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

Hello, everyone, and thanks so much for joining us here today. My name is Jim Suva. I'm the IT, hardware and telecom equipment analyst here at Citi Investment Research. We're very pleased with this fireside chat to bring Keysight Technologies to you, ticker KEYS. We're highlighting today's discussion and interaction with the Chief Financial Officer, Neil Dougherty. We also have Jason, who's also for Head of Investor Relations, who may come in if there's any more detailed questions, but the majority of the time will be between myself and the CFO, Neil. We do want to note a few things that there are disclosures for Citi Investment Research associated with this. And if you're a MiFID II customer or investor, please make sure you have your MiFID II agreements in place. We do want to note, this is not for media and not for press. We do ask if you're media or press to please immediately disconnect, and if we notice that you're still on the line, we will disconnect you as we go through the lineups of everyone who's connected.

So Neil and Jason, thank you so much for joining us here today. And I got to say, boy, it's quite exciting and interesting times, all the way from fires in Northern California or all across California to power outages to a pandemic. So why don't we start things off, Neil, by talking big picture about demand trends maybe as you sit there as CFO, say, for the next 6 to 12 months. And how have they changed versus prepandemic and where you sit as CFO?

Hello? Now? Hello?

Yes. Now I can hear you great. Please proceed.

There we go. Now we got it. Okay. So I was saying that I think we've been pleased with the way the business has performed over the course of the last 6 months from a demand perspective. Our order rate has been down kind of low to mid-single digits, but given everything that's been occurring in the broader macro economy, we think that's pretty strong performance. And one of the things that's contributing to that is the kind of the underlying growth themes that are driving our business around 5G, around semi, around aerospace defense modernization. Those trends are continuing and are providing some buffer from the broader market exposures that are impacting a large swath of industries. I think as we look forward, obviously, the COVID situation is highly uncertain, but I think our strong operating model is allowing Keysight to deliver strong profit and cash flow, even in these uncertain times. That's enabling us to keep our foot on the gas from an R&D perspective with regard to our sales investments. And we believe that we're going to weather this COVID storm, if you will, better than anyone in our industry. And so we should be well positioned to capitalize on a macro recovery when that comes. And so it's hard to know exactly what the shape or the timing of that will be, but what we're focused on right now is being ready for that recovery. And again, I'd point back to things like 5G where, clearly, the investment is continuing. I'd point to some of the things that we've had underway to migrate or to grow our software and services revenues. Even as our business has come under the pressure under the last couple of quarters, our software and services revenues have continued to grow. So those strategies have proven to be very successful, and they've proven to be very helpful in helping Keysight weather these uncertain times surrounding COVID.

And Neil, how has -- the pandemic, has it shaped the underlying drivers at all for your outlook for your end markets, whether it be -- all of us are doing this from our home today. We couldn't meet in person live. Any thoughts around that? Because I know you have such a strong amount of business in the research and design and development phase of products incubation.

Yes. I think over the longer term, we believe that the broader trends for our markets remain sound. We view this as more of a short-term perturbation. Obviously, the folks -- the fact that people are having to work from home can create some challenges in the case of hardware engineers that maybe don't have access to labs. But if Keysight is any indication, we're in the same situation. And after we got through those first couple of months, we found ways to get folks onto our sites, into the labs, even if we're having to rotate them through to make sure that we're able to keep R&D programs moving forward. So I think people are finding workarounds or finding ways for their engineering teams to be effective, which is important for us. And then the competitive environment around things like 5G is essentially necessitating that folks continue to press forward and put -- keep your foot on the gas because nobody wants to fall behind competitively. And so from that perspective, I think we're okay. There certainly are impacts. If I look at the automotive industry, as an example, that is one where if we look over the longer term, we believe that the opportunity is a great one for Keysight as that industry moves towards electric vehicles, towards autonomous driving. Those are transitions that are going to play -- is that the installed base turns over, over the next several decades, right? It's a long runway. But given the impact that this current macro environment and COVID environment has had on the auto industry, we have seen a pullback from those customers. But again, we view that more as a short-term perturbation. We believe that, ultimately, they get back towards their significant investments and making -- bringing these technologies to market, and it remains a strategic area of focus for Keysight. So we remain heavily engaged with that customer base even as their spending has softened a bit, and again, believe we're well positioned to participate fully in any recovery.

Neil, you mentioned lots of things that are going on, which is truly dynamic, which is true. Could you or Jason just kind of remind us what's normal seasonality between 3 and 4 on sales and, say, orders? Is there such a thing as -- should we make some adjustments or think about it? I mean we've got trade tensions, we got coronavirus, we also talked about Huawei. Anything we should think about? Because you gave some laundry list of some challenges. I'm trying to think about what's normal for sales and orders and how we should think about it.

Yes. So we do have a normal seasonality that we think about when we're planning our own business. It's -- yes, it would certainly seem that there's enough going on at this point in time that normal seasonality is likely to be disrupted. But what we would typically see is our strongest quarter from an order perspective is currently our fiscal fourth quarter, which is our quarter that began for us on August 1. We then typically things -- see things soften sequentially as we go into Q1, strengthen again in Q2, soften a little bit in Q3 and then re-ramp up. So you typically see, Q4 is our strongest quarter. Q4, typically our lowest quarter. And then with Q2 being above Q1 and then a slight dip down back again in third quarter, if that makes sense. Again, a lot going on at this point in time that could potentially cause actual results to be different, not only COVID but trade, as you mentioned that as well, are some of the things that are impacting that. But demand remains strong. We do have a fiscal year-end coming for the government as well, which tends to be beneficial for aerospace defense orders during this fiscal fourth quarter. If you think about the way -- another driver is -- happens to be just an internal thing about the way our sales force is compensated. So they work against 6-month quota targets, so with quotas maturing at the end of our second quarter and fourth quarter. So there's an incentive for them -- a financial incentive for our sales force to get orders in at the end of each of our halves. And then I think that contributes a little bit to that seasonality, which I previously outlined.

Neil, last year, I remember you and I were at a dinner that was oversubscribed, and I talked about how Keysight is a beneficiary from the 5G cycle, and you just kind of nodded your head and agreed with that. Can you talk to us or give us any granularity about where are we in the 5G cycle? I think Keysight has a lot in the R&D test area of the 5G cycle, whether it be on the base stations or the products. And can you think about the evolution of the 5G cycle and how it impacts Keysight?

Yes. So we continue to believe that we're very early stages in 5G, that there's an awful lot of runway in front of us. There's certainly a lot of development work -- research and development work that's happened over the course of the last, let's say, 5 years. But in terms of broad scale deployment of 5G networks, I was talking to some investors earlier, and none of the folks that were on the phone knew somebody who had a 5G device in their pocket and could actually use it on a 5G network on any type of reasonable percentage of the time. And so if you start to think about global deployments of 5G networks, it's still largely in front of us. And then we believe that the 5G opportunity is likely to be longer than prior generations because of the complexity, right? We're looking at both stand-alone and non-stand-alone versions of 5G. We're looking at sub-6 gigahertz as well as high-frequency millimeter wave deployments of 5G. And you're looking at individual service providers or countries likely going through multiple different deployments. They might start with a non-stand-alone sub-6 gigahertz deployment with an ultimate plan to migrate to a stand-alone millimeter wave deployment of 5G so they can enjoy the performance advantages. So beyond those complexities and those iterations of 5G deployments that are going to add longevity, add complexity, add design cycles and, therefore, market opportunity for Keysight, we also have the fact that the 5G deployment is expected to enable other industries to capitalize on that wireless network. So prior generations, 2G, 3G, 4G, have almost exclusively been about the cellphone and the cellphone industry, whereas 5G is going to enable things like industrial IOT, Industry 4.0, V2X communications for automotive, and you're going to have these industries beyond the cellphone that are going to look to capitalize on the networks once they're deployed. That also serves to lengthen the opportunity and to create additional revenue opportunities for Keysight. And the final part that I'd like to touch on is a portion that is really new to Keysight because of our acquisition of the Ixia business several years ago, and that's the fact that the 5G deployment, once it's commercially deployed and we see the dramatic increase in data traffic that's expected, it's going to require a complete reworking of the wired networks as well. And now Keysight is positioned to participate fully in that wired network modernization that's ultimately linked to 5G deployment as well. So again, we're sitting here. There's a lot of work that has happened to get us to where we are. But in terms of actual deployment and commercialization of 5G, the opportunity really lies in front of us. And so we're very excited about what lies ahead for Keysight from a 5G perspective.

And Neil, you've been outgrowing the market, and the market has been growing faster than expected, or at least faster than normalized long-term rates. I'm sure 5G was part of helping that, but when should we think about -- people are asking about when will sales peak as far as the growth rates, or the 5G cycle actually peak?

Yes. It's difficult to know because as I just said, it's going to be a very long cycle. There are a number of different aspects that are going to serve to lengthen that. We do think that different geographies, different service providers are going to roll out 5G at different points in time. It doesn't all happen serially. Handsets, a lot of the handsets that are coming out and hitting the market today are relatively low-volume, high-priced handsets. Unless you're one of these tech early adopters, there's not a lot of reason to go out and spend the money to get a 5G handset because chances are you don't have a network that you can access. But over the course of the next several years, you're going to see multiple geographies, multiple service providers start to deploy 5G commercially. You're going to see handsets move from these lower-volume initial handsets to more higher-volume, mass-market handsets, and that would lead you to believe that maybe there's some sort of a relative peak as those things start to layer on top of each other in the 2023-ish kind of time frame. But even that is uncertain because we don't yet know how these other industries, I've talked about V2X communication and Industry 4.0, are going to leverage the 5G network, what the timing of that is going to be, what the timing of the wire line improvement -- or reworking of the wire-line networks are going to be as well. So if you think about it from the cellphone side of things, maybe it's a '23 kind of a time frame, but then you've got these other dynamics that are going to play out beyond that.

Neil, switching gears to a different topic, and that is kind of what's going on with the international trade wars, geopolitical entity list can't ship to Huawei. Is that broadening to SMIC customers? Can you update us on the Huawei/China situation, the geopolitical impact to your business financials?

Yes. I'd say a couple of things. So obviously, China is an important end market for us. They've typically been kind of high teens portion of our revenue. And we have now been in this various states of kind of trade war, if you will, for a couple of years. And our China business has continued to grow, right? We've gone through multiple perturbations with Huawei, and our China business has continued to grow. So we have a very, very diversified business in China. We sell into all of the end markets that we talk about for Keysight. There's general electronics; communications of 5G, certainly; next-gen auto; aerospace defense; semiconductor. We really do sell across all of our end-markets into China. So it's a very diversified revenue stream for us. And I think the things that Keysight is doing align well with the areas where China is investing. So we've talked extensively about 5G. Obviously, China is looking to lead with their nationwide deployment of 5G. They're investing heavily both in electric vehicles and autonomous driving, so that aligns well. They're working to build a domestic semi industry, so that aligns well with Keysight's areas of strength. And so that's all beneficial. I think if you look at any of these trade actions on a discrete basis, they can have an impact, and we'll talk now about Huawei. Huawei, we expect to be a 4-point customer for us here in our fiscal '20. And the recent set of regulations across -- against Huawei -- or targeted at Huawei seem to be pretty complete. So on the surface, it would appear that we have a 4-point headwind as we enter into FY '21 as it relates to revenue growth. But that's before we get to work looking to find offsets, it's before any business impacts on Huawei go to Huawei competitors. And certainly, those are things that Keysight can potentially capitalize on. So while on the surface, there is an impact. We're working hard and will continue to work hard to find offsets. And we believe, COVID notwithstanding, the underlying growth trajectories for our industries remain strong, and we remain highly differentiated in our portfolio and well positioned to capitalize on that underlying market growth.

On that topic, do you ever get asked or look internally or hear from people about -- being concerned about the do-not-ship-to extending much beyond Huawei and others, customers?

Yes. It's certainly something that we've thought about and talked about. But I think in the end, nobody wants to -- since it had the dramatic impacts that -- broad scale impacts on China would have on the global macro economy, right? All nations benefit from a strong macro environment from ultimately effective and fair trade across nations. And so while those things are possible, I think there's a lot of reasons for folks to steer clear of those kinds of options. And so we can only respond to the things that happen. But we're strong around the world. And if those things happen, we'll work to resize our business appropriately for the regions of the world where we're able to sell.

I would say one thing that I was a little surprised with is -- on your recent earnings result is the weakening or the softening order trends. And while coronavirus is a part of that, it seems like compared to 3 months ago, things have materially improved. I mean Bay Area traffic is strong again. China has reopened. It seemed like from 3 months ago, things improved, yet on your conference call, it seemed like things really haven't improved. Or am I reading that wrong, because your order growth didn't really show that?

Yes. So I think you need to get within the quarters to kind of look at it. So if you go back to our fiscal second quarter, which was, again, February, March, April, our orders were down 3%. But that quarter is really the tale of 2 quarters, right? You had the first 1.5 months that was kind of pre-COVID through mid-March, and then you had the heavily impacted parts as COVID went global. So we said on that Q2 earnings call that we actually saw order growth through the end of March and then ended up down 3%. And so you could see -- you could do the math, but that basically implies there was a pretty precipitous falloff in our incoming order rate in the month of April that continued into the start of our third quarter. And then you get to the third quarter, and we posted 4% net down. And so we did see a significant recovery from where we were when COVID first kind of went global, right? We kind of got down into that double-digit order decline kind of rate for a month or 1.5 months, maybe even a couple of months, and then have seen it start to bounce back. So again, I think all in all, given everything that's happened in the macro environment with unemployment and with the broader GDP slowdowns, we were relatively pleased with a down 3%, down 4% over the last 2 fiscal quarters. And again, we believe we're well positioned to participate in any recovery that occurs.

So it kind of sounds like from -- when you mentioned the linearity, it sounds like kind of the worst of it is a little bit behind us, or am I reading too much into your statements?

Yes. No, I think there was an initial shock in mid-March that -- when our own factories were closed, many others had to close their factories and figure out how to reopen. We saw significant supply chain disruptions. I think people are now kind of -- I don't particularly like the term the new normal, but I think people are figuring out how to operate in this COVID world, and things have gotten kind of beyond that chaos phase that existed, let's say, through mid-March through mid-May. We're largely beyond that, and things have improved from that point in time.

Great. Can we switch gears a little bit and talk about software and services?

Absolutely.

It's something that traditionally hasn't been a key part of Keysight, or at least you would offer them, but now you're actually selling them in addition and it's creating a revenue and reoccurring stream. Can you talk about services and software, how much of revenues it is and how we should think about that?

Yes. So our software and services revenues combined are now more than 30% of our total revenues, and they're both 2 businesses that are growing at above-average company rates. I think it's worth noting that over the past couple of quarters, while our revenues have been down, in total, both our software and services businesses have continued to grow, right? That's one of the reasons we like these businesses. They provide a level of stability, higher recurring revenue content and ability to kind of buck some of these cyclical trends that can happen in these macro events. It's also important to our customers as we migrated Keysight's product offering from one that has traditionally been kind of hardware instrumentation to now more complete solutions, and those complete solutions often include both software and services components. They provide our customers with a time-to-market advantage. Those are -- they're more differentiated. They're higher gross margin, not just because of the software content that exists but because of the differentiation and the value that we can bring to customers that, ultimately, they are willing to pay for. So clearly remained an area of focus. I think just to put it into context, I think something -- somewhere right around 70% of our engineering talent today is software engineering talent. And so it's definitely an area of focus for the company. I think it's an area where we are able to continue to add differentiated value for our customers, and it's one that we expect to continue to grow at a rate that's above the company average. And I think looking at software specifically, there's a dual opportunity for us. One, there's the opportunity to continue to grow that benefit from the gross margin performance that comes from having higher software sales. There's also an opportunity for us to change the way our customers buy software from us and make it more time based, recurring, subscription-based software rather than onetime software sales. So the last time we sized our software business was at the end of last fiscal year where we said it was over $800 million. But still, more than 50% of those sales are onetime in nature, and we have a concerted effort underway within the company to change the way we do business with our customer base on software sales and to convert the vast majority of software sales to time based. And that will happen over the course of the next several years, right? There's a little bit of a progression and a learning curve and a migration that will have to happen, but I'm encouraged by that opportunity as well.

And then can you maybe take it down to the business segment levels or your reporting segments and talk about are there differences in margins there or levers that impact profitability of those segments?