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

All right. Thank you, everybody, for joining. My name is Michael Tsvetanov. I work with Aaron Rakers here at Wells Fargo. Aaron is the senior analyst covering the semiconductor and IT hardware space. I'm happy to host the discussion with Keysight Technologies' CFO, Neil Dougherty, today. So first off, just thank you for doing this, Neil.

Thank you for having me. Happy to be here.

Absolutely. So why don't we go ahead and get started? Kind of high-level here, just on the Keysight's strategy. While it's appropriate to consider Keysight as a company positioned at the tip of the spear on the evolution of emerging technologies, I think it also seems that investors tend to get focused on the story being predicated by technology cycles alone. I'm thinking 5G, 400G, wired networking, et cetera. So with that in mind, can you just help us appreciate how the company has executed on much more than this as I think Keysight's growth opportunity goes well beyond just engineering?

Yes. So we have an extraordinarily broad portfolio of products and an extraordinarily broad customer base. We sell to substantially over 30,000 customers annually. And I think you're right. I think the investor base tends to think to particular secular drivers, most notably 5G, right? I mean I spend a disproportionate amount of time talking about 5G, and it's certainly an important story for us, but it's by no means the only story. And I think the main message is that there's no one secular driver that drives all of our business. We have significant -- we obviously have a significant commercial communications business of which 5G is an important part. But we also sell into wireline technologies. You mentioned 400 gig and 800 gig. We sell -- we have solutions around other technologies, WiFI, Bluetooth, other communications technologies. We have a significant aerospace defense business. We have an electronic industrial business with focus sectors in semiconductor and on automotive, but then a large, very broad business that covers basically everything else. And so if you think about Keysight and our customer set, what we do at the 10,000-foot view is we make hardware and software tools that enable electrical engineers to do their jobs, the design, development and manufacture of electronic content. And so if you think about a potential customer set, it's really any company out there that is hiring electrical engineering talent. And beyond commercial communications, aerospace, defense, semi and auto, there are a lot of industries out there that are hiring electrical engineering talent. And all of that falls into our general electronics business. And so -- you talked about these cycles. And certainly, these technology cycles and technology transitions are important. They are demand drivers for us. But there are many of them that are happening at various points in time. And I think if you look at our business and our strategy, our #1 focus is to win in the R&D labs. You talked about the focus on engineering, and that's certainly important. We look at -- if you take some time and look at the R&D budgets of large technology companies, what you see is that they're very stable over time. They tend to grow over time, and that's the budgets that we're really tapping into, right? We're enabling those electrical engineers in those R&D labs to be successful. But we also have significant businesses around manufacturing of key technologies as well as post deployment kind of operational solutions for data centers and for technicians and other folks that are working in the field on deployed technologies. So it's a really broad set of tools focused on the electronic industry with, again, no one single driver driving demand across the entire $4.5 billion worth of revenue that we currently are generating.

That's perfect. I'm going to shift over to kind of talking a little bit about the long-term model that you guys have outlined. I know Keysight has seen some impact from COVID in China over the past few quarters, but the company has executed very well on its business model sustainability. And with this, can you talk about the underlying drivers of your confidence in above market 4% to 6% long-term revenue growth? I know you touched a little bit on those, but if you can just expand, and then in addition to the 26% to 27% EBIT margin?

Yes. So first of all, it's a big market, right? Our total market north of $16 billion as we currently estimate. We estimate that, that market is growing in the kind of mid-single-digit range, again, across a large number of drivers. But we believe Keysight's positioned to outgrow the market, and our goal is to outgrow the market by 1 point or 2 every year, and we have a high degree of confidence in our ability to do that, as you mentioned. One of the reasons is because of our scale and the breadth of our portfolio and the strength of our customer relationships. We are by far the largest player in this space. We're in the #1 position in each of our end markets. We're currently investing very heavily in the growth -- the organic growth of our business, invest $700 million or more annually in R&D. That's a number that's hard for our smaller competitors to really keep up with. And we have -- we certainly have a very broad portfolio of solutions that enable us to meet the needs of our customers in the commercial communications space, in the auto space and broadly across the ecosystem. You couple that with the investments that we're making in our field organization over the past several years. We've been working to double the number of direct frontline sellers that we have out calling on customers, and we expect to complete that in our upcoming fiscal year. And so we're making substantial investments to drive organic growth in our business. And I think you've seen -- you really -- since our separation from Agilent, which is now 6-plus years in the rearview mirror, that we've been succeeding in doing that and outgrowing the market and -- not just outgrowing the market but doing so very profitably over that secure period of time. We've increased our operating margins by 600 to 700 basis points. We've increased our gross margins by 600 to 700 basis points. And so we're improving the profitability as we're growing the top line.

That's perfect. I guess with that, I wanted to ask on the EBIT front, particularly. Why should we not consider more upside drivers to this long-term model expectation given that you guys continue to increase your recurring software contributions?

Yes. I mean, certainly, we continue to believe there's margin upside in our business. At our Analyst Day in March, we outlined a long-term target to get to 26% or 27% operating margins by fiscal '23. We made great strides here. Even in this COVID year in FY '20, our FY '20 just ended on October 31, we continued to move operating profits northward. We generated 25% operating margin for the full year of FY '20. That was up over 100 basis points over our fiscal '19. And we expect that we're going to continue to make progress towards those long-term objectives of getting to 26% or 27%. I think from a time perspective, we said that we would get there by '23. And I think we're probably, at this point, a little bit ahead of the schedule, but we're not there yet. So let's wait until we get there and see how long that takes. And then kind of the way we approach things at Keysight is we set a goal, where we have a direct line of sight on how we're going to achieve that goal. We go and we do the work. And then we reevaluate what the next objectives are. You yourself just mentioned, our software business, which is growing at a rate that's above the overall company average. The increasing recurring revenues that we're getting, not just from the software business but from our services business as well. Those things are all additive to our margin performance. And I think we do see continued upside to continue to drive growth in those areas. But first, I want to get to the targets. And I just put the targets out less than a year ago in March. I'm not at them yet. But do I believe that, that's the end game for us? No, I think there's going to continue to be upside beyond that once we achieve those -- once we achieve those objectives.

Okay. Great. I guess now I wanted to kind of move into -- dive a little bit deeper into the key themes that we mentioned earlier, starting with probably the biggest one, which is 5G. It appears that the focus within 5G is the evolution from engineering R&D-driven revenue to mass manufacturing for you guys. So can you talk about this a little bit and how you see your opportunity just evolving around 5G going forward?

Yes. I'd say a couple of things. First of all, I'd point to the overall length of these cycles, right? The G cycles, if you will, 3G, 4G, 5G, are at least decade-long cycles, and I think there's reason to believe, because of the complexity of 5G, that this is going to be the longest cycle that we've seen to date. You see -- we're just now starting to see the early stages of commercialization of 5G. That's clearly accelerating. Most of that commercialization right now is happening in the relatively lower frequencies of 5G, the sub-6 gigahertz bands. But ultimately, the performance promise really comes at higher frequency. And so you're going to see individual service providers, individual nations go through multiple deployments of 5G, starting with sub-6 gigahertz, potentially starting with the non-standalone deployments of 5G and ultimately migrating to standalone high-frequency millimeter wave deployments. And so that's going to serve to lengthen the cycle and lengthen the opportunity for companies like Keysight. I think if you add to that the acquisitions that we've made to move into -- to improve our portfolio on the wireline side of things, specifically, I'm talking about the acquisition of Ixia, this deployment of 5G is going to cause a massive increase in the amount of data traffic flowing across these wireless networks. All of that data traffic eventually works itself back to the wired networks and is going to necessitate a pretty major overhaul of the wired networks as we know them. And Keysight is going to be positioned to participate in that portion of the 5G rollout as well. And so I've already mentioned this as well, but we've been focused to date on the R&D lab because that's where the opportunity has been. I would focus -- I think, to some extent, the investors don't realize the stability of those investments over time. It is not true. There seems to be an impression in some of the investor community that this is R&D phase that ends, R&D stops and then we go to this deployment phase where everything is in manufacturing. That's actually not how this looks. Go look, as I suggested, at the R&D budgets of the big players in the space and show me the years where they're not investing in R&D because the R&D phase is over. It just doesn't happen like that. Those R&D budgets continue to grow. They continue to invest in the R&D lab. And that's one of the reasons that we still have very significant R&D sales for 4G technology today. What we're going to do is take those very substantial 5G revenues that are coming from the R&D lab and add the deployment piece, the manufacturing piece. And Keysight has long been a successful player in manufacturing tests. We're focused on testing components and modems and chipsets as well as the base stations that are ultimately going to enable 5G deployment, and we expect to be very successful in those markets as this thing commercializes. So suffice it to say, we're in the very early innings. Most of us don't know a single person that's made a 5G phone call at this point in time. And so this opportunity is really all in front of us, and it's going to be a very long cycle and one that Keysight is very well positioned to capitalize on based on kind of the beachheads that we've carved out over the last several years.

Got it. Okay. And in terms of the release, the 5G Release 16, Release 17, et cetera, as investors, is there anything that we should consider as a potential implication for you guys there?

Well, certainly, I think we generally view standardization as a positive in terms of its ability to drive demand for our products, right? As these standards come out and they address different parts of the technologies, different use cases in the case of industrial IoT or automotive or millimeter wave, they advance the standards beyond what was included in the original Release 15. All of that drives additional development work in the lab and ultimately, deployment of devices into the network. And so all those things are demand generative. We're not particularly sensitive to any 1 release, but the general progression of Standards development is favorable for business. I often get questions, too. The Release 17 is slipped by several months. We're also not particularly sensitive to those kinds of slips. I think, first of all, if you look back in time, I challenge you to find the release of standards that's come out on time. These slips are very common. But what we find is our customers aren't necessarily waiting for the actual formal release of the standards to start their development work. Many of these players, particularly the big ones, are involved in the standards bodies that are establishing the standards anyway. So they have a pretty good idea of the direction things are headed, and they don't need to wait for the formal documentation to begin the work. And so those types of slips are not really meaningful to us.

Okay. One last question on wireless before we move on. Open RAN gets a lot of discussion these days. It's potentially a meaningful architectural shift in the radio access network market going forward. So that in mind, is there anything that we should think about as an incremental revenue driver in regards to Open RAN for you guys?

Yes. Certainly, we see as a positive demand signal for Keysight and the types of things we're doing, mostly because it brings new potential customers into that access part of the network, right? The disaggregation of the access part of the network away from what we consider the core 4 or 5 base station providers, potentially bringing a whole new set of customers as that disaggregates creates opportunity for Keysight. It gives us new customers to sell to. It creates new problems. If you start to think about disaggregating that access network and people doing different pieces of it, you get new interoperability issues that need to be addressed, and those are all things that Keysight can help with. Ultimately, there's a value proposition there for end users in terms of lower cost per bit. And so I think there's reason to believe this moves forward, and it creates opportunities for Keysight to continue to drive demand.

Perfect. I'm going to move over to a bit about the wired side of things. In terms of 400 gig and it sounds like we're thinking about 800 gig R&D ongoing now. So can you just talk about where we are today in the evolution of gigabit Ethernet overall as a key underlying driver for you guys? And is there anything in these technology cycles that we should consider as potentially expanding your TAM opportunity?

Yes. So 400 gigabit, 800 gigabit, even terabit are things that we're seeing today. Obviously, we've seen some delay in the rollout and commercialization of 400 gigabit given some of the delays and cost issues that exist with the optics there. But suffice it to say that the kind of the insatiable demand for data amongst consumers and industries is necessitating continued evolution of the wired network, and Keysight is well positioned to not only be our legacy strength in this area on the physical layer of the wired network but through our acquisition of Ixia to play in the protocol layers of these network rollouts. I think -- as you think about our thesis and why we went out and made the Ixia acquisition, one of the things that we're looking forward to as a trigger to drive really significant investment in this area is the commercialization of 5G, right? As 5G commercializes, as we start to get not only the 5G networks deployed but the 5G user base up, and we start to see what we believe is going to be a very dramatic increase in data traffic across the wired network, that it's going to create a need for a wholesale reworking of the wire side of the equation. And we are now the 1 company that's positioned to service that entire communications ecosystem, wireless to wireline, physical layer up through the protocol layers. So end-to-end and up and down the stack. And so again, I know we switched to wireline here, but we view the wireline and the wireless is intimately linked. It all ultimately comes back to this deployment of 5G. And this 5G opportunity across the entire ecosystem is going to be one that plays out over many years for us and has many different kind of waves of demand.

Perfect. Just another question, I guess, on that side. Silicon photonics is kind of a topic that repeatedly comes up when we discuss wired gigabit Ethernet. Does this mean anything for you guys in terms of content perspective or just as an opportunity?

Generally speaking, I just think of any technological evolutions that are taking place in kind of this broad electrical engineering space are going to be additive for Keysight. Some are better than others, obviously, but as long as technologies are continuing to move forward, that's going to be additive for us, right? And so if you talk about silicon photonics specifically, we have solutions that address both the optics and electrical signals. And so the -- if you think about silicon photonics as a convergence of those 2 things, it creates an opportunity for us to bring complete solutions to the folks that are working on those. We definitely see it as yet another driver of demand. But I guess I'd probably raise it up a level to just think about all of the different technological evolutions that are happening in the electrical engineering space. And as long as we continue to see that evolution, there's going to be a significant role to play for Keysight.

Got it. Okay. On the semiconductor business that you guys have, I just want to ask, one, can you kind of describe how big that business is for Keysight, if you guys have disclosed that before? And then can you talk about some of the growth drivers there and potentially how big you think this business can get as a percentage of your sort of overall pie?

Yes. So if you look back at the history of -- the long-term history of our company going back to the HP and Agilent days, we've actually done a lot to kind of focus our efforts in semi. We've actually shed some of our noncore semiconductor assets. And what we've kept is a couple of admittedly kind of niche businesses focused in the semi space. But one where we have highly differentiated technology to bring to bear in those markets. And so our semi business is relatively small. We have -- the only sizing that we've done publicly is to say that it's less than 10% of the overall company as a relative measure. But it is an area where we have some highly differentiated solutions around kind of ultra precise 3D positioning for the makers of big photolithography machines and the optics that go into those. And then we make -- for the foundry operators, we make some test equipment that helps test the electrical properties of the wafers themselves, again, highly differentiated solutions that help them in those areas. And so if we think about demand drivers in the semi space, we look at the moves that people make to smaller process architectures, certainly sub-10-nanometer to 7-nanometer, 5-nanometer things that people are looking at today. We look at the building of new fab capacity around the world. So looking at China, specifically, looking to build the domestic semi industry is a demand driver. Those are the types of things that are driving our business. And that business has been very resilient through this most recent downturn as the demand for semiconductors has continued. And you've seen that in other companies that are more exclusively focused in the semi industry and the strength that they've seen over the last several quarters and our semi business is, while small, has participated in that.

Got you. And I imagine increasing complexity and slowdown of Moore's Law, et cetera, should kind of be additive growth drivers for you guys over time?

Absolutely. Absolutely.

Got it. Okay. Question on the automotive piece. Obviously, automotive industry overall now it's troughed in 2Q and kind of recovering in terms of volume production from there. But can you just discuss the overall business opportunity for you guys? I know it's probably a bit more resilient than the automotive makers themselves just as we think about the growth of digital and semiconductor content in vehicles going forward?

Yes. The auto industry is a really exciting one from my perspective. If you think about this over the longer term, go back 15 or 20 years, Keysight really didn't have a whole lot to offer to the auto industry. We had some peripheral sales, but the auto industry was one that typically had mechanical engineering problems in the world of an internal combustion motor. And we were largely a customer -- a company that solved electrical engineering problems. But it started with pretty dramatic increases in electronic content in the vehicles. You can think about infotainment systems, things like air bag triggers or tire pressure gauge sensors or blind spot detection. These types of electronic content that's currently available in vehicles. All of that needed to be designed and tested, and that provided an initial foray for Keysight into this market and into these customers. But I think if you start -- if you turn that lens forward and you think about electric vehicles, you think about autonomous driving, you now have a very, very large industry that has kind of full-scale electrical engineering problems that they're dealing with. And I think that creates an exciting opportunity for Keysight to move into, again, a very large industry that we haven't traditionally served. And so it's largely a greenfield opportunity for us. And so if you think about the drivers of our business today, it's really those 2 things. EV probably more so in the immediate time frame than autonomous driving, but maybe over the longer term, that changes as autonomous becomes more real. But I think the EV opportunity is more directly in front of us. And we have solutions that help electric car manufacturers with battery development to making better and more efficient batteries that last longer on each charge and longer charge dissipations, many more charge dissipation cycles. We make equipment that actually sits between -- in the lab sits between the electric vehicle and the charging infrastructure that we sell incidentally to both vehicle manufacturers as well as charging infrastructure manufacturers to make sure that the protocol handoffs between the many brands of electric vehicles and the many brands of charging infrastructures happen efficiently. You get a safe transfer of power, you get safe protocol, you get safe payment, software updates, all of those types of things that happen when you pull into a charging station. And then if you think forward about autonomous driving, it's ultimately a big communications problem that you need to solve. And obviously, Keysight has great strength in communications. And so you're going to use numerous communications technologies. 5G, wireless -- excuse me, WiFi, Bluetooth, coupled with things like RADAR and LiDAR. Incidentally, things that we have solutions for in the aerospace defense space so that the vehicle knows where it is in relationship to everything that's out there on the roadway, is communicating with the other vehicles with the infrastructure to have a safe autonomous driving. And so I think it's a very exciting opportunity for us and one in which really all of the major auto companies around the world today are investing. And for one, which I believe Keysight is uniquely positioned to help them solve some of those issues.

Very exciting Opportunity, indeed. Next thing I want to touch on is, we talked about software and just the recurring nature of your business that's growing, I think, currently about 21% for software and services. Can you just remind us where you think this can ultimately expand to? And then kind of tag on to that in terms of what you're doing with the just subscription model for some of that software?

Yes. So growing our recurring revenue base is certainly an area of focus within the company. We currently estimate that recurring revenue is about 20% -- low 20% of our existing revenue base, and it's growing substantially on a year-over-year basis, not only as our software and services businesses grow but as we change the way they buy those things, particularly software from us, from perpetual onetime sales to subscription or time-based software subscriptions. And so Keysight really, since its inception as an independent public company, has been focused on providing our customers with complete solutions. Those solutions include the traditional hardware that we've sold, but now also layered on with software and services that ultimately help speed our customers' time to market and enable their success. And if you look at our software and services businesses in total, not just the recurring portion, but those businesses in total are 1/3 of our total revenues, and those businesses are growing at a rate that's faster than the overall rate of growth of the company. And so I think we're very excited about the opportunity that exists for us in software and services. We're investing heavily in the growth of those. I think you see, particularly on the software side, the things that we've done in the M&A space have been additive to our software portfolio. We recently completed the acquisition of a company in the U.K. called Eggplant, which uses software to test user interfaces, which I think is an exciting space for us. We obviously did the acquisitions of Anite and Ixia earlier in our history that moved us out of the physical layer and into the protocol layers of test for wireless and wireline. We've moved into the network visibility space, using software to help track data traffic on the networks. And so we are finding these places that are relatively near adjacencies to our core business that have higher software content and are driving not just software and gross margins but recurring revenue and the stability of our business as well.

That's perfect. And then the last couple of minutes we have left, I just want to ask you on the competitive landscape overall. I think you guys have done a really good job in terms of your competitive execution over the past few years. But I want to ask how you think the competitive landscape has changed over -- you can pick your time frame, 1, 2 or 3 years? And what are kind of your expectations for competition going forward?

Yes. I mean I think in terms of the players in the space, they tend to be relatively stable. We tend to not see a lot of new entrants into our end markets. I think it's -- that can be a challenge because you really need a breadth of a portfolio to really service the needs of customers. And I think from a competitive standpoint, that's what really makes Keysight unique. We have, by far, the largest -- the broadest portfolio, right? We tend to compete against one set of customers that may be strong in communications, another set of customers that may be stronger in the industrial space. If you look at individual tools, engineering tools, there's -- nobody has the breadth of tools that we have available to customers. And I think as the markets move towards, again, away from just tool providing to complete solutions, the ability to have that broad portfolio and couple individual instruments and software together in a way that provides complete solutions that address the specific needs of the industries that we serve is a competitive differentiator for Keysight. And it's one of the things that's driving the outpace growth that we've seen relative to the markets over the last several years for this business. So we're very pleased with our competitive positioning. As I said, we're by far the largest player in this space. We're investing heavily in both R&D and in our field to drive organic growth, and I'm confident in our ability to continue to outgrow the markets even as the #1 player in the space.

That's perfect. Thank you so much for doing this. I think we're about out of time. So again, thank you, Neil, for joining us.

Thank you, and thank you for having us. We appreciate it.

Of course.