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

Hi. Good afternoon. I'm Samik Chatterjee, the network, equipment and hardware analyst at JPMorgan. On day 2, in the afternoon session, the next session we are hosting today is Keysight Technologies. As you can see on your screen, we have Neil Dougherty, who's the CFO. So definitely want to start off with thanking Neil for taking the time to host this session and also participating at the conference.

Neil, thanks for the time here. Let me kick -- start it off with a question just really in relation to the acquisition that just hit the gate this morning that you've closed, I think, announced this morning on quantum. I think I am definitely blanking on the exact name here but -- so if you can kind of give us the details there, looks like something that continues on the quantum investments that you were targeting, but just give us a bit more background to start with and we can get into the more kind of normal business questions after that.

Yes. Happy to do it. So yes, we did. The company did issue a press release today highlighting our acquisition of a company called Quantum Benchmark up in Canada. This is the same acquisition that we mentioned on our earnings call last week. I think the acquisition was actually closed 6-or-so weeks ago, and we're just issuing the press release here today following our earnings season. But Quantum Benchmark, it's a small technology acquisition for us. They have some software capabilities and most importantly some key talents that we wanted to acquire as we look to build a quantum capability within Keysight. So this is the second small quantum acquisition that we've done over the last couple of years. I think it was about 18 months ago, we acquired a company in Boston called Quantum Labber. And now today, we announced the acquisition of Quantum Benchmark. And again, looking to build a set of capabilities as we work with partners who are investing heavily in quantum computing. So Keysight obviously is not looking to build the quantum computer. We're not investing in quantum in that way. Much like we do in other industries, we're looking to build a tools and solutions portfolio to enable those that are investing in quantum to bring technologies to market. And so we're very excited to have the Quantum Benchmark team on board within Keysight. Like I said, it's been a few weeks and so far, things are going very well and we look forward to continuing to build our presence in the quantum markets over the years to come.

Great. Neil, the other pertinent question that we're getting since yesterday is the impact of the, I think, 2-week lockdown that Malaysia has imposed. And I think even hardware companies has issued a negative preannouncement based on the 2-week lockdown in Malaysia, which has triggered a lot of questions. So I wanted to see if you can address that. What kind of impact should we think that could have on the operations for Keysight?

Yes. I'm aware that there have been at least 1 other player in the broader technology space that has highlighted the Malaysia shutdown as a potential concern. I was actually a little bit surprised by this. And so I've followed up with my team just yesterday to confirm that we are not -- us and our primary subcontractors are not impacted by the recent regulations or statements of the Malaysian government. We continue to operate, obviously, with strict operating procedures in place around social distancing and other controls to prevent the spread of COVID. But there has been no announcement by the Malaysian government at this point that has changed our operating procedure in the recent weeks, right? Really since we brought our factories back online last April and May time frame, we have been operating within the guidelines outlaid by the Malaysian government and we continue to do so.

Okay. So it sounds like, based on your charts, the lockdown here is different from what you had last year in terms of the government regulations or what their recommendations are, it's different from what you encountered last year.

Absolutely. A year ago, we were included in the requirement to shut down and at this point, there is no further announcement that is requiring us to take -- make adjustments to the procedures and the operations that we currently have going within our Malaysian factory.

Okay. Great. So I wanted to go into more kind of business side questions a bit, [Operator Instructions]. So Neil, let's start with the order trends. You had record order trends in the quarter of $1.3 billion. Just talk through what are the broad drivers. I think the industrial -- broad industrial recovery is not as surprising. We've seen that across multiple other companies, but what's driving strength in aerospace as well as communications?

Yes. It's a great question. As I sat back and reflected on our most recent quarter, to me, the most impressive and frankly the most telling aspect of our results within the second quarter was our order situation, right? We generated 22% order growth in the quarter. And that's, again, just as I call people's attention to compare orders last Q2, we're down 3%. So not nearly as big of an impact a year ago on the order line as we saw in the revenue line when our factories did shut down. And so that 22% order growth I view as a strong signal to the strength of the broader economy as well as to the rollout of numerous technologies that are driving our business today. And what was most impressive to me about it was the broad nature of the strength within our order book. If we look across our major end markets, we generated record orders really across the board, commercial communications, aerospace defense, automotive, semi and general electronics all generated record orders within the quarter. And if you look at geographic basis, we put up strong order growth in all of our regions. And then maybe most impressively, even with all that and 22% order growth for the company, our software and services businesses, which has been a particular focus of the company, have actually outgrew the broader business. So growth north of that 22% rate. And I don't think there's any one driver, right? I think it's different things in each end market. If you would start -- starting with commercial communications, right, it's certainly the continued investment and rollout and commercialization of 5G, it's investment in 400 gigabits in terms of a rollout and an 800-gigabit on the wireline side in terms of R&D investment. On aerospace defense, it's really about defense modernization that is happening around the world. We saw great strength in our aerospace defense business led by the U.S. and Asia but with recovery in Europe as well. So that was broad-based. Moving over to electronic industrial end markets. I think semi, there are a number of drivers there. Certainly, we've talked about component shortages and everybody is familiar with those. So that has just broader capacity adds being at -- across the semi space. But beyond that, you're looking at China who's looking to develop a domestic semi industry, you're looking at other areas, including the U.S. Looking to re-onshore semi production as they look to ensure supply. And then from a technical perspective, it's the move to smaller process architecture, 5-nanometer and below. All of those things are additive and are driving demand for Keysight's products. I think in automotive, I think we've seen a strong bounce back. Automotive was one of the industries that was most heavily impacted a year ago by the COVID economy, if you will. We've seen a bounce back in production. About 30% of Keysight's auto business is tied to production vehicles, both electric vehicles as well as legacy internal combustion vehicles. And then while the investment in R&D was not nearly as impacted as the investment in manufacturing, we start seeing a further step-up in investment in R&D across the industry, particularly in the AV and EV space, as all the major OEMs and Tier-1 providers are looking to bring products to market in that EV space. And so that's very encouraging. And then you led off your question by highlighting our general electronics business, extraordinarily broad market here and so tied to GDP. And I'd point to macro strength, right? If you survey the banks around the world where you're looking at growth between 5.5% and, in some cases, north of 6%. And I think we're benefiting from that broad macro strength as well.

Neil, I know that's a pretty broad portfolio to go through, so thanks for that. So I think the order strength, obviously, record orders, great to see one concern that lingers on with investors when they see this, particularly during times of capacity constraint as the over-ordering from customers. What are you seeing there? Is there any particular segment of the broad portfolio that you have or the verticals that you address where there could be a bit more of an inventory build that can be possible? Like how should we think about that? Is there any channel dynamics in any of your businesses as well?

Yes. I mean the simple answer is, I don't think so, right? First of all, that over-ordering or double-ordering is not a phenomenon that's particularly common within this test and measurement space. It is something we monitor for and we don't see any signs that it's happening. But I'd even raise that one step further. And if you look at what's happened to our own lead times, we have seen some lengthening of lead times over the course of the last 5 quarters really since COVID started, but we're talking about a few weeks not months or, in some cases, in excess of a year as you're seeing from some suppliers. And so I think on average, we've seen our lead times stretch through 4, 5 weeks, something along those -- along that order of magnitude. I think we're doing a good job getting product into the hands of our customers. I can't point to a single instance where Keysight has lost a customer in order because they've gone somewhere else to get assurance of delivery. And so I think we tend to be really well positioned. We talked a little bit about on the call some of the dynamics that go into that. And as you know, Samik, Keysight is vertically integrated. We run our own fab. We have our own packaging technologies, which we manufacture in-house. And so a lot of our most highly differentiated components for instrumentation are under our control. And what we're producing -- what we're procuring from the general market is more a general purpose, more broadly available types of componentry. And so that has limited to some extent the downside impacts of some of these supply chain concerns.

Again, as a reminder for the audience here, you do have the option of sending in a question if you have any, and I can ask them on your behalf. Neil, let's move to commercial communication here. And obviously, coming into this year, you had the headwind from the restrictions of Huawei to navigate through. I believe they were a low-single-led percentage customer, for the total company that is. So how are you offsetting some of those headwinds? I mean you seem to be, at least in my model, on track for like mid-teens revenue growth roughly for the full year or so. Just help us think through what did you have to tweak or what were the offsets that are helping you offset that weak revenue -- Huawei revenue falling off.

Yes. So you're right. We have had a significant headwind from the trade restrictions on Huawei. But so far, we've done a good job in overcoming it. It's really in our compares for just one more quarter here in the third quarter. It's about a 5-point headwind for us during this current quarter. And then it is largely be out of our numbers. And I think we've touched a little bit already on this call on some of the broader demand strength that we're seeing across a number of end markets as well as the broad macro strength in the economy. Certainly, that's helping. I think, but if you look at what we've done, we've worked really hard to redeploy sales resources. We've added sales resources in China. To -- and our China business is -- not just as Keysight continued to grow, but our China business, our current commercial communications business have all continued to grow as we successfully offset that headwind from Huawei. And so I'll come back to Keysight, has extraordinarily broad portfolio. We've got a very deep customer base, a loyal customer base. We've got technology leadership in a number of areas where you've seen disruptive technologies come into the market. And that puts us in any position to be able to capitalize on the growth that's driven by these secular trends.

Got it. So moving to backlog here, and there's been a bit of divergence between the orders that you're recording and the revenue guide. It suggests your backlog is increasing. And I'm guessing with the backlog, you should have good revenue visibility for the coming quarters as well. But one of the aspects that has been brought up by investors is as you start to build backlog and there's a bit of a divergence between orders and revenue, why is it another concern that some of your customers might move to competing suppliers? Just help address that. What is the switching cost for the customer? Why are you comfortable not digesting backlog in a kind of more material fashion in the company?

Yes. So it's a great question. So clearly, we have built some backlog here over, particularly since the COVID shutdowns of a little over a year ago when revenues were more severely impacted than the incoming order rates. But Keysight has invested significantly in bringing capacity online. If you take a look at our first 2 quarters of actuals plus our guide for Q3, we're on roughly a $4.8 billion revenue clip, and that compares to $4.2 billion last year, $4.3 billion the year before COVID happened. So we have added significant capacities. And we continued to make investments and adding capacity. The reality is that in a COVID environment, it has proven to be a little bit more difficult and a little bit more time-consuming to add capacity than it typically would be, right? We talked a little bit about the situation in Malaysia. Our factory continues to operate, but we do have strict operating procedures around social distancing and other things in place that we need to follow. And that does, to some extent, make the problem a little bit more challenging. It's not as simple as just buying some new equipment and hiring more people because we don't necessarily have places to put them and maintain the social distancing that we need to keep our current employees safe. And so we continue to make those investments. I expect the capacity to continue to ramp for the company and I expect us to work the backlog down over time. As you note, the improved backlog situation or the increased backlog situation we view us an asset at this point in time as we look forward. And as to the question of why -- what gives us confidence that our customers aren't going elsewhere to secure supply or just secure delivery. First of all, I can't point to a single example, as I've said, where we've lost a customer who is searching delivery. I think we've done a good job of managing the needs of our customers. We've seen a relatively small increase in our own delivery time. So it's not like our customers can't get product out of Keysight. They're waiting, in most cases, a couple of extra weeks to get delivery. And given the technology lead that we have in a lot of these key end markets and the market presence and, as you noted, the switching cost of trying to not only qualify a new vendor but then have your engineering teams using with multiple -- operating multiple user interfaces, it's just not -- it's not worth to switch at this point in time given the fact that we are, in fact, getting product out the door in a very timely fashion to our customers.

That's helpful. So let me focus a bit more on the commercial -- comm R&D pipeline here. Obviously, we keep getting questions on when does the R&D cycle be? What are the kind of entire work -- does the timing look? How does that cycle look from here on? Just help us with what visibility do you have in terms of the 5G R&D pipeline from your customers. What are the areas of strength? How long of a 5G R&D pipeline should we be expecting here? Just kind of the top-of-mind investor questions and I'm sure you get some of these as well on a continuous basis.

Yes. So the #1 point that I tried to make is that the reason -- one of the reasons why we like the R&D markets is because the R&D investments of our customers tend to be very stable over time. It is not true that there's this R&D phase and they invest in 5G R&D and then the R&D stops and they start to do something else, right? There's -- the R&D investment continues over time. And as we look forward, it will eventually pivot to 6G, right, or other new technologies. But those R&D engineers are going to continue to work for these customers and they're going to continue to need tools. And so we believe these R&D state investments that our customers make are very stable over time. We're still in the very early stages of 5G deployments. There's a lot of equipment that still needs to be developed. Just focusing on -- much less deployed, but just focusing on the development side, a lot of the development today is happening in the sub-6 gigahertz frequencies. There's going to be a complete -- there's going to be a need to redeploy and develop the millimeter wave equipment that will ultimately enable millimeter wave networks. You're looking at continued evolution of the standards for a 15, 16, 17, each one of those further refines the standard and necessitates additional R&D work. You've got the other use cases beyond the cell phone that will necessitate work in R&D across the ecosystem. You have dynamics that didn't exist in prior generations, like O-RAN and the disaggregation of the access side of the network, right? This is a network access used to be a 4- or 5-customer opportunity for Keysight. But now with the disaggregation of that part of the network, there are literally dozens of new companies that are now working on various parts of network access and that are potential customers for Keysight. And so we continue to see a lot of opportunity. We believe the 5G cycle is very long in nature and certainly for the foreseeable future, we see great growth opportunities for our 5G portfolio.

Okay. That's helpful. I think partly what you mentioned in terms of this perception that suddenly R&D stops and customers move to doing something else, what we've generally seen as a perception is investors think just because 5G equipment deployment is starting, that 5G R&D slows down. So you addressed that largely to the -- in the answer to my last question. Maybe what I can ask you here on that front is also try and quantify or address what exposure do you have to 5G equipment deployment or as R&D moves towards more validation and production and deployment of the equipment, what leverage do you have? I understand you are more focused on the R&D pipeline communication, but as deployments start, would Keysight have any leverage to that deployment overall?

Absolutely. We -- just because we have tried to execute the shift more towards R&D, we have by no means stepped away from our commitment to enabling our customers as they bring products to market and manufacturing. I think we tend to be more focused on the component and chipset manufacturing as well as the base station manufacturing. Those are the areas that we find we have the most to add in terms of value-added to our customer base. But we've historically been #1 in both of those end markets and I would expect that we'll be #1 in 5G manufacturing as it relates to those areas as well. And so -- and the fact that we've done such a good job winning in R&D we believe provides leverage into our -- or provides kind of synergy into our manufacturing solutions, right? It's going to be an easier transition for companies that are using Keysight in R&D labs who continue to use Keysight on their manufacturing lines. We provide consistency of test algorithms and other things that make that a lower risk option. And so we believe we're very well positioned. We've got the right customer relationships. We've got the right products and we're going to be very strong participants in the deployment of these 5G networks when and as it is occurring. We've already begun to see ramps in our 5G manufacturing solutions, we talked about that on prior calls, and I only expect that to continue as the rollout gains momentum.

All right. Neil, thanks for that. Maybe, again, just to remind the audience if they have any questions, please send it through. Neil, one of the other topics that I did want to hit on is really how we think about the long-term model here that you have for 4% to 6% top line growth. It does tend to imply that you outperformed the underlying industry. So how should we think about the outperformance to the underlying industry? What's the driver there? Is it consistently gaining more dollar share of your customer wallet? Or is it more market share and expanding to a broader base of customers? What is the driver of when you -- what's embedded in the 4% to 6% guide and outgrowth to the underlying industry?

Yes. So I mean, I think you highlighted our strategy, right? It is to definitely look to outgrow the broader market. And I think there are a number of things that are unique to Keysight that serve to make that possible, right, both in terms of just outgrowing the share or, as you say, gaining wallet share at particular customers. So first of all, I'd point to the breadth of Keysight's portfolio, right? We have, by far, the broadest portfolio of tools in the industry. And that's important because as you look to migrate from simply being a tools provider to being a provider of complete solutions to your customers, the more underlying building blocks you have with which to comprise those solutions, the better off you're going to be, and that's both hardware and software tools. So Keysight today, we're investing north of $700 million per year in R&D. That's the revenue line or more than the revenue line for many of our competitors. So we have ability to invest in technology innovation that I think is unique in the industry and to support that broad portfolio of solutions and tools. We also have a very significant sales presence that I think is unique in the industry, and we've actually doubled the number of direct frontline sellers that we have out calling our customers over the course of the last 3 or 4 years. It's been a significant investment to increase the reach of our sales force and I think that helps. But as you get to this wallet share issue, what I would point to there is the migration that Keysight has made from being a simple tools provider to being a solutions provider and adding in software and services and specifically addressing the design and test needs of our customers rather than looking at them to integrate our various tools to figure out how to use them. We're increasingly taking that integration on ourselves and providing them complete solutions that address the specification issues of the industries that we're working to solve. That differentiation is obviously monetizable and comes in the form of increased wallet share at key customers as we're doing more and allowing them to focus on the core and us absorbing more work for them. It would be context, right? And so we're very encouraged by our position in the market, our product portfolio, our ability to continue to invest in all of those things and I think the relationship that we have with customers, right? And it just serves as a positive feedback loop and helps to inform our future R&D decisions and help derisk those R&D investments because, in many cases, we're working directly towards a specific request from a current customer.

Got it. Helpful. So that was helpful. Let me pivot a bit here to asking you about the competitive landscape. I think one of the questions that we keep getting is how is Keysight differentiated relative to competition? Also, how should we think about the primary competitors in each of the different markets just given that the test and measurement market doesn't tend to have as many kind of global players of the likes of Keysight? There tends to be a bit more confusion about who you compete with, each of those either verticals or kind of product areas. So can you just help take us through that? What's the differentiation in each of the markets? And who are you competing with?

Yes. So as you noticed, there's a relatively finite set of competitors in this end market of which Keysight is significantly the largest with by far the broadest portfolio of tools and solutions for the electronics industry and for electrical engineers. And so we compete -- you could look at the way that we compete either by kind of market segment, commercial communications or, in some cases, you actually need to go down to the individual tool levels because there are some competitors that specialize in particular tool categories. And so it really depends. But I think you look across the competitive landscape, the players really haven't changed: it's Rohde & Schwarz in Germany, it's Anritsu in Japan, it's Tektronix, it's National Instruments. Those are the biggest players in T&M besides Keysight. And again, but none of them have the breadth of portfolio, the market presence, the sales force reach, the vertical-integrated supply chain that we have, the ability to invest in R&D at a rate of $700 million per year or greater. And so we're uniquely positioned relative to that peer set. And I believe we're very well positioned as we look forward, right, with leading technologies and across a broad range of industries. I think as we look at kind of the challenge for us, we see ourselves as an enabler of disruptive technologies, right? Our customers in many -- across many industries are looking to disrupt and we provide them with the tools and solutions necessary to bring those disruptive technologies to market.

Neil, where does software fit into all of this? Like particularly amongst the competitors that you talked about, investors are always curious of where those individually held companies are on their software transformation. Do they have necessarily the same capabilities that Keysight is working on when it comes to the software capabilities?

Yes. Software has certainly become an increasingly important part of Keysight Solution's portfolio. We have roughly 20% of our current revenues are coming from software. And I think that the software is interesting. I look at right now kind of software that's linked in some way, either operating on or some operating with some of our hardware instrumentation, and in those cases, the competitors are very much the same historical T&M competitors that I've just mentioned. But Keysight, as we've looked to build software capability, has also entered some software-specific businesses. For a long time, we -- for example, we've had an RF microwave EDA business, electronic design automation business, that we believe is, from a strategy perspective, it's very well aligned with our other T&M businesses because our customers in the communications space in many cases or in most cases are using our RF EDA tools to design in the software space before they prototype and then ultimately use and choose to use Keysight equipment and solutions to test those prototypes in the physical world. Beyond that EDA business, we've used acquisitions to enter some other pure software businesses. Through our acquisition of Ixia, we acquired network visibility tools that help network administrators and IT departments monitor traffic on their networks. And that obviously brings a new set of competitors beyond the traditional T&M competitors that we've dealt with. And most recently, we completed an acquisition last summer -- I don't remember the month exactly -- but of a company called Eggplant, which developed software that is used to test software user interfaces. And so again, another pure software business again introducing another set of kind of nontraditional T&M competitors to Keysight. I think those pure software markets tend to be more fragmented in nature. There's a lot more newer companies that are operating in those spaces, and it's one that I think we continue to have interest in and particularly as we look at our M&A strategy and an opportunity to bring in to other new pure software businesses. Obviously, we're conscious of software valuations and need to remain disciplined, but when we find the right targets at the right valuations where we believe we can add value and that link in well with the other things that Keysight has going on across our broader operations, we won't hesitate to bring in those assets within the Keysight umbrella.

Great. Neil, one of the questions that I get often on the software side is what -- today, you're about 20% software mix, what could that look like longer term? Definitely, I think nobody is expecting like a pure software company in the future, but what could that mix look like or a ceiling for that mix could be? And the other second part of that question I had was on the services front. I know you had embarked on the transformation there. Are you now largely done in trying to monetize services to the maximum with your customers or the installed base? Where do things stand there?

Yes. So let me start with the software question. Obviously, we haven't put out a specific target as to where we think software can get. It's north of 20% of revenues today and continues to outgrow the broader company, even with the 22% order growth that we put up in the most recent quarter. Both our software and services businesses actually outgrew the broader company and so we continue to shift the mix of our business more heavily towards software. As I said, I don't have a specific target for you today, but maybe as a point of indication, we do have solutions today, primarily in the 5G space, that are north of 40% software content. And so as you start to think about the opportunity for software to be part of our solutions portfolio, that's at the high end but it gives you an idea of what's possible. And as I've just mentioned, we've entered into a number of pure software businesses that aren't linked to hardware at all. And the more we do that and develop pure software content, that provides further ability for us to significantly increase the percentage of Keysight revenues that are coming from software. On the services side, we had a services -- at the time that we separated from Agilent, we had roughly a $400 million services business that had been $400 million really for as far back as I can remember. It was very stable, not really growing. And at our first Analyst Day, we came out and said that we saw a path towards increasing that business by 50% and getting it to $600 million. We've now achieved that objective. And -- but we don't believe that we're done. We continue to see very nice growth in our software business as evidenced by our growth in the most recent quarter, which is, again, above the 22% company average. We're in the process of transitioning our customer base from essentially free tech support to a pay-for-support model. And I'm very pleased with the way the rollout of that what we call KeysightCare solution, it has been growing and the receptiveness of our customer base to this model. And I think we bring unique value to our customers through the technical support and other support that we provide to them, and they realize that value and have been open to paying for continued access to that level of support. And so like I said, we've achieved the objectives that we outlined when we launched the company, but we don't believe that we're capped out by any stretch and we're going to continue to grow our services business. Both of those things, software and services, are contributing heavily towards a base of recurring revenue for Keysight. A full 1/3 of our revenues are coming from software and services. And not all of that is recurring, but as we announced on our most recent call, we now have north of $1 billion of annualized recurring revenue, and that's another focus for the company, not just growing these businesses but changing the way our customers buy software and services from us to make it more recurring in nature is another opportunity for us as we look forward.

Neil, just to follow up on that in the time we have left. You talked about services and software, supporting the recurring revenue mix, we should be expecting that to support the gross margin percentages as well. How do you think about longer-term margins -- how do you think about longer-term gross margins for the company?

Yes. I mean, obviously, we've seen very nice progression in our gross margins over -- since the launch of the company, I think we were in the mid- to high 50% gross margins at the time that Keysight spun out of Agilent. And today, we're close to 65% gross margins. I think as we see software continue to grow as a percentage of the portfolio, as we migrate towards more higher value-added solutions, I think there's opportunity for us to continue to drive further expansion of the gross margin opportunity within Keysight. Again, I don't have a specific objective for you. We highlighted at our Analyst Day a year ago some gross margin objectives, but we're very close to achieving those today and I haven't put out a new bar. But I don't believe that the business is capped by any means with regard to our current levels of gross margin. I think there continues to be opportunity for us there.

I think we're very close to the session end time here. So Neil, thanks a lot for taking the time to go through our questions. Thanks for hosting this. And thank you for everyone -- thank you to everyone who dialed in as well now. Thank you.

Yes. Thank you, Samik, for having us, and thank you to JPMorgan for allowing us to participate in the conference. We appreciate your time and continued support of the Keysight story. Thank you.