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

Hello. Thank you for joining. Tim Long here at Barclays. Happy to have Neil Dougherty, CFO and SVP at Keysight for a fireside chat. We're going to jump right into it here with Neil.

Neil, maybe I feel like we should start with wireless. It's obviously one of the most important businesses for you guys. It's been a big driver over the years. Could you give us kind of an update on where you see that cycle, particularly on the R&D side? We're still early stages of millimeter wave, maybe talk a little bit about Releases 16 and 17? And kind of how you see that R&D cycle for wireless where we sit today?

Yes. I think from our perspective, we're still in the very early innings of 5G rollouts, outside of China, where we have a sub-6 gigahertz deployment that's well underway. But outside of China, we're really still looking at a few trial locations in limited geographies. And one of the things I always joke is that I don't personally know anybody who's actually made a 5G phone call at this point. And so the 5G opportunity is very much in front of us, and there's a lot of -- both research and development as well as deployment work that is going to need to occur. And as we're all seeing right now, the early deployments of 5G are all relatively lower frequency, sub-6 gigahertz deployments. They're typically non-stand-alone deployments of 5G. And we think that you're going to see a migration, not just of some future deployments, but really those that are already deploying sub-6 gigahertz, ultimately want to migrate to the higher frequencies to get performance advantages. And so we see this 5G cycle as one that's likely to be longer than prior cycles because of the complexity, because of the different flavors. And then from a Keysight perspective, in addition to participating in all of that, there's also the other use cases that are going to leverage the 5G networks, the industrial IoTs, the private networks, the automotive industry for autonomous driving. And there is the complete, what we believe will be, a relatively thorough reworking of the wired side of the equation that will be necessitated by the increased data traffic. And so we see a very long runway in front of us. We believe that the R&D budgets of our core customers are very stable over the time. In fact, they're stable and increasing over the long run, and that's one of the reasons we're attracted to those R&D revenue streams. And the second part of your question was really around the standards, the standards revs, Rev 16, Rev 17. And from a Keysight perspective, we're not overly reliant on -- certainly, on any one rev of the standards where we're not particularly sensitive to the timing of the standards deployments for a couple of reasons: one, if you go back in time, you'll know that these things are quite often delayed. I'd say that's more of a norm than not. But typically, the customers that we're dealing with, the big ones anyway, are participating in those standards bodies. And so they have a pretty good idea of the direction those things are headed before you get a formal release of the standards. The actual development work actually begins after -- before you added -- before those standards are released. But the standards themselves do provide a positive impetus for investment. Each time there's a new set of standards that comes out, new documentation of add-on technologies, use cases, those types of things, those create new design cycles. Design teams get moved onto those technologies and that creates waves of investments. It's one of the reasons that we continue to see robust investment in 4G, here, 10-plus years after the release is those people continue to eke out performance from those standards long after they were first deployed.

Okay. Great, great. Maybe if I can follow on and talk a little bit about the manufacturing side. I'm sure you're pretty well into it for semiconductors and infrastructure equipment. Maybe just talk about the cycle on the manufacturing side? And just give us the latest on where you stand on devices as we start to see a real ramp of phones -- 5G phones in the market?

I mean in the grand scheme of where we're ultimately getting ahead, and things are still happening at relatively low volumes. And so I think even from a manufacturing's perspective, we're still early days. And you got a little bit of a chicken-and-egg problem here, right? And which -- why go out and buy a 5G handset, if there's not a 5G network in your neighborhood on which you're going to be able to use it. And so I think from a volume perspective, as networks get deployed, the demand for devices is only going to increase, and this thing will play out over time. I think that from a Keysight perspective, the good thing is that we're well positioned, particularly, in areas of that manufacturing rollout. I'm thinking about component test, chipset test, base station test. These are all areas where Keysight has unique capabilities. We have a history of being very successful in these end markets. We know these are end markets where the level of test is more complete and more complex, and those tend to be the types of markets in which Keysight excels.

Okay. Great. And why don't we move to the A&D business under the Communications Group, CSG. How sustainable do you see the recent growth in A&D sales setting aside normal seasonality relative to the record levels that you saw in your October quarter?

No. I think if you look at kind of our overall view on the broad A&D markets, we continue to be very bullish. I think there's a trend that's happening globally as nations around the world invest in defense technology. I think we're seeing a change in the way folks think about aerospace/defense, and it tends to have that technological bias. If you think -- pull back to a U.S. perspective and you look at the budget increases we've seen over the last several years, there's a particular line item in the budget called research, development, test and evaluation, that tends to be the one that's most relevant to us. And that typically has seen larger growth on a percentage basis than we've seen in the overall aerospace expense budgets, and that represents the shift away from logistics types of spending, bullets and boots and those types of things towards -- to more technology spending. And anytime in any industry, people are investing in technology that tends to be good for Keysight. And there's no change in the defense cycle -- the defense sector as well. And so we believe that's a long-term trend that is going to provide -- we're going to provide a benefit -- a long-term secular trend is going to provide a benefit for us for years to come.

Great. Good point.

Maybe sticking on the comm side, Neil, you did mention with 5G, it might have a follow-on effect on some of the traditional wired -- wireline businesses. So could you touch a little bit on optical? Obviously, we're seeing a pretty good migration to 400-gig in some places, 600, 800 in others. So could you touch on that cycle? And how you think that will play both for the kind of the legacy KEYS business as well as for Ixia?

Yes. So there's a lot in that question. So first of all, as you think about kind of the follow-on benefits of a 5G deployment into the wireline network, I think it's that thought process that led us to complete the Ixia acquisition in the first place. That way, our thesis was largely based on that, right? You get a 5G network deployment of which Keysight is going to be a key enabler, and as the data traffic across the network expands -- across the wireless network expands, all that data traffic ultimately works its way back to the wired side. And you're going to need to see a -- you're going to need a pretty complete overhaul of that wired network. And what Keysight did view the Ixia acquisition is to position ourselves to fully participate in that entire ecosystem development, from wireless to wireline and from the physical layer up through the protocol layers. And so that was -- that's how we've been thinking about this problem. And as you said, in the second part of your question, we have -- we're seeing right now the deployment of 400-gigabit has clearly been delayed, right over the course of the last couple of years. But Keysight has referenced in our past couple of earnings calls, the strength that we're seeing in not only 400 gigabit, but in the research phases of 800 gigabit and even terabit. And I think these are -- it's going to cycle. We're going to see, just like we saw a move from 100 to 400, eventually, it's going to go 400 to 800. But these are the moves that are going to be necessary to deal with this expanding and unsatiable demand for data that exists in the marketplace. And we're encouraged by our ability to participate across that entire ecosystem refresh.

Okay. Great, great. Maybe just talking across the businesses, Neil, you guys have had a really good move on the software and service side and recurring revenues. So could you talk to us a little bit about the evolution of the -- more as a service and software elements of the solution that you're selling? And how much runway do you think there is for that change in business model? And obviously, for you as a CFO, it's much more predictable, good margin. So just walk us through the puts and takes on it.

Yes. Absolutely. Clearly, we've seen outpaced growth from our services and software components really since our separation through this most recent fiscal year. We're at the point where if you look at our FY '20 revenues, we just completed our fiscal year, a full 1/3 of our revenues came from our software and services businesses. And those businesses continue to grow at an above-average rate for the company. And I do believe there is a significant runway that exists in both of these areas. Maybe starting with software first, not only is our software business growing but we're changing the way in which our customers buy software from us to one that's historically been biased pretty heavily towards perpetual or onetime sales to hopefully we're at a point -- over the course of the next several years, we get to a point where we're very heavily biased towards subscription sales of our software. And so we have 2 vectors in which we're working there. One is the absolute growth, and then, two, is the change in the nature of the sale to be more recurring in nature. We've actually seen our total on a -- if you think about it from an ARR perspective, exiting this year versus exiting the last year, we saw our annualized recurring revenue increase almost 20%. And so again, that's a function of growth in software, growth in services. But also this change that's occurring in terms of the way that we're selling these products. On the services side, obviously, we have the very large installed base of equipment that's out there in the marketplace. Our customers are regularly coming back to us for repair, calibration, spare parts, those types of things and provide a very steady stream of revenue. But we're also moving to things like pay for support, even on our hardware instrumentation. We've rolled out this product called KeysightCare a little over a year ago, and we're seeing nice take-up of that as we provide the ongoing technical support to our customer base via a subscription model. And -- so we see opportunities to not just grow these things, but to continue to add value for our customers. I mean, ultimately, that's what this is all about is us helping them with their key challenges, helping them speed time to market, helping us do some of the things that are maybe more contextual for them, but that we can bring on and provide differentiation as part of our solutions, and ultimately, deliver more comprehensive solutions that are highly valued by our customers and drive brand loyalty.

Okay. Great. And Neil, just wanted to touch on China and trade. That's been a source of concern for investors for a couple of years now. And -- but it's never really materialized into a large headwind. It seems like you've always been able to sort of fill in those gaps. How can investors think about gaining confidence that you'll be able to continue to do that and to grow the China business?

Yes. I mean I think we have a long-standing presence in China. We've been there since the early 1980s. We have a significant -- not only sales presence, but research and development and other professional sort of we're -- we operate across the board in China. We have great customer relationships. I think if you look at the types of things the companies in China are investing in, it aligns very well with the types of things Keysight is good at and is driving strength. You think about, obviously, commercial communications and their early deployment of 5G comes immediately to mind, but they're also investing heavily in electric vehicles and autonomous driving and consumer electronics and all of these things. And we clearly have value to add in this space. And so I think that match-up is unique. And I think, as you said, the China trade situation has kind of been ongoing for a couple of years at this point. And we have been -- we've kind of taken the approach of wanting to communicate with our investors how -- as transparently as possible, what we're seeing, right? And the headwinds have been real. But at the same time, you have these underlying secular growth drivers within China, and you've got a set of Keysight solutions that are at the leading edge. You've got -- we have very deep customer relationships in China. Those customers are pragmatic, and they ultimately care about their own time to market and their own businesses. And we've been able to offset some of the direct headwinds from Huawei, from ZTE, from others and continue to grow that China business. And we're very optimistic in our ability to continue to do that going forward.

Yes. It's a great point. It's easy to forget that China also has the majority of the world's electric vehicle market and a lot of parallels there.

Absolutely.

Neil, I did want to touch on one other vertical, which has been really strong in that semiconductors. You guys have had a pretty good run there. And it just seems like as an end market, it's been very strong as well. So can you talk a little bit about sustainability of that? I feel like it's continued to outgrow the rest of your business. What kind of trends are you seeing there as far as the durability of that line?

Yes. So you're right. The semiconductor business has been very strong this year. Obviously, there's -- the chip demand globally has been very strong. We've seen that across the semi industry. And I think just the circumstance happened that said that our semi supply chain was less impacted than the supply chain for some of our -- it's a bit of a unique supply chain within the company, and it was a little bit less impacted than our more standard supply chain. So we've been able to match that demand over the course of this most recent year, I think. As you think about the opportunity longer term, I don't think that -- obviously, there's some cyclicality that we know about that exists in the semi markets, but the demand for chips certainly doesn't seem like it's at itself anytime soon. And we know -- if you look at the drivers of our own business, it's the move to smaller process architectures. It's the continued advancement of chip technology that ultimately drives the investment for the types of things the Keysight is bringing to the marketplace. So we continue to be very optimistic about our ability to deliver value to our semi customers. We think we have very strong market positions in the segments of that market in which we play, highly differentiated solutions that our customers value, and again, very optimistic as we look forward.

Okay. Great. Maybe just touch on kind of M&A. Could you just give us an update on Eggplant? And kind of how that integration has gone and the rationale behind it? And when you look out into the future, I'm assuming for the capital allocation strategy, there could still be other assets added to the ecosystem. So maybe just give us a little high level on what type of technologies you might want to add to the portfolio?

Absolutely. So obviously, it's still early days with regard to the Eggplant acquisition. They've been part of the company for less than 6 months at this point in time. But we're very pleased with the acquisition of Eggplant and the team and the business that we've acquired there. It's obviously a pure software business, but it's in the testing space. So Eggplant uses software to test software, specifically test -- they test the user interfaces of certain point-of-sale or you can make of -- the infotainment system in your car as an example. And they want to make sure the user experience when interacting with those devices is as thrilled. And I think one of the things become immediately apparent as we closed this acquisition and got our teams working together is there's a way in which folks that do test think there's a common language. And so whether it's the types of things that Keysight has historically done to help allow electrical engineers or it's the type of things that the Eggplant is doing to help, again, with this user interface testing, there's a synergy that exists there. And we're very pleased with what we've been able to achieve. They're ahead of targets at this point in time. The integration is going very well. And it's the type of thing that we'd like to be able to continue to do more of to kind of pivot to the second part of your question, which is, obviously, Keysight is in a very strong balance sheet position at this point in time. We'd like to get out there and continue to add to our business via value-accretive acquisitions. And -- but I think the key there is for us to stay disciplined. We put a lot of targets at the top end of the funnel to get a relatively small number out the bottom, but we want to continue to actively be looking for targets. We are attracted to software assets. Ideally, we'd find targets that are accretive both to our organic growth and to our gross margin. And with our gross margins approaching the mid- to upper-60s at this point, that's increasingly meaning either pure software assets or assets with high software content. And so we're actively looking at that space. We realize that valuations are high, and we need to maintain our discipline about return hurdles and strategic alignment. But when we find the right targets, we won't hesitate to act on them.

Okay. Neil, on that topic of integration, over the past couple of years, you've also been progressively integrating Ixia and also the Service Solutions Group under the Communication CSG umbrella. Can you talk about how that's played out in terms of improving your go-to-market strategy and organization?

Yes, absolutely. I'm going to start with services first. So obviously, it was several years ago that we completely reorganized Keysight to focus on industry verticals rather than product segments. But at that time, the one thing that we left out of that was our services business because it had been flat for a long period of time, and we felt like we needed some dedicated focus on growing our services business. And we wanted to manage that kind of separately from these industry verticals. We got some great early traction on that to turn that business around to the point where it's starting to grow. But then you get to this point where you have the lion's share of the company is focused and organized around industry segments. And you've got this one thing that's kind of being managed separately. And what we really want to drive is upfront attach rates of services. And so when we're dealing with our communications customers or our automotive customers or our general electronics customers, we want them not just buying hardware and software from us, but services as well and ideally doing so upfront. And the best way to facilitate that was to actually pull the services businesses into this industry model so it wasn't the one outlier. And I think the evidence that we've been very successful is the continued ongoing growth rate of that business. We no longer reported this as a separate segment. But in our very first Analyst Day post spin, we talked about being able to grow that business from its -- the $400 million size that it had been basically for the previous decade to $600 million. And on the order line, we felt just short of that this year. I think we're in the close to $590 million of orders here in fiscal '20. So we've continued that growth trend. I think there's still plenty of runway for us in front of services. But aligning it with the industry solutions teams was absolutely the right way to go. I think with regard to Ixia, the trigger was a bit different, right? We went out and did the Ixia acquisition. And the thesis that led us to make that acquisition was really a desire to service the entire commercial communications ecosystem, end-to-end, wireless to wireline and up and down the stack, physical layer to protocol layers. The first acquisition we did earlier, a smaller transaction, was to get protocol layer tools for wireless via the Anite acquisition. We then went out and got protocol layer solutions for the wireline network via Ixia. We managed that business separately for a couple of years to get through the integration, get them folded into Keysight and do that in a way that was kind of separate. But the intent always -- all along was to pull this communications' end-to-end vision together under one leader who could tie together our solutions across that ecosystem. We're obviously -- that one is a more recent move. It's about a year old at this point. But again, we're making good headway. We've talked about the strength that we're seeing in 400-gigabit and 800-gigabit, talked a little bit about some of the additional profit improvement that's come for the behalf of -- for our Ixia business on prior calls. And -- so again, very pleased with the strategic results that have happened from both of these moves.

Okay. I think we're running out of time. Maybe just one last quick one here, if you can touch. You mentioned the strong balance sheet. Just kind of give us an update on capital return priorities for the company as we look out.

Absolutely. So if I think about our capital allocation priorities, really no change from what I said at our Analyst Day in March, right? The first thing we want to do is we're making sure we're investing through our P&L on the organic growth of our business. That means healthy investments in R&D. We're investing at about $700 million per year at this point in time, 16% of revenue. We're investing in our field, expanding -- our direct sales force has been a multiyear effort that is ongoing, and we continue to make those investments. I've just talked about our desire ideally to put the money to -- on our balance sheet to work, doing value accretive M&A. We're going to continue to look for targets. But that being said, we're not in this business to hoard cash, right? And so to the extent we're not finding targets, we'll go ahead and return capital. We bought $200 million of shares in our most recent quarter when they're at pretty attractive pricing, about $95 and change. So we're very pleased with the ability to do that. And that exhausted our prior share repurchase authorization. And our Board has just recently approved a new $750 million authorization for management. We -- as always, we have the stated commitment to at least to be anti-dilutive with our buybacks. But I think we've proven over the course of the last fiscal year,that when we see opportunities and when the balance sheet dictates, we'll be more aggressive with those return of capital programs.

Okay. Great. That's really helpful. Thank you very much for the time. Appreciate everyone for joining, and we will sign off here. Everyone, be safe and have a nice holiday.

Thank you, Tim. Appreciate it. Happy holidays.

Okay.