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

Good afternoon, and welcome, everyone, to this fireside chat presentation with the management team of Keysight Technologies. It's my pleasure to introduce Satish Dhanasekaran, the Chief Operating Officer of Keys; and Neil Dougherty, who's Senior Vice President and Chief Financial Officer. We've got about 30 minutes in this forum to do a fireside chat. If you do have any questions, feel free to e-mail them to my e-mail address, and I'll try to work them into my prepared comments. And Satish and Neil, first, thank you for participating in the conference this year and supporting the conference. I wish we were live and not virtual because if we were live, I could buy you a drink after this was over. But hopefully, next year in the desert.

We'll both take a rain check on the drink.

That's right.

I always find it helpful in this setting to help set the stage for the conversation to make the first question kind of an open-ended question. I don't know if this is more appropriate for Neil or for Satish, but wanted you to just help position Keysight, what's your core IP, kind of the history of the company and, more importantly, how you've taken that IP to exploit the end markets that you participate in.

Yes. Why don't I start, and I'll let Satish fill in the gaps? I would start at the -- literally the million-foot level, the super high level. Keysight at its core makes hardware and software tools that enable electrical engineers to do the work that they do: design, develop, manufacture technological products. And so we bring these -- and we have the broadest portfolio of these tools for electronic -- electrical engineers in the industry. And we use those tools to service a number of specific end markets and then industry more broadly. And so the #1 industry that comes to mind is commercial communications. When people think about that, they tend to think about cell phones in the cellular industry, 3G, 4G, 5G, and that's certainly an important part of it. But it goes beyond that to other technologies, including the wired network. You can think about the migration to 100-gigabit Ethernet now to 400 gigabit and ultimately the 800 gigabit or terabit, but also other technologies like WiFi and Bluetooth and other communication technologies that exist out there in the marketplace. We have tools that help with developing all of those types of solutions. Aerospace/defense is another end market that we serve and, interestingly, most people may not realize, kind of directly linked to our commercial communications business because the portions of the defense industry that we serve are really communications and have to do with signals, right, the capture of signals, the jamming of signals, the safe transmission of the signals, all of that, that are kind of the realities of modern warfare. And so we actually manage those commercial communications and aerospace/defense businesses together within a single group simply called the Communications Solutions Group. We have a second group that's called our Electronic Industrial segment. And in there, we serve a couple of specific businesses, notably the automotive and energy industries. So with big focuses right now on electric vehicles and autonomous driving vehicles, which are big opportunities for us as we look forward. We have a relatively small semi business that is less than 10% of the overall company, but where we have some very specific solutions targeted at testing the electrical properties of wafers and helping the manufacturers of big photolithography machines make sure that they have ultraprecise positioning of their equipment via these 3D positioning optics that we manufacture. And then finally, we have a very broad general electronics business. And it's a bit of a catch-all because you can think of our potential customer set as any company out there that would have a need to hire an electrical engineer. And certainly beyond aerospace, defense, automotive, semi and commercial communications, there are a lot of other industries out there that are hiring electrical engineers. And all of those kind of fall into our general electronics business. So whether you're talking about consumer electronics or IoT or education end markets, medical end markets, all of those fit into that business. And so the tools, generally speaking, are general-purpose tools. They can be targeted at -- depending on their level of sophistication and specification at various end markets. But there's a pretty significant overlap of the types of tools that we use across all of these end markets. Satish, do you have anything to add to that?

Yes. I think just a couple of things, Neil. The mission -- for those new to the story, the mission of the company is to accelerate innovation and where we are positioning the company, it's focused on the big trends of digital transformation that are playing out across these end markets. So if you look at the common thread of what's different for an engineer or an engineering team, it's the space of innovation and the rapid adoption of new complex technologies in the umbrella of digital transformation. You can think of 5G, think of 6G, quantum, the industrial IoT and automotive revolution and other -- to name a few. And we are in all of those, and we play in all of those teams. So we're really at the front end of enabling our customers, which really lends itself to the second part of our strategy, which is to expand with software. Because we're on the front end of these technology waves or technology evolutions, we're often engaging with the customers early, and we have the opportunity to create a life cycle value through those big trends that we mentioned. So 2 things, takeaway: our focus on early R&D and our focus on expanding contributions from a life cycle point of view, which lends itself to the software expansion initiative that we have at the company.

Well, Satish, I'm glad you brought up software because I think that's sort of an underappreciated driver for the company. I'm wondering if you could just help us level-set, where is software today as a percent of revenue versus 3 to 5 years ago, versus 3 to 5 years from now? And really expound upon the life cycle because I think Wall Street, if we have a core IP on Wall Street, it's oversimplifying and jumping to conclusions. And I think that there's this view out there that you guys are well positioned in maybe the R&D aspect of a lot of these new technologies, but you tend to be an early play and not a commercialization play. Maybe as you talk about the software strategy, you can address that concern.

Yes. I think maybe Neil can provide some data points, but Neil, I'll just start, if you have some updates to the data provided, I'm going by memory. Roughly our software today is at 20% of revenue. That's the level we're at. Historically, if you go back and look, it's probably in the low teens. Would that be fair, Neil, Jason? Yes. So that's in the low teens. And the big jump that we've made is by getting into the R&D applications, so on the front end of many technologies such as in 5G, where we have actually started by putting a platform together that creates this end-to-end solution value, which is not just a onetime sale but also creates a runway for perpetual value capture and creation for the entire industry. And for example, with some of our 5G solutions today, software as a bill of material is 40% of the total sales. So it creates an opportunity for us to continue to grow that content with our customers. And many areas, whether it's autonomous car or whether it's IoT or it's 5G or 6G, lend itself naturally to this continuous need to update content, which invariably means we're engaging with our customers a lot quicker, a lot often. So if you think of the software releases, we probably do 3, 4, 5 releases a week now to our customers. That creates the runway for a subscription model or ARR, which has been the push that we're working on. As we look ahead, that's the other opportunity we have: a, grow our software content; and b, also transform our business model to be more subscription-based, in line with the contributions we're making to our customers, which tends to be a lot more of perpetual value.

I would just add 2 things to that. First, a final note on software. I think you can see the contribution that software is making, not only to our top line but to our margin performance with the relatively rapid expansion we've seen in our gross margins from, call it, 58% at the time of our separation from Agilent just 6 years ago to being in the mid-60s today. And there are a number of factors that play into that, but at the top of that list would be the increased role that software plays in our portfolio. Now the second part of your question really focused on Keysight as a front-end play and not so much a commercialization play. And I do agree with you that, that is a misrepresentation. And I think it's a misrepresentation for 2 reasons. One, we do have a very active role to play in the manufacturing and commercialization of technologies. We're just selective about the portions of that manufacturing business that we go after. And we focus on those areas of manufacturing tests where there is still a premium that is being paid for relative levels of sophistication. The example that I would give would be flat-panel televisions. Nobody really tests the flat-panel television anymore because failure rates got to be so extraordinarily low that, that market has basically gone away. And so where we want to focus is on areas where the risk of failure is high. And there are plenty of those markets out there, and we typically are #1 in those high-margin manufacturing markets. And so it's not only an opportunity that we're focused on, but it's an opportunity where we've had significant success. And then the second thing is an area that I think is actually pretty dramatically misunderstood within the industry, is the nature of the R&D sale. And the thing that I've been encouraging investors to do is to go out and look at the R&D budgets of our customers and to really look at how those R&D budgets trend over time. They're amazingly stable, and they tend to increase year-over-year, right? There seems to be this impression out there in the investor base, this is an R&D phase that ends and then R&D ends and things move to distribution. And again, I challenge you to go to our big customers and show me on their P&Ls the year where R&D ended, right? As the CFO of this company, I would tell you the first time someone like Satish or an R&D manager comes to me and says, "Next year is the near -- I'll need less money," that will be the first time in 25 years that this ever happens. So we are very attracted to those R&D markets because of the stability that they represent over a very long period of time.

That's a great insight, Neil. I appreciate it. The comms business, the commercial communications business is slightly more than half of the business, but I think it dominates like 95% of the conversation on Wall Street. It's my goal today to only spend about 70% of the time on that, but I do want to explore kind of that part of the business and what's going on with 5G. Satish, maybe you can help us better understand the life cycle of 5G as it compares to 4G. How do we think about sub-6 versus millimeter wave? and how do we think about the network sort of transforming from just supporting handsets to supporting all those other interesting things around edge computing that 5G promises?

Yes. No, happy to do that. I think at the highest level, I think we've said this sort of life cycle of 5G if you were to look at it that way. Telecom revolutions, 4G or 5G, let's say, a decade long in nature and along the way, they start off, make the way for the next wave. It happened with 3G to 4G, 4G to 5G. And it will happen, no doubt, between 5G and 6G. Things get more complex, and therefore, these rules play out. A couple of things for Keysight. We recognized early that with 5G, the complexity was going to be more in the software layers of the telecom stack. And we bet on that rightfully. We made some acquisitions. We expanded our portfolio to go beyond just the physical layer to the protocol layer, and now we're looking at the application layer. So that's the progression of our strategy to address this life cycle need that 5G creates. 5G comes in -- you broadly think of it as 4 flavors: the low-frequency version of 5G, which relies on 4G as a backhaul or NSA; the version of 5G that's real 5G, you could call it the SA version; and then the versions that have the millimeter wave spectrum associated with them. And so you look at these flavors, and they are all -- create this heterogeneous framework for 5G, which we -- which is very beneficial to us. Our platform has been designed, ground up, to cover all these flavors in a modular fashion. So a customer can start at one of the flavors and upgrade their way through. And so to your comment about it being an early R&D play, the R&D really doesn't stop. And that's the point that Neil mentioned because the customer may start by doing low-frequency version of 5G but eventually end up wanting to do millimeter wave because that's where the industry is going. And so that creates that continuous R&D innovation that you heard. But let's take a step back and think about where the industry is today. There is about 122 operators that have announced 5G services. It's doubled in the last year roughly. There is about 250 devices roughly in the smartphone devices predominantly but other form factors of devices that have come up. There's about 1 million base stations being deployed so far. And a large part of that is in China. And I think if you think of it that way, outside of China, it's still very, very early innings in terms of assessing the -- accessing the smartphone use case. But even customers that have deployed 5G to date, it's largely been the version of 5G that relies on 4G as a backhaul or the NSA flavor. And so the road map for the industry is robust to move from NSA to SA and then to add millimeter wave spectrum or high-frequency spectrum. So from our point of view, we see like these sort of global deployments are scaling and will continue to scale for the next 3 to 5 years. The technology direction and the complexity associated with them is continuing to build as more spectrum is getting added around the world, more auctions are being released, more spectrum is added. And the standards are progressing from release 15 to 16, which opens the door for what you described, which is new use cases beyond the smartphone, which is very early innings. And finally, what that results for Keysight is that the ecosystem of addressable customers is expanding. And we touched upon that. Last year, we added another 300 new customers. And if you think of where those customers are, there is surely a chunk of them in the commercial communications area where there's a lot of innovation happening, such as new innovations such as ORAN, which is bringing in more software players into a traditional NEM space. So that's an opportunity in the core, if you will. But we're also seeing more opportunities in the application layer. I think we've talked about the fact that as 5G progresses, different verticals are going to play in it, and we're starting to see that. Our business in the aerospace and defense, which is a traditional business for us, with 5G has picked up around the world significantly. And in the U.S. with the U.S. DoD launching a 5G initiative, we're seeing a lot of interest. And so we're applicating our 5G platform to address that opportunity. C-V2X is gaining steam in Asia and especially in China. And so as that rolls out, the automotive end market is starting to adopt our technology stack, and we have a leadership position with C-V2X capability as well. And then there are other industries, especially in the industrial sector, who are interested in industrial IoT or enterprise IOT, enterprise 5G deployments. And they're starting to look at what that entails. So these are new customers now that are accessing our technology and our platform in order to realize the promise of 5G. So very early innings. What this all means is that we see, as we have said before, the R&D opportunity is long-term, and we continue to believe that 5G remains a substantial opportunity for us. And the early lead that we have taken and we've held on for the last 5 years now in 5G will -- positions us very well moving forward.

Satish, just to follow on, on that. And I want to know if this is an oversimplification, but recognizing that we are very early innings in these new use cases around the 5G network and as those use cases kind of build out, what happens to the test requirements when the network is not just handling handsets, but it's handling remote surgery or autonomous driving? And the analogy I'd like to use is there's a bunch of semiconductor companies that will sell the exact same chip to the handset market that they sell to the auto market. But the chip they sell to the auto market will be tested 4x longer because clearly, the failures in the auto market are more consequential than a dropped phone call. Is there a similar analogy as to how we should think about network integrity as these new applications unfold?

Yes. I think network automation becomes a must, right? I think you think of, let's say, managing a network being a manual operation. You can do that when you have a few billion users, which are in the smartphone use case. But when you start to scale that to multiple billions added because you have more sensors, you have more enterprise deployments, I think managing the whole network becomes automated. Security and the threat surface, even though 5G by itself is more secure, but the threat surface associated with 5G inherently means there will be more opportunities for test especially in the -- with the security use cases that are coming online. And the third is the regulated markets. As health care or utilities or the ones you mentioned with autonomous cars, as they start to embrace 5G, there's a certain hardening element of that 5G stack that has to happen to sort of -- to customize the 5G capabilities to that end market application. And that creates in itself opportunities for us, not only with our traditional customers, like the ones you mentioned that make a chip or make a base station, but also these new customers who tend to be more software-oriented because they're really testing that software pieces that enable them to customize the solution to that end market application. So the ecosystem of addressable customers for us expands, and we continue to see that expanding over the long run.

Neil, one of the questions I get asked is, how do I think about your 5G revenue stream compared to the 4G cycle? Recognizing that you're in a much different sort of product portfolio for 5G than 4G, but one of the questions I always get asked is sort of, hey, from inception of 4G to peak revenue quarter, how many quarters was that? And then how much longer did 4G kind of hang around before it starts to decelerate? Is there any sort of milestones you can give us on how 5G compares to 4G based on some of those metrics?

Yes. Let me start, and then I'll let Satish. I will, first of all, play back to you. You said it as much in your question. I think it's really hard to compare where Keysight is in 5G to where we were in 4G because we're just such a fundamentally different company as a stand-alone entity than we were as an operating business inside of Agilent. Just start with the level of focus and the level of investment that we're making to ensure that we win in the space is completely different than where we were. Agilent was underoptimizing the investment. We had to pick and choose, and we could not turn our entire portfolio in a timely fashion. So the reality is we missed the market windows. Where we were successful, we prioritized. Where we got to market on time, we did well. Where we were late, we lost some share. But in this case, Keysight clearly not only enjoyed a first-mover advantage as pivoting -- as we pivoted to 5G investment well ahead of our competition. Since that time, we've done a number of acquisitions, the acquisition of Anite notably, which moved us into the protocol layers of wireless; the acquisition of Ixia, which moved us into the protocol layers of wireline; the acquisition of PRISMA, which has filled a point solution gap within our 5G portfolio. And so we just have a completely different breadth and scope and, frankly, level of success across the entire ecosystem than we have within -- than we had a decade ago in the 4G windows. The only thing that I would add, and Satish has touched on this, because of the complexity of 5G, the different flavors that are out there: stand-alone, non-stand-alone, subsea, gigahertz, millimeter wave; the different use cases that are going to be out there: IOT, automotive, aerospace, defense; the different tiers of customers: the global Tier 1 customers that started off the investment years ago now moving into the Tier 2 and Tier 3 customers that are starting to come into the market as it commercializes, going to be a really long opportunity. You add to that the fact that we now participate on the wireline side, which is going to need a pretty wholesale modernization once the traffic starts to flow, we see this as a much longer window for us than existed in 4G.

Yes. And then we think of it end-to-end -- to just build on Neil, we think of it end-to-end in terms of our offerings to the ecosystem, the chipset companies, the device makers, the network equipment manufacturers, the operators and then the data center in the cloud, but also into the enterprises and the companies that actually end up deploying this technology beyond the ones that create the technology, if you will. Talked about the aerospace/defense opportunity, the automotive opportunity. So 5G for us is really -- touches much more end markets than it did 4G partially because of the applicability of the technology and the use cases but also because of our own portfolio, which is now broader than it's ever been, and I think we've used this before, with many of our customers on a relative basis to our 4G presence, we've more than doubled our wallet share with them on an annual basis. And that's probably a good example for the kinds of things we have done already, which we continue to sustain, but now opens the door for new opportunities as that industry and 5G gets deployed at scale.

Neil, on the one hand, you guys have done a pretty good job keeping your book-to-bill right around parity and slightly above parity every quarter. But if you look at the sequential growth you had in the October quarter, in order to achieve that, you needed to see pretty healthy growth in your order book, which you saw. I'm kind of curious if you could help us get a better understanding of the broad-based nature of what drove the order book. How much of that was CSG versus EISG? There's a concern out there that with the U.S.-China trade tensions continuing to escalate that perhaps there's some pull forward. How would you characterize the order book that you saw in October and what it portends for the next couple of quarters for revenue?

Yes. I think it's an interesting question. And I think we were pleased with the kind of the broad strength that we saw across the portfolio in the back half of the year. I would point to a couple of things. So the first, let's start in the commercial communication or in the communications business. Over the last several quarters, I think very positive that we saw investment in 5G continue more or less uninterrupted, right? I think that train has left the station for competitive reasons. The big players in that space had to keep their foot on the gas. They prioritized other investments away from other investments to keep investing in 5G. And we benefited from that. The counterpoint to that is we did see an acceleration in the slowdown of legacy network -- legacy investment in 4G technologies, as an example. But even there, I think we have reason for optimism, right? Because of the non-stand-alone deployments of 5G, 4G is going to be a standard in your phone for a long time to come, at least a decade, maybe more than that. And we believe that service providers and others are going to look to continue to innovate along 4G to eke out performance from those deployed assets. And so we believe over time that, that market stabilizes. In aerospace/defense, obviously, typically, we would see sequential improvement going from Q3 to Q4 driven by the U.S. government fiscal year-end. But in addition to that strength, which we did see, we also saw a great strength in aerospace/defense in international markets. And maybe a bit of a surprise, we saw the rebound of European aerospace/defense investment. So I think over the previous couple of quarters, our European customers had -- countries had redirected investment away from aerospace/defense towards fighting the pandemic, and we saw that turn back on. And so I view that as a net positive for the direction that the economy is headed. And then if you look to the electronic industrial businesses, I'll touch briefly on those 3 segments. Semi was surprisingly resilient through this whole thing, right, that we've seen that business be very resilient. And that strength continued into Q4. But the other 2 markets, automotive, our automotive orders were still down on a year-over-year basis, but we saw a big sequential improvement Q3 to Q4. And so we looked at that as a pretty good indicator that things were getting better in that industry after a pretty significant checkup back in the spring. And then if you're looking for forward-looking indicators, probably #1 on my list would be the business I came to last, which would be our general electronics business. And the reason I say that is it's such a broad cross-section of industries that make up that business. And we saw really good strength in general electronics in the fourth quarter. So I think that bodes well to a broader economic recovery starting in this period of time. And so we were very encouraged by the order book. I think as we look forward to Q1, we've talked a little bit about some of the headwinds that we're going to face from Huawei. But I think those are short-lived in nature. The broader underlying macro trends are positive. And luckily, we have the backlog that is necessary to essentially weather a little short-term perturbation on the order line and continue to grow revenue through the early part of the year while we're working through those tough comps. I'm not hearing you, John. I think you're on mute.

Sorry about that. Good commentary around revenue. I was wondering if you could talk a little bit about sort of profitability especially on the op margin line. Clearly, in the October quarter, outsized sequential revenue growth helped. In addition, there's been nothing usual about this year from an OpEx perspective with COVID actually providing some tailwinds to OpEx around travel and entertainment. You talked about on the conference call a step-up in OpEx as we go through the new fiscal year. Can you just help us understand how we should be thinking about op margin and op margin target on a normalized basis?

Yes. I think about it 2 ways. So first of all, we're obviously thrilled with the results that we put up in the fourth quarter. Now obviously, on a big revenue number, but we saw a $30 million sequential increase in -- actually more than that's just the SG&A line of more like a $50 million increase in total OpEx from Q3 to Q4. And I kind of view that as spending more or less returning to normalized levels after being depressed in Q2 and Q3 because of the big COVID disruptions. And to do that and still see 29% operating margin, record operating margin for the business, I think, is very encouraging driven by the gross margin importance and obviously the outsized revenue. As you start to look forward, I'd point to the full year, right? On the year for Keysight in FY '20, we did $4.2 billion of revenue, 25.3% operating margin. And I would expect that we're going to continue to make progress driving operating margins northward in FY '21. We have seen unique aspects of our operating model with our variable pay programs that impact 100% of our employees. And with the negative revenue growth in Q2, revenue growth being a key component of our variable payouts, we saw those numbers be down in FY '20, and off relatively soft comps, are going to be -- they're going to be up significantly in FY '21. But even with that, I expect to continue to make progress towards our long-term objectives of getting to annualized rates around the 26% to 27% operating margin levels by FY '23. And we expect to continue to move that ball forward here in FY '21.

One of the high-class problems with strong profitability is strong free cash flow. I'm wondering if you could talk a little bit about how we should think about the deployment of that free cash flow. And Neil, maybe you can talk about dividend buyback, and Satish can talk a little bit about the M&A strategy from here.

Yes. So let me start. We outlined our -- in detail our capital allocation priorities at our Analyst Day in March, and I don't really see any changes. First and foremost, we want to invest through the P&L in the organic growth of our business. So keep up our investments in R&D, continue our investments in doubling our sales force, those 2 things are core, are key to our driving our organic growth rate of our business. Beyond that, we do clearly have an appetite for continued M&A. I think we set a very high bar. I'm not exaggerating when I tell you, we put literally hundreds of millions into the top end of our funnel to get out the 13 deals that we've closed in the first 6 years of Keysight's independence. And so we want to continue to look for transactions that align with our strategy, ideally targets that are additive to our gross margins, additive to our growth rates and are at price points that allow us to get a return for our investors. And if we find those targets, we're not going to hesitate to act on them. Beyond that, we obviously have a strong balance sheet, strong cash flow position. We will return capital. We've committed to at least being anti-dilutive with our buyback program. But as we've proved in Q4, we will go above and beyond that and be opportunistic when we see a disconnect in the valuation of the company. We're very pleased that in the fourth quarter, we were able to take $200 million of stock off the market at very favorable pricing around $95 and change. So that's proven to be a smart use of capital and one that we'll look to continue to repeat when we get opportunities in the future.

And Satish, I'm sure you're not going to give us a detailed road map of your M&A strategy. But any broad brushes you could give us would be helpful.

Yes. I think consistent with the big trends that we laid out at Investor Day, we're obviously looking for M&A prospects or opportunities that get us to those end goals from an end market perspective, get us to hit those market windows quicker. So the ones that do that, obviously, we're interested. So we did a M&A transaction recently in the quantum space because we had an asset called Labber that got us into the quantum software. And that's an example of the kinds of things we're looking to do. I think last year, we did PRISMA Telecom, which got us into the virtualization trend that's playing out in the telecom. And then most recently, very excited by Eggplant, which takes us from just testing hardware and software combination to purely testing software in the application space. So I think these are -- sort of gives you the flavor of the big megatrends that are playing out in the end markets, the ones that give us an opportunity to accelerate our contributions. And then second, it's really enhancing the software footprint consistent with the strategy that's outlined. But as Neil mentioned, well, we stay significantly disciplined in the ones that we decide to pursue. But the ones that we have pursued, we're pleased with the progress we have made such as in 5G with Anite and more lately with Ixia.

Perfect. With that, we've come to the end of our allotted time in this fireside session. But I want to thank both Satish and Neil for joining us this afternoon. I also want to pass on our best wishes that you both, your immediate family and the larger Keysight family stay safe and healthy in what's been a really trying year in 2020. So thank you very much for the time this afternoon.

Thank you so much, John.

Okay. Thanks, John.

And thanks for having us at the conference today. We really appreciate the opportunity.

Bye.