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

Good afternoon, everyone, and thanks again for joining us here on Day 1 of our Stifel Cross Sector Industry Conference. We're fortunate today to have Keysight Technologies with us. We've got the CFO, Neil Dougherty, who is also known as Neil Stevenson, to those of you who have traveled extensively throughout Europe. But Neil, where I'd like to start is there's been obviously a lot made of what's going on in the supply chain right now. You've got some internal capabilities, obviously, with the Santa Rosa facility that you have in terms of the fab there. But you also do quite a bit in Malaysia. You work with a lot of partners. Can you just talk a little bit about maybe what's going on on that supply side? And then maybe as an offshoot of that, how that's impacting your customer demand? Are they struggling to get everything they need and then you see the sort of the ripple effects of that right on down the line.

Yes. It's a great question. And certainly, Keysight is not immune to some of the supply chain shortages and component shortages that are out there. But I think on a relative basis, I feel like we believe we're better positioned than many others as a result of the vertical integration that exists within the firm. So as you know, John, we operate our own fab. Here in California, we do some of our own special packaging technologies for the core highly differentiated components that go into our instrumentation. And so while not all of those differentiated components are made in-house, a significant number of them are. And that obviously reduces the number of highly specialized components that we're having to be out in the open marketplace trying to procure. So most of what we're procuring in the open markets are more general purpose instrumentation, high-volume type of products, which right now are easier to come by than the highly specialized parts. And so again, I think that vertical integration in addition to providing a technology and cost advantage to us in times like today is providing us supply advantage, which I think is very beneficial. I think if you look at our Penang facility, I know there's been a lot of questions about this given what some others are experiencing in the region over the last month or so. But we have seen no changes to our operations, either in our own factories or at our subcontractors in the Malaysian area since really last -- April and May when things were coming back online after the initial shutdown. So we feel like we've ramped capacity well. There are some limitations, right? Certainly, we're making investments to take capacity above where it currently sits. Now that's proving to be more difficult than it would be if COVID -- we weren't in this COVID situation. We have strict operating procedures. The government is recalling us to -- requiring us to follow around separation, physical separation, safe distancing, those types of things, movement control, in some cases, we're staggering access to the line so we can keep people 6 feet apart, those types of things. And so it's not as simple as hey, buy some more machinery, hire some more people and cram more people into the space, you just can't do that right now. And so that presents some challenges. But I think by enlarge, at this point, we're doing a good job of getting product into the hands of our customers. I've said before that I can't point into a single example where we've actually had a customer go elsewhere because of Keysight's inability to deliver product. We have seen some lengthening of lead times. But on average, we're talking single-digit weeks, 3 or 4 weeks in terms of lengthening of lead times as opposed to some of the things you're hearing in in the broader markets of lead times being out 1 year or something like that. We have nothing like that that's going on. And so we believe the quality of our backlog is very strong. We monitor that. We see no signs of double ordering or some of those things. And really, there's a reason for our customers to be doing that because we're getting them the product they need in a satisfactory window, right, with a very minor lengthening of lead times here to date. So I feel pretty good about it at this point in time.

Okay. Great. I appreciate that. Maybe shifting gears to the Communications business. Obviously, largest segment that you've got. And a lot of focus, I think, around where we are in 5G cycles. And what that means even as we get to peak and how quickly that may or may not drop-off on the other side of it. But one of the things that has surprised me over the last couple of quarters is the number of new 5G customers that continue to come on for the first time, right, true new logo wins, so to speak. Are we at a point now where that we've moved beyond, let's say, basic test of the 5G technology, and we're moving into more application focused use cases. And that's what's really broadening out that customer set? Or where, I guess, are we in some of that 5G cycle? And how do you think that market sort of continues to develop for you over the next couple of years?

Yes. I mean -- so first, at the high level, I mean, Keysight, we continue to believe we're still very early in the overall 5G opportunity and 5G time line. I've never made a 5G phone call. I'm guessing you've never made a 5G phone call. And that's true for just about everybody around the world. I haven't been to China in a couple of years, given recent circumstances. So I can't speak exactly what's happening on the ground. But there's a lot of 5G deployment that's still in front of us. Most of what's being deployed today is sub-6 gigahertz deployments. We believe that operators are going to ultimately want to migrate to higher frequency versions of 5G because that's where the performance advantage happens. So all of that is in front of us. You are correct. We have seen pretty strong additions of customers. We talked about adding over 100 new customers to our 5G portfolio of solutions in each of the last 2 quarters. And that's being driven by -- early-stage research and development was really being done by the big guys. And as you get closer and closer to these things, deploying at scale, you get the Tier 2, Tier 3, Tier 4 players that are coming in and investing and trying to get devices and product out into the marketplace. So that's some of it. You see things like O-RAN, right? Disaggregation of the access side of the network. I mean this was a handful of customer opportunity really for us in prior generations. And as you disaggregate that and you give opportunity for different companies to come in and do a piece of it, you expand the potential customer set for companies like Keysight. All of those folks that are doing just a piece of that access side need engineering tools, and that's what Keysight provides. And so I think you take a look at that, you take a look at the use cases, the new use cases around automotive, around IoT, around private networks. These are things that didn't really exist in prior generations and are going to serve to increase the opportunity for Keysight and to serve to lengthen the opportunity for Keysight. And so we continue to believe we're in the very early stages of what's going to be a long 5G window.

Got it. And maybe along those lines, from a competition perspective, particularly in that 5G market, you guys were obviously very early there, I think, benefited from having that kit ready when customers needed. How do you expect that market, I guess, to develop more from a competition standpoint going forward? I mean, we've kind of seen the big land grab for lack of a better term. Is it now a function of just kind of keep going forward and expanding that use case and expanding the capabilities. Is there still greenfield opportunity to win in 5G? Just how do we look at it relative to where some of the competition is coming on now?

Yes. I mean, I think it's all of that, to be honest. I think, first of all, I would say that you talked about the land grab, right? I mean, I think that is something that we can continue to capitalize on because switching costs for our customers are high. And so once they've committed to a portfolio, it's not that they can't switch, it's just that the cost of switching are high. So if we continue to execute, if we continue to keep our own product portfolio moving forward, continuing to meet their needs, they're going to -- their bias is going to be to stay with us, stay with the platform that they're currently operating in their labs, which in most cases is a Keysight platform. And so one, that installed base and that market leadership position that we've carved out over the last several years is an asset at this point that we're going to be able to continue to leverage. You talked about greenfield opportunities. I do believe there are still greenfield opportunities. We've talked about new customers coming into the marketplace. We've talked about things like O-RAN, we've talked about new use cases. There's lots of business that's still out there to be won. But I think the fact that not only do we still believe that we continue to enjoy a technology lead on the competition, but that we have carved out such a strong market position, kind of gives us a de facto position of strength when others are choosing a platform to go with. If they see what's out there and has been deployed in the marketplace, they know that in many cases, we're almost a de facto standard at this point, and that makes the Keysight decision that much easier. And so we're going to continue to scale. We're going to continue to leverage our position. We've got both fiscal layer and protocol layer tools at this point, which is different than where we were in 4G. So we're servicing a broader portion of the ecosystem and continue to be very well positioned.

Got it. Got it. And then maybe just moving beyond 5G and looking at the rest of the communications portfolio. Getting closer to having 400-gig now start to -- really start to deploy on the switching side. Obviously, optical going through its own upgrade cycle, whether that's carriers moving to 400 or cloud moving to 800, things of that nature. How much of an opportunity does that present? Looking forward from where we are here, now that we're deploying, does that drop off a little bit and you're already on to what's next? How should investors think of the sort of non 5G portion of the Communications portfolio?

Yes. So first of all, we see them as linked, right? That was an integral reason of why we did the Ixia acquisition as we see the data traffic that's being driven on the wireless side, ultimately working its way back to a wired network and facilitate or forcing some of this upgrade that happens on the wireline side of things. think from your standpoint, we've talked about the strength of 400-gigabit and 800-gigabit we've seen over the last several quarters, right? As you've noticed 400-gigabit, we're really kind of seeing that now. It's -- whereas the 800-gigabit is much more of an R&D opportunity, and this is still largely in front of us. But I think we continue to look at that network side of things as an opportunity as we service this whole Communications ecosystem end-to-end wireless to wireline and up and down the stack from the physical layer where Keysight's traditionally been strong up into the protocol layers, which have largely been add -- that capability has largely been added through inorganic activities. First with Anite on the wireless side, then with Ixia on the wireline side, is giving us an opportunity to strengthen and broaden the way that we participate in both of these end markets, wireless and wireline.

Got it. Okay. Okay. Maybe shifting gears a little bit over to the EISG front. Obviously, a lot of focus on automotive, both in terms of what's going on from a demand and supply chain perspective, but also in the focus there on some of the next-gen stuff, whether it's around EV, whether it's around AV and ADAS, things of that nature. Where does that market segment stand for you now in terms of where it ultimately can be. How big an opportunity is that given all the investment that we're hearing from the actual car OEMs in terms of what they're looking at over the next several years.

Yes, it's a great question. And really pleased with what we're seeing right now in the auto business. Obviously, rewind 12 months and auto was one of the most hardly hit industries as a result of COVID. And and we saw a pretty dramatic pullback in our auto business last spring and summer. And we saw a pretty sharp bounce back here in this most recent quarter to not only nice growth, we actually achieved record levels of orders. So we're back above kind of pre-COVID levels of business. And again, 1 quarter doesn't make a trend, but it certainly was a very nice data point to put up here in the second quarter. And even over the course of last summer, where buying was stopped, our engagement with our customers remained high on exactly the topics that you're talking about, EV, AV, those are the things that are driving the industry. Everybody is investing in these areas. And we believe it's a tremendous opportunity for Keysight as we look forward. I think -- the thing that excites me about it is the longevity, right, just drawing a contrast, if you will, between the automotive industry and the cell phone industry. People buy UI, we buy a new cell phone every 18 to 24 months, right, whereas most people buy a new car once a decade, right? We're getting legislative help around emissions and the push towards electric vehicles. And so we're looking at this auto opportunity as something that's going to play out for Keysight really over probably the next couple of decades. And so I think it -- maybe it evolves a little bit more slowly than we've seen on the wireless side. But I think it has a longevity that is really unmatched. I mean, we typically don't see markets with decades-long runway.

And maybe if you can, Neil, spend a minute on sort of the competitive landscape there. I think investors have a better understanding of what that competition looks like on the communication side. But when we think about this type of market, is it a similar set of competitors? Is it different? Is it still evolving? And more importantly, I guess, how do you differentiate there in a way that you differentiate it and [ what of ] leading in the comm space?

Yes. So I think it's -- if you look across the Keysight ecosystem, it's the same set of customers, but they're servicing the ecosystem differently, right? And so we tend to see different folks on the EV battery side of things than we see on the ADAS side of things, so there's much more of the communication set of customers. But we see those battery guys in other places. So it's a similar set of customers that we see. I think in terms of differentiation, the #1 thing I'd point to is the transition that we made a few years ago from really focusing on instrument categories to focusing on end markets. And the fact that we were focused on communications and automotive and that we have this broad portfolio of tools, by far, the broadest portfolio of tools in the industry so that we go to meet with our auto customers, and we're working with them to understand this not just with tools that they need, but what problems are you trying to solve? And then we ask the question ourselves, well, how do we use this set of tools that exist within Keysight to solve the problems of this industry. That's ultimately how you differentiate, is by taking that work on yourself, providing them a higher value-added solution that addresses the specific problems that the industry is facing. That gets them time to market. It's more differentiated. It can be monetized in the ecosystem. And ultimately, gets your ability to differentiate relative to your competitors. So I'd point to the breadth, I'd point to our software strength. I'd point to all of those things, just the things that are going to make it possible for us to differentiate in the auto space, much as we have in the commercial comm space.

Got it. And then maybe a little bit on the semiconductor side, too, Neil, while we're in EISG. That's been a nice little uplift here over the last few quarters. I've always thought of it as the industry itself is going through transition from a node size change, I think that, that's really where you shine. So how do we think about that business, but maybe even in terms of in context of what's going on now globally with a lot of effort to try to strengthen and localize some of these supply chains, particularly within that semiconductor line.

Yes. It's an interesting industry because certainly, even right now, where we sit today, we've already been on a relatively prolonged up cycle for semi that is by traditional standards longer than you would typically see. But as we turn that lens forward, we see continued strength. And there's no 1 single driver. There are a lot of things that are going on right now that are contributing to that. And I'd start with global component shortages, right? There's this global component shortages causing investment and capacity. And that ultimately is helpful to Keysight. But beyond that, you've got China that's looking to build the domestic semi industry, and that's additive. You've got other areas, U.S., Europe included that are now looking to the security of their semiconductor supply chain, and are looking to re onshore semi production, and so that's additive. And then beyond that, you look to the -- to what we would traditionally point to, which is the technological advances, the move to smaller process architectures, 5-nanometer and below. And that's what we would have pointed to as a traditional driver, and that's still going on. It's just in addition to all these other things. So I mean as we look forward for the semi business, at least over the kind of what I would call the reasonable horizon for which we have a view, call it, 12 months, we continue to be very bullish.

Got it. Got it. Maybe just building off of that a little bit, given that you mentioned China. You guys have traditionally had a high-teens percentage of revenue associated with that geography across a lot of different end markets. Overall, has much changed for you over the last year or so, COVID aside in terms of the administration change or behaviors even just from customers there. How do you think about that China risk or that China market as we look out over the next couple of years?

Yes. China has been interesting for the last several years really since the kind of "trade war" has kicked off, right? And we've gone through various levels of trade tariffs and trade restrictions and restrictions and other things. But through it all, our China business has continued to grow aggressively. And we continue to believe that China is a great opportunity for Keysight. I draw a lot of parallels between what Keysight is doing in this company and what China is trying to achieve as a country, right? And so we were first to market with 5G solutions for test and measurement. China is looking to lead with 5G deployments, right? We've made this pivot towards autonomous driving and electric vehicles. China is making big investments in these areas. We've got -- we've kept some niche semi businesses, which are growing very well. And China is trying to build the domestic semi industry. And then maybe if you step back to the even highest level, one of the things that I think is most interesting is Keysight has made a pivot over, say, the last 10 to 15 years from a business that was once highly dominated by manufacturing based solutions to 1 that is now probably 30% manufacturing, 60% R&D, 10% kind of operations. We've got -- 60% of our business is now coming from the R&D lab, which coincides with China trying to move from manufactured in China to designed in China, right? So they don't see themselves any longer, is just the manufacturing engine of the world, right? And so we've been able to make that transition with our Chinese customers as well. And so I continue to see a lot of opportunities. And I think it's proven out by various rounds of trade restrictions and Huawei and other things, and we've continued to grow right through all of it because the demand for electrical engineering based tools in China remain so strong.

Got it. And just following up on that, Neil, can you just remind us sort of the near-term challenges as you work through the Huawei comps that were so strong a year ago? And how we should think about that over the next couple of quarters?

Yes. So obviously, Huawei is a significant headwind here for us in FY '21. But this quarter, the current quarter we're in, which is our fiscal third quarter, is really the last quarter where we have a material headwind. It's about 5-point headwind for us on both the order and the revenue line. There's a little bit that carries into Q4, but I suspect it's going to be so small that we don't have to talk about it anymore. So I'm anxious to get this 1 into the rearview mirror. And like I said, we've done a good job at the company level, at the commercial comps level, even at the China level, overcoming these headwinds and continuing to grow the business.

Got it. Maybe shifting gears a little bit to the software and services side, right? It was a little bit over a year ago where you clearly started to call that out a little bit more. You made a big focus, particularly on the services side, to start charging for some of those things that were typically bundled in with the hardware sale and whatnot. I guess, where are we in that services transition a little bit? How do we think about the overall mix between software and services and recurring and what that does, not just for your visibility but also for margins as we look forward from here.

Yes. So it's a great question. So first of all, I'd start with roughly 1/3 of our business today is now coming from software and services, right? And not all of that is recurring in nature. We're working to migrate so that more of that is recurring, change the way our customers buy those products from us. We're a little bit north of 20% recurring revenue at this point in time. In fact, I said on the last earning calls on an annualized basis or annualized recurring revenue or ARR is north of $1 billion at this point in time. So that's exciting. One of the things that excites me about our services business is we've made some pretty dramatic changes in the profitability of this business. So if you were -- services used to be a separate reporting segment. If you go back to that period of time, this was a low-teens operating margin business for us. It's now north of 20% operating margin, which we always stated was the goal and we thought we could get there, and we now have. And so not only have we made great progress on growing the business. We talk -- just put that in context, in our very first Analyst Day as an independent company, we talked about taking a business that had been -- a services business that had been $400 million forever. And we thought we can get it to $600 million. We're now north of that figure. So we've achieved -- it took us a little longer than we expected, an extra year or 2, but we've gotten there, the profitability is very strong. Continue to do very well. And both software and services continue to outgrow the broader company. And so we're continuing to shift the mix of our business to be more software, more services-savvy than it's historically been.

Along those lines, and it's a little bit of a different question, but I think sort of look at the stock, if you will, sort of in a similar way. How do you think about the business in terms of secular versus cyclical, right? You mentioned when we were talking about the semiconductor, we've seen an upswing for longer than you would have normally thought. Is the move to software, or is the move to services, is this changing the profile of that business? Are we becoming a more secular business than maybe this was a few years ago? And how do you think about that? Because we get the question a lot. Where are we -- isn't this just a cyclical business that's enjoying a rebound?

Yes. Yes. Absolutely. capital A, absolutely. I mean, I think we're a fundamentally different business than we were under our prior parent. And I'll point to a couple of things. We just talked about 33% of the revenue is coming from software and services, north of 20% recurring revenue. We used to be 60-ish percent manufacturing. We're now 60% R&D. I mean, go look at the R&D budgets of our customers and show me the cyclicality in their R&D budgets. These R&D budgets are very stable over time. They tend to grow. Their capital expenditure in R&D tends to grow. And so we've fundamentally changed the nature of this business over the course of the last decade to a point where I think we are a secular grower. There's a number of secular themes that I think are really conducive to Keysight's growth story. 5G, automotive, aerospace, defense modernization, IoT, all of these things are going -- are helping. And I look at -- one of the things that we try and track is electrical engineering talent, right? As the world is graduating more electrical engineers, they're going to need more electrical engineering tools, and we continue to believe that the secular themes that underlie our growth are very, very strong, not just currently, but as you turn that lens forward.

Right, right. And then maybe lastly, Neil, because we're close to running out of time here. Cash flow, balance sheet all continue to be very, very strong. I mean, should we still think of the key priority in terms of M&A or tuck-in type of acquisitions to continue to drive whatever might be next, like what you've done in Quantum, some of the things you've done in 6G and things like that. Are there larger things that maybe still might prop up from here. But how should we think about M&A as it relates to your whole capital allocation strategy?

Yes. I mean, certainly, our bias would be to take the money that we've generated and put it back and invest it back in the growth of our business, both top line and bottom line growth of our business. And I would tell you, John, that generating a funnel of ideas is not the problem. We have an ample funnel of ideas. The challenge, as you know, is valuations right, particularly in the areas where we're looking, right? We like assets with high software content. We want things that are additive to our inorganic growth rate. On things that are additive to our gross margin performance, which now -- 5 years ago, we were in the mid-50s. It was 1 thing, but now we're in the mid-60s, it makes it more challenging. High recurring revenue. These assets are very expensive, right? And so you have to have a high degree of conviction about your ability to grow them over time. So look at the acquisitions that we've done. The acquisition of Eggplant, for example, which we did last summer, software tests, get us into the software test markets. Recent acquisition of Sanjole, which is another 5G tool, right, that fits in very well with our portfolio. Again, high gross margin, high software content kind of a business. These are the types of assets that we're looking for. I think you mentioned the Quantum acquisition. Right now, we're planting seeds around quantum investments. We think it's a technology of the future that Keysight has ability to deliver. I like our acquisitions to be bigger than that, right? So that they move the needle more immediately. But we're going to continue to stay disciplined. And again, we've got a wide set of ideas but we're going to stay disciplined around our strategic and financial hurdles and look to put money to work. And if not, we've proven that we're willing to get more aggressive and opportunistic with our buyback program. If you look over the course of the last year, the business has generated about $1 billion of free cash flow. We spent about $500 million on acquisitions and we spent about $500 million on share buybacks over that period of time. So the -- we've got a lot of flexibility to implement the strategy, and I think it's a good place to be.

Great. Well, unfortunately, we're all out of time. Neil, thank you, again, as always, for spending some time with us today. And best of luck, and we'll catch up again soon.

My pleasure, John. Thank you so much. Take care.

Be well.