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

Great. Thanks very much, and welcome, everybody, to the Stifel CSI conference. We're fortunate to have Keysight Technologies with us today. We have Satish Dhanasekaran, who's the Senior Vice President and President of Keysight's Communications Solutions Group. We also have Jason Kary, who's Vice President, Treasurer and Director of Investor Relations. I'm going to ask Satish just to start off with a brief overview of the Communications Solutions Group for those investors who may not be as familiar with Satish's role, and then we'll jump right into some Q&A. So Satish, if you wouldn't mind just spending a moment or 2, sort of giving everybody a quick overview of the Communications Solutions Group, I would appreciate it.

Yes. Thank you, John. Again, appreciate the introduction, appreciate having us here. It's -- as you mentioned, I lead the Communications Solutions Group, roughly $3 billion business in Keysight, focused on 2 different end markets: commercial communications and aerospace defense. The common theme being, we offer communication solutions to both customer sets, diverse end markets, diverse set of customers, significant ecosystems where there is considerable innovation and change and disruption happening, especially with the big theme of digital transformation that is really changing the innovation paradigm for customers. And even through this COVID difficult phase, we believe that communications have really taken a higher priority with our customers, especially some of the new technologies such as 5G on the wireless side, 400 gig on the wireline side, security in networks and communication and defense modernization. All of these are areas we have invested in for a number of years, and we're on the front end of delivering significant value for our shareholders. We also believe that number of these trends will play out over multiple years, and we're on the -- our solutions transformation that we affected in the organization that's not just about products, but really focusing on our customers and offering differentiated solutions, creating greater differentiation and value for our customers that we're able to now capitalize on. I've been in the communications technology industry for over 2 decades and in my role for a bit over 3 years now. And as we look ahead, we see considerable opportunity that I look forward to getting in to you with more detail today.

Great. And then maybe as a transition, Satish, could you just spend a few minutes maybe updating investors on where the operations stand as we're coming out of COVID. You had several shutdowns as a company. Maybe whether that disproportionately impacted your communications business, but how, I guess, you're looking at the next several quarters as you come back up to speed on the operations side?

Yes, I think on the operations side, I think the team is pretty consistent across the company, both business units, CSG and EISG. The first thing that we did, John, was to make sure that the health and safety of our employees remains a top priority. It is the culture and the values of the company that allows us to lead this way with a long-term focus. We took proactive measures to ramp down our operations across all the major sites and ensure thus to have procedures and guidelines in place before we reopened. And while that did have an impact in the near-term quarter, I'd say, on the demand side, some of the themes such as 5G, 400 gig, defense modernization have continued to be very strong priorities for our customers. I mean, the engagements with customers through this COVID phase has remained very consistent and strong. And I also want to add that our customers are also faced with challenges because they have to configure their teams and work from home. But their higher priority is to keep their R&D workforce productive. And this is an area where we are making a significant contribution. In fact, a number of our customers have been classified as essential services in their parts of the world. And so it's our priority to keep them fed with supply and also capabilities that they need. And I think this will enable us to -- this will position us to recover stronger as the market rebounds from COVID. So the demand side, I would say, for the Communications Solutions has remained consistent and strong and when we -- when you start to think about the outlook, as we look ahead, we continue to believe that demand for 5G, especially as China is ramping back up, will remain strong. For aerospace, defense, the U.S. DoD's actions for supply chain robustness will keep that business strong as well where we see weakness in the international business for our aerospace defense, which tends to be broad and where different governments of the world have been diverting the funds to COVID recovery efforts. But for our business, I think the #1 priority is, obviously, our employees were safe and making sure that our operations ramp up to -- through Q3 in a very stable manner and in a sustainable manner. And looking beyond that, we're continuing to invest in these key technology areas with our customers so that we're able to come out of this stronger than the position we were in.

On that demand side, specifically looking at it a little bit more geographically, China obviously comes up as a frequent question with investors, just given the high teens exposure in terms of a percentage of sales that, that geography represents. I'm just curious if you can comment at all about maybe how the China business specifically has been trending? Within comms, obviously, they were a little bit earlier in 5G as well. And I guess, secondarily, if you're seeing any of the impacts on some of the recent trading tensions that may hurt the business in your area or even overall?

Yes. So that's a really good question on outlook or demand projections from China. I would say what we're seeing is for, let's say, the first -- China, obviously, went into the COVID starting in December and has been -- but our business in China has continued to be strong. And if you look at the commercial communications group, we see 2 dynamics, right? 5G acceleration in China is a positive and a favorable dynamic for us, and that was favorable before the COVID and it's continued to be favorable there as the China Mobile, China Unicom and China Telecom have all laid out plans for accelerated deployments of 5G. And in fact, this year, China is on track to deploying over 500,000 base stations, 100-million-plus 5G-enabled smart devices. So all that is a favorable dynamic. On the wireline side of the business as well, there is a big push in China for indigenous capabilities and manufacturing. And that has really been a driver for our 400-gig business this year, and it continues to trend favorably. The automotive, obviously, has been down across the globe, and it's been down in China as well. And then if you look at the broad general electronics business of ours at the company level, the education end markets have been impacted equally in China, too. Specifically, as it relates to the U.S. DOC regulations that you mentioned, based on the recent regulations, we expect a 1% to 2% headwind that we've already disclosed as we move forward. And there is some uncertainty to what that impact might be to the semi suppliers in China. Our semi business continues to be strong at this point. With respect to Huawei, we'd already factored in a decline in the Huawei business that Neil had already mentioned before on the calls. And I think that's trending in a similar trajectory as we had that forecasted. When it comes to the most important thing, which is our engagements with customers in China, it continues to be strong. And I'm also confident about our abilities to reconfigure our team in the region to focus then on the opportunity that lies ahead. And it's a big opportunity in the region that we're engaged with. And so given our lead in a number of these technology areas, I continue to believe that we're well positioned in China, but more importantly, across the globe for our portfolio.

And maybe that's a good segue, Satish, to a broader question on competition. But even, I guess, specifically in China. I guess, one, do you worry about sort of an anti-U.S. sort of focus with customers within that region trying to find vendors that are not U.S. based? And I guess, more broadly, with companies like Anritsu and Rohde & Schwarz finally, sort of, coming to market with some of their 5G test kit, I know they've been late certainly compared to Keysight, but how do you think that sort of competitive dynamic plays out over the next 12 to 24 months? So particularly around 5G, do you worry that whether it's second sourcing or those impacts might have a negative impact on your growth?

I would say that the diversification strategy for supply chain is not a new one. I think customers across the globe practice that as a case in point, we only have 25% share in our end markets that we serve. But we're #1 in our end markets. And where we are playing, such as in 5G, where we've invested for leadership in 5G, 400-gig and other areas such as AV, EV, we have a differentiated advantage that we offer to customers that I think is a compelling value proposition for us, and it plays out in different parts of the world. The other dynamic that's important, John, that maybe is not obvious is many of our customers have a global footprint for their business. And the geopolitical situation right now is causing, as you've pointed out, considerable uncertainty in this marketplace. But still our customers serve a global market, including the customers in China who are often follow global standards that they are involved in for their innovations. And so they're looking for a partner that gives them the advantage, right? And we are that trusted partner for them. And whether on the fringes, they look for some diversification plays with other competitors you mentioned, of course, that will be the case. But I think when it comes to selecting a partner, they often make a multiyear sort of a look and see who's in the lead and who has the best ability to scale for them because that's the advantage they seek when they engage with a design and test partner. And I think from that point of view, our value proposition continues to be strong. As a case in point, our 5G business grew in the most recent quarter across all regions including China as well and across all parts of the ecosystem, which represents the different customer sets we talk about.

And then I guess, just more broadly speaking, Satish, if I think about 5G globally, China has obviously been one of the early adopters of it and pushing hard to get it established. But if these bans on Huawei in particular take hold, do you think it has a negative impact on the pace of 5G adoption globally? And would that then filter down into a slowing of your test business in 5G? Or are those 2 sort of disassociated at this point in the cycle?

Yes. I think it's -- John, it's very hard to maybe make a definitive statement on this. But I would say that we're -- when I look at the entire ecosystem, there are enough customers we serve in the commercial communications, enough customers that represent the diversity of -- across the ecosystem, while our business from different customers ebb and flow over time. We think it's a very robust ecosystem that we serve. And therefore, the sum total of customers will continue to represent a bigger opportunity for us as we look ahead. When it comes to, let's say, the specific segment you mentioned on the base station front with Huawei, we do see, not only the traditional competitors, such as Nokia and Ericsson that in Europe, but also the emergence of new technologies and new innovations such as open RAN, that has just come in. And open RAN stands for open radio access networks, which is really all about virtualizing the radio access network and taking a more of a disruptive software-defined approach. And this has brought in newer players into this ecosystem such as Mavenir, Altiostar and other customers for the first time, more software-centric approaches, which really enables our differentiation, which has been -- the shift we made from hardware to software-centric solutions, a better fit for customers as we look ahead. So when I study the opportunity landscape for 5G, despite these changes that are happening in customer sets, I see no material change to the opportunity progression I laid out at the Investor Day. We see steady demand for R&D solutions and for R&D investments in general across our ecosystem, given the innovation dynamic remains very strong, and customers are in a race to differentiate. And I think that fits our strategy very well. Our select manufacturing strategy will capitalize, and it's already showing signs we're well positioned in component and base station manufacturing. And then this proliferation of new use cases will -- across multiple verticals that will now take advantage of 5G is a further opportunity for us that we're well positioned to take advantage of. So in summary, I think we have a lead in 5G, and we're investing for continued leadership in that space.

Great. And then maybe following up on that question, Satish, how do we think about where we are in the 5G cycle, specifically for Keysight? Obviously, we've had some very strong growth, particularly in 5G lab, but it still seems to be primarily focused in sub-6. We still have millimeter wave, I would think, in front of us, to some extent. So can you characterize maybe where we are in this market? And then maybe also just spend a minute on sort of the difference between lab test and production test. And as we start, as the technology starts to move a little bit more into that production and deployment phase, how we should think about, sort of, your growth or exposure to those phases changing as well?

Yes, that's a multidimensional question, but maybe I can start by just taking a look at what's going on in the industry first, John, and say if you look at the deployments today, they're largely driven by sub-6 gigahertz and nonstand-alone versions of 5G with a clear road map in the industry that's forming to adopt higher frequencies for greater capacity needs and then moving towards stand-alone version of 5G for lower latency networks of the future. So there's clearly a road map that the industry is working towards. Compounding that or in parallel, I would say that there is continued work on 5G standards from at Release 15 to 16 to 17. While some of that has encountered some delays largely a few months of delays and pushouts because of having to do this remotely, but largely that innovation dynamic continues to be strong. And in parallel, there's also the whole wireline evolutions from 100 gig to 400 gig. Now folks are starting to think about 800 gig and terabyte -- terabit networks of tomorrow. So I think there's a healthy pipeline, both on wireless and wireline evolutions that I think is a favorable dynamic for us from a -- so that's sort of our market landscape. And when I think about what that means for Keysight is, we see steady demand R&D. Our customers in this industry and ecosystem are going to continue to want to innovate and get and differentiate. And that creates an opportunity for us, and it's a sweet spot because we've invested for this. All the organic investments we've made, combined with the acquisitions that we have made of Anite and Ixia and PRISMA have really positioned us to offer complete solutions to this industry and especially in R&D. From a manufacturing point of view, we've taken a select approach. We've taken our modular platforms, and we've deployed it for component and base station manufacturing where we continue to progress that opportunity very well. And as the industry scales, I see opportunity. The other opportunity that's created from this geopolitical situation that we have today is the fact that our -- number of our customers are now pursuing a diversified supply chain strategy, where they may be having more factories in different parts of the world. And that creates additional capacity adds in production that I think could be an opportunity that plays out in the next 12- to 18-month time frame as we emerge from COVID. And then the next opportunity that we think is pretty significant is as the 5G networks gets rolled out, there is this entire move towards, let's say, use cases or applications, and so we continue that progression on that stack, and we're currently using a lot of our capabilities acquired from Ixia around security and cloud to really continue the progression of our portfolio in that direction. So when I put it all together, I see the next 3 to 5 years to be a rich opportunity in front of us that we're investing for right now. And we have some exciting road maps that we're working with customers on that I think would position us very favorably in the marketplace to win.

You touched on something there, Satish with Ixia that I just want to follow up on. You mentioned sort of as 5G continues to maturity, we think about, sort of, the application opportunity over time, and obviously, you've got the -- the physical layer test, or what I kind of think of as the more traditional, sort of, Keysight business, you've made those acquisitions in the protocol test phase, whether with Anite or something along those lines. But as you think about moving more into the application space for 5G, does Ixia give you what you need to sort of really compete there? Or should we expect that over time, that is potentially, maybe, an area where we're likely to see some more M&A activity?

Yes, I think that's a good question. What Ixia allows us to do is gives us tremendous credibility in the wireline space. And with the acquisitions we made in the wireless space, we're the only player that allows us to stitch that wireless to wireline convergence of the networks in the context of 5G. So it positions us well. The capabilities we derive from the acquisition are largely around network test and security and network visibility. So these are strong foundational capabilities that allows us to continue that progression higher in the stack. But we're also, as Neil has pointed out as capital allocation priorities to the company looking for acquisitions in the application space that would enhance our portfolio and allows us to continue our leadership in the 5G space as the action shifts from pure R&D and then deployments to then the application or use cases.

Right. So when you decided, I guess, a few quarters ago to move that Ixia business under your umbrella rather than having it be, sort of, a stand-alone business that was run, was it with this migration towards, sort of, that application focus in mind? Or was there something else within that business that provided synergies for you to that where it makes sense to have it come directly under your control?

I think the wireless to wireline convergence that we see occurring is definitely a very powerful vision that's -- that I think we saw at the time we acquired Ixia, and the first phase was obviously to bring and stabilize them, upgrade the platform. So there has to be that work done. With that being completed, the next phase of this was to really realize the customer synergies that occur and start to position that to growth, and that's exactly the phase we're currently in. And I'm very pleased with some of the work that's underway between our teams. And as the teams interact more, we continue to uncover more and more solution opportunities. We've already launched a few of them that are doing well. And especially during this COVID time, I would say that some of the tool kits from Ixia that we just launched, 1 of them was a VPN test solution, is really enabling customers to test their VPN infrastructure. Working from home, all of us are now having to rely on our VPN infrastructure for secure communications. We're also engaged with a number of defense organizations across the world because they are having to figure out how to work from home for the first time, and now their IT infrastructure has to evolve. So I think having that capability in one group gives us the ability to address more of the market. And especially in the COVID environment, I think we find that the communications is becoming a critical priority, more critical in today's world than it was pre-COVID.

Right. And then I guess, again, just following on, on that, the applications push. It seems like that piece of it dovetails nicely with sort of the overall corporate strategy of increasing the software content and the more software and service or the recurring revenue piece of the business. Can you talk a little bit more broadly about sort of the impact that we should look for that increased recurring piece of business to have, not just on visibility, but maybe on margins as well?

Yes. Let me maybe take a crack at this, John. Let me know if maybe, Jason, you can join in as well. I think at the highest level, we have about $800 million in software revenues as of 2019. And that's significantly up since we started the company, as you know. And it's been a focus for us to grow our software faster than the rate of the overall business. And I think that's -- we're well positioned to do that. If you think of the 5G technology stack that we have built up and you just look at the diagram laid out in our Investor Day pitch, you'll see the sheer layers of software content that we keep generating. And as we look ahead, the road maps for that continue to be very robust, and it's often based on customer pull. The customers that we've been collaborating with are taking us in these directions. And having a platform approach really enables us to be successful. Many of our software solutions today, I would say that the software content in 5G, especially, is roughly in many of our software solutions running at 40% of the total sale for the customers. So that's sort of on the higher end and an example of what's possible through this solutions transformation and paints from where we are today, which is roughly 19% to where we want to go in the future. And along with that, obviously, comes the improved margin. And Neil has already laid out those targets at the Investor Day, the long-term targets for gross margin and operating profit targets based on the content. As far as the recurring basis, less than half of our total software today is of the recurring kind. And we have a strong push, especially as we have deployed these 5G solutions, for example, to shift more of our software into subscription-based capabilities. And that's actually a good model for our customers because of the way we interact with them today. We interact with our customers through software releases 1 or 2 times a week, which is very different than maybe a perpetual sale where we just created a product and sort of upgraded it once or twice a year. So it's a very agile model. And so our subscription capabilities are a better fit for our customers. And so there is a pull from customers as well for more of this type of interactions. And all of this is enabled by the vision for PathWave that we laid out. It is connecting our customers' workflow, but also changing the business model in the way we engage with them.

And then, I guess just over the short term, obviously, the model has proved to be fairly resilient. Despite a nearly 20% decline in revenue, operating margin was only down about 600-plus basis points. Is there any reason, I guess, over the next several quarters as we start to get back to a more normalized environment, that we shouldn't expect those margins to trend back up to where they were? Or, I guess, has something changed as a result of some of this that you either have some increased expenses as you're bringing everything back online things like that? Or do you expect that these margins come back pretty quickly as revenue moves back up?

No. As you've seen through our software-centric transformation that we have made, our gross margins continue to be very sustained, and you've seen very strong gross margins in the most recent quarter, where our revenues were down roughly 18%. So as we ramp back up, you should expect that model to play out. There's no change to the model at this point. And all of this is enabled by a relentless focus on the Keysight leadership model that we implemented a few years ago.

And then specifically within your business, when you look out longer term, the next 3 to 5 years, let's say, you guys have made some recent announcements about investments in areas like 6G and in quantum computing. When you think about how your business maybe evolves over the next 3 to 5 years, what areas, I guess, are you most excited about? And how should we be sort of measuring against some of these newer opportunities that you guys are clearly focusing on for the longer term?

Yes. You're basically asking what am I most excited about. I think a few things. This application layer progression. I think that's something that'll play out for the long run. And we're on the very, very early innings of establishing that, and I talked about that a little bit. I would also say 6G and quantum are other powerful drivers that are playing out. 6G is a more, let's say, a natural evolution of 5G, but takes us into the higher frequency domains than what it is today and I think the next frontier for connectivity. And I know it takes 10 years potentially, but things tend to happen sooner from our experience of 5G. So we're investing for the future there. Quantum is another area, which is a leapfrog of technology for the next-generation of computational needs. And there's one thing that COVID has -- with the COVID situation, clearly, there is more emphasis on bringing AI, machine learning capabilities. And quantum computer could really be one of the potential solutions. So I think there will be more investment in that space. So across our end markets, when I look at the multiple themes that are playing out, Keysight is well positioned to be making contribution consistent with our mission to accelerate innovation to connect and secure the world. And the capabilities that we now have in the company position us very well to have offerings to enable our customers to lead us to other opportunities. So it's a very exciting time as we've -- as we navigate through COVID, that our innovation in the company continues to be strong, our customer engagement continues to be strong. And that, by far, is the biggest source of differentiation for us, is the strong customer relationships we continue to maintain.

Well, Satish, I really appreciate your time with us today. Unfortunately, we are out of time. So thank you again, and best of luck as you continue to move the business forward.

Thank you.