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

Hey, everyone. Thank you for joining us at the next track at our virtual tech conference. This is Matt Niknam, the communication services and data networking analyst at Deutsche Bank. We are very pleased to be joined by Keysight, CFO, Neil Dougherty. Neil, thank you for joining us.

Thank you. It's a pleasure to be here.

Well, maybe just to start, Neil. From a high level, what would you say are the top priorities that you're focused on as we close out 2020 and head into 2021?

Yes, Matt, it's a great question because obviously, this has been a bit of a challenging year with the COVID situation. And I think as we've tried to navigate the past couple of quarters and as we look towards the end of our fiscal year, the #1 thing that we're focused on is trying to stay connected with our customers and make sure that we're continuing to meet their needs and understand their priorities. I think beyond that, I think the strength of our financial performance, even in the case of -- even in the face of these headwinds, has enabled us to keep our foot on the gas from an investment perspective. And so we're very much focused on continuing to execute on core R&D programs and execute on our sales force expansion. Those are things that are going to enable the company to really fully capitalize on a broad recovery when that happens. And then the last thing, which I probably should have started with, is the health and safety of our own employees, right. Still highly uncertain times. We have large portions of our employee population that are working from home. But our manufacturing folks are back in our facilities, a significant number of our R&D folks are back in the labs on a day-to-day basis. And we want to make sure that we have the safety protocols in place to make sure that we're keeping our own people safe and healthy during this uncertain time. But by and large, I think we're pleased with the way the company has weathered the storm, and we feel like we're really well positioned as we look forward.

That's great. Well, maybe if we can jump into the demand backdrop. Can you talk a little bit about how customer demand has held up in light of the COVID pandemic? And whether you've seen any changes in terms of order trends during fiscal 4Q?

Yes. I'd go back to our fiscal second quarter, which just keep in mind, we're not a calendar fiscal year-end company. So I'm talking about the February, March, April time frame was our fiscal second quarter. And where we really started to see the impact was mid- to late March, right, when COVID was kind of clearly expanding beyond China. That's when folks started to send, including Keysight, started to send their employees to a work-from-home environment. We saw our supply chain as well as many other supply chains disrupted. And so what we'd said at that point in time was that we were actually -- in that second quarter, so again, February, March, April, we were in a growth position through the end of March on the order line. But we ended up the quarter down 3%. So that gives you an idea that April was down pretty sharply. Things stabilized relatively quickly. And while our orders were down 4% in total across the fourth quarter, that was with relative stability across the 3 months of the quarter. So things definitely got better than kind of what we saw in the back half of March or the last week or so of March and into April and have kind of stabilized in this low to mid-ish single-digit decline kind of range. And even within that, I think what you're seeing is it's really different by market, right? I mean, we see areas of real strength in our portfolio. Our 5G businesses continue to grow. Our software businesses continue to grow. Our services businesses continue to grow. Our U.S. aerospace defense business has remained strong. And then we've got area -- semi would be the other area that's been very strong. And then we've got areas of relative weakness, right? No secret that the auto industry, it's been hit really hard over the last several quarters. And we've seen that flow through to our auto business. Our general electronics business, which tends to be our most GDP-linked business, has also been under pressure. Included in that market is education, and obviously without students on-campus, the education markets have been hit pretty significantly. So it's been a mix of puts and takes, but I think the diversity of Keysight across all of those end markets across our 30,000-plus customer base is really a strength and has brought a durability to the top line that I think is attractive. The other thing I'd point to is I mentioned that both our services and software businesses have continued to grow even over the past couple of quarters. I think the efforts that we've put into those areas into building an increasing base of recurring revenue has really also helped the business during this period of time.

And so maybe just to go back to one of the points you brought up. So obviously, order trends at the start of fiscal 2Q were pretty solid in a growth position. I think also on the last call, you mentioned exiting fiscal 3Q sort of improving trends in terms of exit rates. And if I'm understanding it correctly, the start of fiscal 2Q and the exit rates from fiscal 3Q would imply some modest year-on-year growth despite the sort of low single-digit declines reported for the aggregate of those quarters. And so I'm wondering, is that sort of a reasonable -- is the exit rate from fiscal 3Q, is that sort of a reasonable run rate to consider for fiscal 4Q?

Yes. So all I'd say is the times remain highly uncertain, right? I do not believe that we're kind of back to normal operating levels post COVID. I think there's still significant uncertainty. I'd point you back to the end markets that I've talked about, right, continued strength in 5G; U.S. aerospace defense, where we're entering government fiscal year-end; software and services remain strong. But then we -- similarly, we have businesses that remain under pressure, right, auto and general electronics being the 2 -- and maybe international aerospace defense being the third. And so it is a bit of a mixed bag, but the -- we continue to believe that the long-term secular growth trends for our industry remain intact even if there's short-term perturbations that are impacting them in the immediate period of -- time period and that we remain really well positioned from both a customer relationship standpoint as well as from a technology standpoint. So when you start to think about the return to normalcy in a post-COVID world and in the shapes of the recoveries, I continue to believe that Keysight is going to be better positioned coming out of this situation than we were going in.

And just to -- I don't mean to stay on this theme, but you did mention a couple of more macro sensitive customer sets that have been pressured like auto, like general electronics, international aerospace and defense. I'm curious, have you seen any sort of green shoots or data points more recently that would indicate were sort of on an upwards inflection? Or is the environment still too uncertain to call right now in terms of a recovery?

I think auto is the one area where, at least if you're tracking kind of end auto sales, there's been a lot of positive news recently about the auto industry in China. So at least I think there's some bread crumbs there that lead you to believe that maybe a recovery is on the way with regard to auto. I don't think that's been realized within Keysight as of yet, but certainly, there are signs that some of those industries are starting to see some favorable uptick. So we'll be watching those things carefully. And as I said, I think we're very well positioned to participate in the recovery when it happens.

Great. Great. So let's talk about 5G. Where would you say we are right now in the sort of 5G cycle? And then, I guess, more specifically, how do we think about the duration of this tailwind for Keysight?

Yes. I still think we're very early days in the grand scheme of the overall 5G cycle. As I told another investor earlier today, I don't know a single person that has a 5G phone in their pocket and can actually use that phone on a deployed 5G network, any reasonable amount of time, right? So as you think globally, with a few small exceptions, the deployment of 5G is entirely in front of us. And then the complexity of 5G is such that it's going to make the 5G cycle more elongated than prior generations. And by that, I mean, the complexity around the different versions of 5G, standalone and non-standalone; and then the frequency differences, right, sub-6 gigahertz and high-frequency or millimeter wave deployments, you're going to see individual countries or individual service providers to actually go through multiple deployments, right? They might start with a sub-6 gigahertz, non-standalone deployment but then have eyes towards getting towards a millimeter wave deployment at some point in the future. And so that's going to serve to elongate the cycle and as well as the opportunity for Keysight. I think the other thing that contributes to that elongation is these use cases beyond the cell phones. We're thinking of -- think of [ Rev 16, Rev 17 ] as the standards and the other use cases that are going to be able to capitalize on the deployed 5G network, things like Industrial IoT, Industry 4.0, V2X communications in the auto industry. Those are areas where we've already started to see some seeds get planted and some investments be made beyond kind of the typical cellular industry. But I think those are really just the beginning because those follow-on industries, think of things like industrial private networks and those types of things, are really going to be deployed once the broader scale deployment of 5G is underway, and they're looking to leverage deployed assets. So -- and then the final piece is, once you have a fully deployed network that's in use and people are utilizing that network, the belief is the amount of data traffic flowing across the 5G network is going to be dramatically higher than the existing networks. And that, that is going to essentially necessitate a complete reworking of the wired network, right? This was a key part of the thesis that led Keysight to acquire Ixia. We want to fully participate in the entire 5G cycle that includes that reworking of the wired network. And so if you put all that into it, we are very early days in terms of the overall 5G rollout.

Yes. I want to go back to the point you mentioned around different sort of use cases because I think this is pretty unique to 5G. We haven't really seen this with prior network evolution. So is this sort of opens the door to newer use cases, things like Industrial IoT and the like? I mean, is there sort of a framework investors should use in terms of the incremental revenue opportunity that presents for Keysight maybe relative to prior generational upgrades?

Yes. I mean it's hard to know because it's a big greenfield, but just as an example, I mean, we've sold complete 5G test solution kits to auto OEMs, right? I mean that is not something that happened, right? We see government investment in 5G technology. So those are all examples of things that did not happen previously. And again, I think this is going to be a bit of a follower, right? I think the real test is going to happen once these networks are deployed and folks realize that there's now all this bandwidth, and there's this 0 latency requirements and kind of the entrepreneurial spirit is going to enable folks to figure out how to capitalize on these deployed networks. And so I think the driving force between 5G deployment -- behind 5G deployment today is clearly the cell phone, right, and the cell phone industry, but once those networks are deployed, I think there's going to be a lot of other folks that come to the party, so to speak. And that's going to create a lot of opportunities for Keysight as all of that -- those devices and tools need to be developed and in the R&D lab as well as manufacturing brought to market.

Let's talk a little bit about software and services. You alluded to this in your opening comments, but maybe if you can update us on how much of your revenues today are coming from software and services and how the growth profile of these businesses is compared relative to maybe some of the revenue pressure you've seen on a more consolidated basis.

Yes. So software plus services is north of 30% of the total company at this point. Those are businesses that have continued to grow even over the course of the past couple of quarters. So even as the broader business has come under pressure, we've seen continued growth in those areas. And prior to COVID, they were businesses that were growing at above -- at an above-average rate for the company. So that's continued. I think we continue to believe there's a lot of opportunity in both of those areas for us to continue to increase the percentage of our business that's coming from those. I think we like the -- not just the overall magnitude, but we like the stability, right? There's high recurring content in both of these businesses. We're very much focused on building our recurring revenue base. So not only do we have the growth of these 2 businesses, but we have the opportunity to change the way in which our customers buy software from us and make it more recurring in nature. I think that presents a big opportunity for us going forward. And then, of course, we've got the margin benefits that come from these businesses. Software is obviously a very high gross margin business, and it's additive to our gross margins. But even on services piece, which is -- it's a very strong operating margins, but typically a below-average gross margin business, but we've made great strides in improving the gross margins of our services business. And so -- and that's one of the big drivers of the big improvement in profitability that I referenced in our most recent earnings call, where our services business is now generating operating margins that are north of 20%, which had been a long-term goal.

And when I think about 30% today coming from software and services, is there a specific long-term target investors should think about in terms of what percent of the revenue base could eventually come from software and services over time?

We haven't set a target, but we've continued now for a reasonably long period of time to grow these businesses at an above-average rate for the company. I think you see us focused. I think something like 70% of our engineering talent now is software engineering talent. And so it's definitely an area where we're focused. I think you've seen it as an area of focus in our M&A efforts. Obviously, we just acquired a pure software business with high recurring revenue in Eggplant. We did an acquisition last year of -- in Italy called PRISMA that had gross margin -- it's a hardware and software business, but gross margin is well north of 70% because of the high software content associated with that business. So growing these areas remains an area of focus and, we believe, remains one where there's a lot of runway ahead for us.

And if I could just go to dig in a little bit with software. I think you mentioned, I believe it might have been at the Analyst Day, seems like a world ago back in early March. But I think you had mentioned about 20% of your fiscal 2019 revenues actually came from software. But I also think you've talked about over 1/2 of these software sales that are more sort of onetime or license-oriented in nature relative to maybe being subscription-based. So I'm wondering how do you think about transitioning towards more of a subscription-based model. And how long would something like this take to play out?

Yes. So we definitely -- so I see this as a big opportunity for us. So you're correct, right? A little bit more than 1/2 of our software sales now are still sold on, on a perpetual or onetime type of license purchase. And our challenge is to migrate the way our customers buy software from us to one that is more software-as-a-service or subscription-based recurring revenue kinds of models. And so I don't think that that's a transition that happens overnight. I think it's going to take us a number of years. I don't know, 3 or 4 years to significantly get to the point where the lion's share of our software is coming from recurring-type subscriptions. But I think the migration is really going to happen as we bring new tools into the market, right, our new solutions and new software bits into the market. I look at some of our 5G solutions today, where the only way those solutions can be purchased from us is with the subscription to the software content. So that's the plan is to over time, migrate our customers to that type of a model, which really provides a dual benefit [ from ] us, right? Not only do we get the incremental software and margin growth, but we get the stability that comes from the increasing levels of recurring revenue.