market, obviously, and we'll adapt and no doubt come through this [ fine ].

And so it just -- I mean 2 things. One is, and I really don't want to get too specific, but I'm going to just for a second. One of the things that was outstanding on the second set of regs was around this direct product rule and also the de minimis rule about content. And is that the most significant maybe piece of the most recent pending regulation, I mean, as it might apply to any exclusions just around test equipment sales?

Yes. I mean they've taken a similar approach, both with their Huawei restrictions as well as with this Department of Commerce defense restriction. It's really they're looking for you to evaluate solutions that have significant U.S. content. And if you have significant U.S. content, you're either banned from or required to get a license to sell those solutions in. The good news is regardless of such a global economy at this point, that there's significant U.S. content and a lot of different products regardless of who the provider is. So I think it still remains to be seen how competitively this thing is going to impact. There are going to be competitive differences in the way this impacts certain people in the industry. But as with all things, Keysight is positioned to comply with the order. And we estimate the impact to be relatively small at 1 to 2 points headwind to growth. And given the other secular trends that exist in our industry, we believe that once we get through the COVID situation, that the growth trajectory for our business continues to be favorable.

Okay. Fair enough. And just last thought here is 20% of your revenue, Keysight's revenues, say, $850 million-ish on a kind of a trailing basis is in China. Is there any scenario -- I mean we're talking about restrictions around communications, around Huawei. I mean might you suggest that the risk is narrowed to 5% to 10% of total sales versus that whole 20%? I mean is there any scenario that the whole 20% is somehow at risk relative to what the Commerce Department is trying to accomplish there?

Yes. I mean I think it's highly unlikely. Could I create a scenario, a hypothetical scenario? I probably could, but you've got to think about what that would mean for the global macroeconomy. At some point, both sides need to figure out a way to come to a cease-fire, if you will, in a way that allows the global economy to continue to be resilient. So again, we've been through this now for a number of years with various levels of tariffs and other [ restructions ]. And we really have seen, when you step back, no significant impact on our China business. It continues to grow at reasonably aggressive rates. And prior to COVID, the global economies continue to be minimally impacted. So can you create some scary scenarios? Again, it is possible, but it seems highly unlikely given the broader impact of how those things would be -- would impact the global economies.

I got you. Okay. Okay. Fair enough. And to move on, obviously, just having -- being on the back of the fiscal second quarter, and you provided some thoughts going forward around the third quarter, fiscal third. As we kind of took a look at the second quarter results, there were 2 things that were kind of COVID impacted. I mean literally, the supply impact was about $200 million, and I just define that by what went into backlog. And then there was also a demand issue that I might define it as around $70 million of revenue that gets deferred out. But let me just talk for a second around the supply side here, the $200 million that kind of ended up in backlog for future ship. What surprised many was just around the shutdowns both in Malaysia and Santa Rosa, maybe the length of the shutdown at both facilities. It just seems the closures have a longer tail than what we've seen with some other tech supply chain players. And maybe you could just kind of talk through both those facilities and just kind of speak to the impact here, which will still be felt here in the third quarter.

Yes. It's a great question, Rick. And it's hard for me to comment on exactly what's happening at other places, but I can certainly walk you through kind of how Keysight has approached the situation. As COVID started to expand beyond China and it became clear that it was going to become a global risk, we made a decision very early on that we were going to put the health and safety of our employees at the forefront and let that guide our decision-making. So in most cases, we were typically out from a couple of days to, in some cases, maybe even a week or more out in front of local legislation in terms of requiring either shelter-in-place or shutdowns of those sorts. And so on March 18, we put out a press release and announced that we were closing the overwhelming majority of our facilities, sending our office folks home to do -- for a work-at-home-type situation and essentially shuttering manufacturing for the time being. We then spent a couple of weeks making sure that we had the safety protocols in place so that when we did regain access to the facilities, our employees could restart our production in a safe fashion. So that's everything from relaying out, in some cases, production lines to allow for appropriate social distancing, putting protocols in place so that we could check temperatures multiple times a day. Dealing with logistics issues, how do you deal with social distancing when you have shift changes or mealtime? And how do you enable folks to arrive, depart and eat in a way that allows them to stay safe and at a safe distance from one another? So then beginning in April, we started to -- at various times, depending on geography, we started to regain access to our facilities, but it wasn't digital. It wasn't like 1 day you're off, and the next day everybody returns to work. We started slow, right? It might be 10% of the workforce coming back at the beginning, us getting some production turned back on, testing these processes and then slowly ramping the presence on the site to the point where we are now, where we have 100% of our manufacturing-based employees back on-site in our Penang, Malaysia facility. And we're at or rapidly approaching 100% of our internal capacity in Santa Rosa and some of our other manufacturing facilities around the world. The employee population -- manufacturing employee population is closer to 70% as sort of the capacity levels. We continue to ramp production as we look forward. We're working with our subcontractors to similarly match our production ramps. And then we're working with our suppliers to ensure that we have the piece parts that are coming in that are necessary to manufacture our products. We are, in some cases, seeing lengthening of lead times for piece parts. And so our supply chain experts are working with our suppliers to kind of just attack the long pole in the tent, work with them to remove those supply hurdles and then move on to the next one. And as we've said, we do expect our supply chain to continue to be impacted through the third quarter. We expect third quarter results to be more or less in line with the second quarter, which is, again, revenues in the $900 million range and operating margins in the very high-teens. But by the end of the quarter, we expect that ramp to be largely complete, and we expect to be back at or near 100% of our pre-COVID capacity. So that's how we're approaching it. And again, as you noted, the demand impacts were much more muted than the revenue impacts. We put a lot of dollars into backlog. And I think we're convinced that we made the right decisions: Put employees first. Make sure that we're doing the right thing for the long-term safety of the business and recognizing that, that backlog will convert to revenue eventually and the dollar that I don't get today is the dollar that I get tomorrow. And so we could afford to be patient.

Yes. Yes. So a little bit more self-imposed because again, I had one client just say, "How in the world can Keysight not be an essential business?" But this is -- but again, the shutdowns here are a bit more self-imposed based on internal concerns around employee health and things like that.

And we did see that. In certain instances, we had kind of second tier. It's much more that our customers were essential businesses, and we were essential to them, right? So it was kind of one step removed, but there were -- some of the first places that turned back on were for places where we're actually providing tools into the health care industry. And those folks needed material from Keysight to continue their work, and those were amongst the first places that turned back on for us.

Okay. All right. And then I was -- again, the second part of this is, again, that's kind of the supply side. Maybe we cover the supply side, supplies, COVID-related issues. The one thing that kind of strikes me, though, is there is COVID impact on demand. I think you touched on it in auto and general electronics and education. And again, we're all kind of looking at the same thing here in terms of what the re-ramp might be in those industries. But is it fair to say that that's -- maybe those industries from a demand standpoint that have been impacted by COVID might be 30% of revenue? And that we have to maybe run with a negative kind of -- or a decline in those businesses for 6 to 12 months? Is that the right way to try to separate the 2 end market exposures?

Yes. I think everything is relative, Rick. I'd be hard-pressed to say that there's any place that has had zero impact, right? Across all of our industries, we've seen R&D engineers move to a work-from-home environment at least for periods of time. I think we've definitely seen businesses be more resilient. 5G, we saw very strong double-digit growth in 5G within the quarter. We saw strong semi business. And then we've seen businesses that have been relatively more impacted. But again, I'd be hard-pressed to say that there was zero impact really anywhere. It's hard to know the depth or the length of how long these things were going to go. I guess I would say 2 things: While we did see our order rates slow really in the back half of March and certainly through April, as we said on our earnings call last week, we have the strongest funnel on a dollars basis, dollars in the funnel. We have the strongest funnel that we have ever had, right? What we're seeing, I think, is caution on behalf of our customers that given the background certainty and certainty in their own businesses, that the conversion of that funnel to orders has slowed a little bit over the last 6 to 8 weeks. And so we don't know is when that reacceleration occurs. But I think from Keysight's perspective, we were a market leader when we went into this. We have the broadest portfolio of electronic design and test solutions. We've been taking share in the last 4 or 5 years consistently. And we have a strong business model that's allowing us to deliver strong profitability and cash flow even in these troubled times. And so that's going to enable us to keep our foot on the gas from an investment standpoint. And we're not in this alone, right? Everyone's going through it. But given our strengths, I think we feel like it's highly certain that we'll come through this stronger at the back end than when we went in.

Okay. All right. And then I just want -- just a couple of quick questions on the software. I mean the software expansion in terms of revenue at Keysight has been quite dramatic and just a great story. I think now we're kind of referencing software at about $800 million of Keysight's revenue. And just 2 things: One is, as quick as you can, just the role of PathWave in the software growth. And then also, when you look out 3 to 5 years, what percentage of Keysight's revenue does translate into software revenue?

Yes. So there's a couple of things in there. As you noted, we've grown our revenue from -- our software revenue from the mid-$300 million to over $800 million over the course of the last 5 years. And so we're making great progress, and it continues to be an area of focus for the business. I think if you look at our revenues today, PathWave is still having a very small impact. We're -- I would still say we're in the infancy of what PathWave can be for us. What we're designing is a tool that ultimately is going to connect the workflow for our customers' design and test workflows so that they can move efficiently and quickly from designing products and software to prototyping and validating those prototypes to manufacturing and then ultimately optimizing post deployment. And we are just starting to bring out what will eventually be a full suite of tools in the PathWave platform. And I think PathWave is really going to have 2 impacts for us: First is the ultimate increase in software sales because of the effectiveness of this tool that we bring into the marketplace, but it's also going to change the way that we sell software. So of that $800 million plus that we sell in software today, still more than half of it is sold on a onetime or perpetual basis, with the other less than half being time-based sales. And we're going to migrate using PathWave largely as a platform to help us make this migration to the point where the overwhelming majority of our software is sold on a time-based or subscription-based method. And so that's a big opportunity for us. We have not put out a specific goal as far as how big software can be. We always said is that software has outgrown the overall company, and we expect it to continue to grow at a rate that's significantly above the company average. I think it's also an area of focus. And as we look for potential M&A targets, our M&A search, if you will, is increasingly biased towards targets that have high software content. You saw that with Anite and Ixia. You saw it with our recent acquisition of PRISMA. These are all assets that have above-average software content relative to the Keysight core, and I think you'll see that trend continue as well. And so I don't think there's really any end in sight in terms of our ability to continue to grow software.

Okay. And then, Neil, I just want to flip over here to the Communications Solutions Group and just a couple of questions around commercial comp spend. And obviously, as we've started to deploy infancy stage but networks globally around 5G, there's puts and takes around the adoption of sub-6 and millimeter wave. And there's some combination of the technologies in many systems. But how does that change the 5G opportunity set for Keysight, whether it's infrastructure, device? Maybe just throw -- put some color around that as where we might be in these multiple spending cycles down this path of 5G networks.

Yes. The 5G opportunity is really exciting because of the complexity, right? You've got a number of different vectors that you touched on, right? But we're looking at kind of 4 different flavors of 5G. You've got non-stand-alone and stand-alone versions. You've got sub-6 gigahertz and high-frequency deployments of 5G. And you've got in individual regions of the world likely to go through multiple different versions of 5G. Certainly, we're seeing a lot of folks start with non-stand-alone and start with sub-6 gigahertz deployments. We're -- and certainly, we know just to get the true performance advantage of 5G, you ultimately need to migrate to higher frequencies and likely to stand-alone versions as well. And so you're going to see multiple deployments in individual geographies. That's going to serve to lengthen the overall cycle. Our business at this point is still heavily skewed towards R&D. I think it's probably underappreciated, the balance that exists between sub-6 gigahertz and millimeter wave because in the R&D lab, people have been and continue to work on millimeter wave even though it looks like these millimeter wave deployments are going to follow the early sub-6 gigahertz deployments. And it's also worth noting that this 5G solutions that Keysight put into the marketplace for sub-6 gigahertz are all upgradable to millimeter wave. So that provides a nice progression for our customers, but it also provides a nice future revenue stream for us as we move forward. So we have a long runway. We serve the entire ecosystem, as you mentioned, from components and chipsets, to handsets, to base stations and service providers. But you can even take that beyond that into the wired network because as 5G deploys commercially and you see the rapid expansion in data traffic, it's going to cause a need to have a wholesale upgrade to the wired network as well. And with the tools that we brought on through our acquisition of Ixia, we now have ability to service that entire wired side of the equation as well.

For Keysight, as you look at these waves of spend around R&D, around validation, manufacturing, more dollars typically spent on the validation or manufacturing side, just dollars, maybe not as high a margin. The margin pool is not as great. But just -- the question is does Keysight have the same opportunity set as spend moves into the manufacturing and validation test phase that they have in R&D.

Yes. So I'd say 2 things. First of all, I'm not even sure that I agree with your premise. I think if you look at the entire 10- or 12-year cycle of 5G, I can make a pretty cogent argument that the dollars spent on R&D are at least as big, if not substantially larger, than the dollars spent in manufacturing in aggregate. There certainly will be years where that is not true. But over the entire cycle, we continue to believe that the real prize is the R&D price. It tends to be far more stable, far longer lasting, higher margin, as you mentioned. And there's an awful lot of dollars that are spent there. But to get to your second part of your question, we believe that yes, Keysight has an equally strong value proposition on the manufacturing side based on our strength in R&D. We provide our customers with an ability to have consistency of test algorithms as they migrate from R&D to manufacturing. We have manufacturing-based tools, again, across the ecosystem for handsets, for components, for base stations. We have solutions that are peaked for manufacturing. And so we would expect to do very well on the manufacturing side of things as well.

And when you wrap this R&D and manufacturing validation, when you wrap these dollars together and in the context of what you just said, 10- to 12-year cycle, give us an inning here. So we got kind of a 12-inning game. We're kind of an over time here, but just give us an inning in terms of dollars spent.

Yes. I don't know, maybe third or fourth inning, something like that.

Yes, yes. Okay. Okay. And then I just -- I have to -- I have one question here. And just to quickly summarize, it appears -- is the priority shifted dramatically around spending on 4G upgrades versus 5G? And I think the gist of the question is, has 4G spend falling off quicker as we move down this path of spending on 5G?

It's a hard question to answer, Rick, because up until the most recent quarter, our 4G spend had been quite stable. If it was declining at all, it was in the kind of the low to mid-single digits over the course of, say, the last year. We definitely did see an acceleration of that 4G decline in our second quarter. The question is, obviously, it was a highly tumultuous quarter and remains to be seen whether we can read anything into that at all. I mean those R&D engineers are still at work. They're still going to continue to need tools, but if -- on a 1 quarter basis, we did see an acceleration of the decline in 4G in our most recent quarter.

Okay. All right. And with that, running a bit over here, so I'll end the session here. So thank you, again, Neil. Thank you, Jason, and thanks to everybody for joining the call. Have a good day.

Thank you, Rick. We really appreciate it.