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

Thank you. Keysight is a leading test and measurement company with a strong presence in the communications space. The company has roots tracing back to the earliest days of Hewlett Packard. About 75% of all 5G equipment out today has been developed with their test and measurement tools and software. They also have strong business in general electronics, aerospace and defense, semiconductors, connected autos and are participating in the electric vehicle transition. We're lucky to have with us today CFO, Neil Dougherty, who has been with the company and its predecessor firm since 1996, and CFO of the company since its 2014 spin-off from Agilent. Thank you very much for being here.

I guess I'll start off with a couple of questions just on demand. Commercial communications, that's roughly half your revenue, biggest in market. And you've obviously won more than your fair share of work in 5G on the R&D side and the development of these products, and that continues. I'm just kind of curious where are we in the ramp on manufacturing.

Yes. That's a great question, David, and thank you for having us today. We appreciate the chance to participate in this conference with BofA. So we continue to believe that we are in the very early stages of 5G rollout. And so there's significant opportunity that lies in front of us on both manufacturing and on the R&D side. Keysight, as you've mentioned, has carved out over the last several years a very strong leadership position in 5G, still at this point heavily skewed towards the research and development lab. But if you go back in time, Keysight has historically been #1 in component manufacturing for cellular communications, 4G, 3G and other standards as well as on the base station side of manufacturing. And so we would expect to continue that strength here in the 5G cycle. And we are starting to see and have over the last several quarters started to see an increase in that manufacturing activity within our portfolio, but we continue to believe it's very early days. I don't know about you, David, but I've never made a 5G phone call. Most of the people I know have never made a 5G phone call. So there's an awful lot of deployment here that still has to happen. Most of the service providers and geographies around the world that are deploying 5G currently are doing so at relatively low frequency, sub-6 gigahertz. We do believe that over time, most, if not all, are going to want to migrate to higher frequency implementations of 5G because that's where you really get the performance advantages that have been promised. And so that's going to create a whole second wave of deployments. And so when we think about this from a runway perspective, there's an awful lot of the opportunity that is still in front of us on both the R&D side as well as the manufacturing side. And we haven't even really talked about the use cases beyond the cell phone, places where we're seeing demand in automotive and IOT and aerospace/defense, private networks. All of those types of things are really going to look to capitalize on the technology once it's more mature and has been deployed.

Sure. So you started seeing, I guess, initial orders on that manufacturing side probably a number of years ago for the base stations and so forth. Are you starting to see a broadening out, if you will, of that manufacturing base, the manufacturing ecosystem for you?

Yes. Certainly. I think -- and Satish has talked about some of the manufacturing business that we've got on recent calls. I like that theme about broadening out because that's one of the things that we're seeing really across the portfolio. It's a broadening of the customer base for Keysight's 5G solutions. Now early on, go back several years, a lot of the business was being driven by the big players in the space that were driving a lot of the early-stage research into 5G, but as you get closer and closer to deployment, you see a far broader set of customers, the Tier 2, Tier 3, Tier 4 players. You've got things like open RAN that -- in the disaggregation of the access side of the network. If you think about that access side, that used to be a handful of customers that were providing all of those access tools into the marketplace, but now you've got dozens, if not more, customer -- potential customers for Keysight that are looking to step in and do a single piece of that access side of the equation. And so this idea about the broadening out of our customer base, whether or not you're talking about in manufacturing where we're certainly seeing it or still further broadening on the R&D side, is a theme that is definitely playing out.

Got it. And then switching over to the Electronic Industrial Solutions segment. This is where you have customers in the electronics, semiconductor and also your autos business. I guess beyond the cyclical recovery, which is very, very strong, what are the areas that are you perhaps seeing a little bit more of an underlying secular demand trend? You've invested a lot on autos. I'm sure you'll touch on that one. Are there others sort of along the same lines in that?

Absolutely. And I like the way you phrased the question because certainly, we are seeing a strong secular recovery -- or excuse me, a strong cyclical recovery as a result of some of these businesses being pretty heavily impacted by the impact of COVID roughly a year ago. But if you take beyond that cyclical recovery, there are a number of secular themes that are driving growth and driving demand in some of these businesses. And the #1 thing that comes to mind is in the semi space. So certainly, we're seeing the impact of supply shortages and the need to add capacity more broadly, and I'll call -- for the moment, we'll lump that into the cyclical side of things. But beyond that, you're seeing these -- the investments that are being made and the re-onshoring of fab capacities into the U.S. potentially into Europe. You're seeing China look to invest in a domestic semi industry and driving significant investments. And then you're seeing the moves to smaller process, architectures. 5-nanometer and below are all themes that are driving demand beyond that broad capacity expansions that are being made to solve these chip shortage issues that are out there right now. Second area that comes to mind is, as you mentioned, the auto side, particularly on the EV side. We're heavily levered to both the EV and the autonomous or AV side of the equation, but we believe and are, in fact, seeing the EV side of that happening first. And so you're getting legislative help. You're seeing all of the major OEMs and Tier 1 suppliers are investing in electric vehicle technology. You're seeing a pretty rapid proliferation in the number of electric vehicle models that are out there and available in the marketplace, and we are definitely seeing strong demand signals as a result of that EV side of the equation, AV as well but maybe to a lesser extent currently than what we're seeing on the EV side.

Got it. And since you did touch on semiconductors, I want to follow up on that. For people on the -- listening in, just to be clear, you own your own semi fab plant. So you're in the enviable position right now that chip shortage isn't affecting you, but how much of an increase in capacity is just raw capacity matter for you? Because I tend to think of you more on that R&D side, so a new chip design and -- but maybe just sort of unpack that. What's the [indiscernible] from all the products that are coming up in the U.S.?

Yes. I think we definitely see the current expansion in semi capacity and semi capability that's happening around the world is very positive for Keysight. So our semi business today is more heavily skewed actually towards the manufacturing side than our broader portfolio. So Keysight as a whole, across our entire $4.5 billion-ish of revenue, we are roughly 30% manufacturing, 60% R&D and kind of 10% other things, mostly post-deployment, operational-type applications. But our semi business is far heavily -- far more skewed towards manufacturing than that 30% that is the overall company level. And so, one, on a direct level, we benefit from capacity, semi capacity going in around the world. All the big foundries, Intel, Samsung, TSMC, GLOBALFOUNDRIES, they're all customers of ours to some extent. We're a little bit more agnostic as to where that capacity is being put in, but the fact that people are investing in fab capacity is beneficial. Beyond that though, I look at the kind of the second order or the more indirect benefits to Keysight. And so you think about all of the semi content that's being manufactured, it all has to go somewhere, right? And the reason why demand is so high right now is because we're seeing this very rapid proliferation of electronic content in all things, whether we're talking about electric vehicles or aerospace and defense solutions or things like 5G that are driving the communications ecosystem. And so all of that is ultimately an opportunity for Keysight to sell tools into the industries that are making use of that semiconductor technology.

And when you say you're indifferent as to where the capacity kind of falls in, is that because the pricing is the same whether or not you're selling in Taiwan or Arizona?

I mean that's largely correct. Obviously, we price in local currency for our relevant customers, but the products that we maintain in our semi portfolio are pretty highly differentiated and they provide significant value to our customers in terms of the capabilities that we're able to provide. And so we don't see big discrepancies in terms of the margins that we get selling those products based on the geographies in which they're sold.

Got it. And in terms of what you're seeing in terms of current demand, do you think -- we've seen $50 billion of CapEx. Your name -- the companies, they're building plants. When does that show up for Keysight in terms of orders and revenue?

Well, I mean that's a hard question to answer. I think we sell -- we saw certain instrumentation that is essentially used to test the wafers themselves, the electrical properties of the wafers themselves. And so people are placing those orders to -- in a time line that essentially goes with the outfitting of the fab rather than construction of the fab, if you will. They want those equipment that are showing up at the same time that the fab lines are coming online. Another big component though is we sell subsystems that do kind of ultra-precise. You can think of nanoscale positioning that's actually sold as an input or a component within these big photolithography machines. And so you need to back up further because those are often long-lead-time items. We're selling into the manufacturing, to the manufacturers of those big photolithography machines, which then end up in the fabs themselves. So that demand comes to us a little bit earlier in the time line than the wafer test aspects.

Got it. And then this is -- I know that this is a sort of an emerging area for you, but there was headlines out just this week. Honeywell merged its quantum computing business with Cambridge Quantum Computing. You, Keysight, recently acquired Quantum Benchmark that makes test and measurement software for the space. Just sort of curious, what gets you excited about it, about the space? And are we on top or the first? Are we into the second? Is there some revenue that's really coming through? Just your thoughts on that.

I certainly love the baseball analogies because they're easy, but I certainly think we're in the first inning here. I mean we're very early days as far as quantum computing, but it's definitely an area that Keysight is interested in and excited about. And as you mentioned, we just acquired a company called Quantum Benchmark up in Canada. 18 to 24 months ago, we did a second -- another acquisition in the quantum space of a company called Quantum Labber (sic) [ Labber Quantum ], which is in the Boston area. And so we are building capabilities in this area. Keysight, not surprising, we're not out building quantum computers. We're out there selling tools and solutions to those governments, educational institutions, companies that are investing heavily in this area. And I think I'd draw some parallels to what we did in 5G, right? We've carved out a very strong lead in 5G, but we did that by investing early and recognizing where technology was headed. And I think we're looking at quantum the same way. It's like we wanted to make some early-stage investments and go with our customers on this journey as they continue their investments in quantum, and so very early. We do have revenues today. It's not big numbers by Keysight relative to $4.5 billion Keysight, but we have significant revenues and significant customer engagements, and it's certainly one of the areas that we are, I would say, planting seeds for future growth opportunities and it's an area we're excited about.

Got it. I'll just remind investors on the webcast, if you have any questions, put them in, have the screen open right now. So if you do have some questions, just type them in, in the system, and I'd be more than happy to ask them on your behalf. Last week, David Barden, BofA's U.S. telecom analyst, hosted a call called 5G in the Wild, which is a pretty good title, just the real-world 5G applications in the areas of manufacturing, in medicine and even agriculture. I learned that John Deere has actually bought some 5G spectrum in Iowa and Illinois. So it's some perhaps unique applications here that we're going to see. And I wanted to ask you, since you have an interesting perspective, what are the end markets that maybe we wouldn't think about that you've started to see some demand outside of the usual suspects?

Yes. It's interesting. And I did not know that about John Deere. So that's interesting. I think 3 areas come to mind. So first of all, I would say right now, clearly, the killer app, if you will, for -- that's driving the deployment of 5G networks is still the cell phone, right? I mean, I think our position all along has been that there is going to be -- unlike in 3G and 4G, there are going to be significant applications that make use of the 5G networks once they're deployed beyond the cell phone, but they were likely to follow the actual deployment of those networks once the 5G networks are available. I think where we are seeing kind of early-stage investment beyond the cell phone, there's 3 areas that come to mind. The first is automotive, right. As folks that are working on the autonomous driving side of next-gen auto, 5G is going to be critical particularly with the zero-latency aspects of higher frequency deployments of 5G. That is going to be a critical component of enabling full-scale autonomous driving. And so we are seeing auto OEMs and, in some cases, the Tier 1 suppliers to that industry investing in 5G toolkits to get ready for that reality. Second area that comes to mind is aerospace/defense. We talked about this on our most recent earnings call that we are seeing aerospace/defense customers invest in 5G tools and test kits as they have discussions about how to capitalize on this capacity and capability once it's deployed. And then the third area -- and like you said, you broke news to me on John Deere, but maybe this is what they're thinking about. It's the private networks, right, companies that are out there looking to do kind of private network deployments of 5G. We have seen investments coming as a result of those types of things. So I got to -- I guess I got to get my sales guys to make sure they're out there calling on the John Deere guys, make sure we don't miss that opportunity.

Got it. Yes. The other thing that -- so the multi-industrial team here at BofA, we cover a lot of industrial automation companies. And they have a pretty wide portfolio of industrial IoT devices, things on machinery, reading them and so forth. Where would you sort of rank the demand in terms of IoT between sort of that consumer-focused variables and that stuff, industrial and -- I'm biased here but there's a lot of industrial IoT investments at least that are going on. And then I think the third area people talk about a lot is health care. So where do you sort of rank order? Or what are you seeing in those areas?

Yes. I guess I would say we think about this, again, in kind of a number of different ways. There's kind of the direct opportunity for Keysight to step in and test IoT devices that are going to operate on 5G networks or other -- connect in other ways. And I think as we think about that direct opportunity, not surprisingly, I would point to those that industrial IoT is kind of the biggest opportunity for us; probably second -- if I'm rank ordering, second, followed by health care; and third, followed by the consumer side. Consumer side, clearly the biggest from a volume perspective, but they tend to be lower-cost devices, and the direct test opportunity for Keysight into some of those could be smaller. But the other lens in which we tend to look through this opportunity is around kind of data traffic and connection points into the network. And so as you think about Keysight looking to serve this ecosystem end to end, including on the wired side and helping folks manage data traffic as we move from 400-gigabit to 800-gigabit, eventually north of a terabit, network visibility tools, all of these types of things, the fact that you're going to see all of these connected devices is going to drive the data traffic that ultimately results in the need to see a pretty whole-scale reshuffling or reformation of those wired networks, which we believe creates a big opportunity for us going forward.

Sure. And maybe just sort of spend a little bit of time in terms of your offerings on that network side. You've made some acquisitions. You've strengthened your offerings there. How complete do you think the portfolio is? And what are the sort of the flagship offerings?

Yes. So the vision that we created for Keysight is to position ourselves as a company that could service the entire communications ecosystem, wireless to wire line and then for the physical layer, which is where Keysight's historical strength has been, up through the protocol layers and now we're even talking about the application layers of the protocol stack. And so when we separated from Agilent, as you mentioned earlier, in 2014, the first big acquisition we did was a company called Anite, which got us protocol layer solutions for the wireless side of that equation. And then in 2017, we acquired Ixia, which got us protocol layer solutions for the wire line side of the house. And so today, we sell on the networking side. We sell physical-layer test tools for networking that help in the development and deployment of wired networks. We sell -- we have -- one of the businesses that came to us from Ixia is a pure software business -- and by pure software, I mean not directly linked to the sale of hardware per se, and the network visibility space that allows IT managers and such to track the traffic and the performance of their networks once they're deployed. And so we have capabilities there. And then more recently, you've seen us again move through M&A to move up into the application layers where we bought -- where we've recently bought a business called Eggplant, which is a software test business, which is using software to test user interfaces for a variety of applications. And so I think we have a very strong portfolio across the ecosystem. I think we continue though to find opportunities to add to that portfolio. And the 2 examples I'm going to give are back on the wireless side of things, but we've done 2 acquisitions in the past couple of years, an acquisition just as last December of Sanjole, which makes some 5G sniffing tools that were additive to our portfolio. And a couple of years ago, we bought a company in Italy called PRISMA technologies, which made some -- had some solutions around base station tests that were very much complementary to our 5G portfolio. And so I think we have, by far, the strongest portfolio of solutions in the industry. I think we're the only company that's really positioned to service this entire ecosystem, both wireless and wire line and physical and protocol layers, but we continue to look for opportunities to add capability to that portfolio, recognizing that there are a lot of interesting firms out there doing interesting things that are additive to ourselves.

Got it. We haven't talked a lot about your aerospace and defense business. And you're a beneficiary of defense modernization spending both with the U.S. and its allies. You've seen very strong revenue growth, but there is a little bit of a backlog component due to some of the issues around COVID a year ago in terms of when you shift in terms of timing of the recognition. What are the budget trends in the areas where you focus? And have you seen an uptick in those, sort of looking through that revenue recognition and timing?

Yes. It's interesting. Yes. So I think we are in a stage right now -- we're in a phase right now where there -- it's really around the globe, significant investments that are being made in aerospace/defense modernization, and that bodes well because Keysight really plays on the technology aspects of these markets. And so when we look out to -- now I'm just talking specifically about kind of the U.S. budget cycles. Over the last several U.S. budget cycles under the prior presidential administration, we saw significant increases in the aerospace/defense budget. And the particular line item that we pay most attention to is the RDT&E line item, which stands for research, development, test and evaluation. And so -- and what you typically have seen is that the growth in that particular line item of the budget has outpaced the growth in the broader budget. I think one of the things that's encouraging to us is we've typically looked to presidential election cycles, whether or not there's a change of administration or not frankly, as being disruptive for at least a couple of quarters to these aerospace/defense buying cycles. And we really saw almost none of that with the most recent election cycle. I think there's a preliminary budget in place for this year. It passed and it was implemented, even in the course of a presidential transition, relatively smoothly. And that allowed spending to continue and to continue to grow in a way that we haven't seen over the past several election cycles. I think the second thing that's really encouraging to us is that there is a preliminary U.S. budget. And keep in mind, about half -- a little bit more than half of our aerospace/defense business is U.S. A little bit less than half is the rest of the world. But there's a preliminary budget out for FY -- for '22, and it also has a growth again in aerospace/defense. And so we -- again, I'd point you back to my original statement that around the globe, there seems to be pretty broad-scale efforts to invest in defense technology and Keysight is benefiting from that. And so if you look at our most recent quarter, we talked about the strength in aerospace/defense coming from investments in the U.S., investments in Asia and investments in Europe. We saw strength across all the regions of the world as these investments were taking place.

Got it. And in terms of -- I know you have a pretty diversified portfolio within the defense space. You're not tied to one program. But maybe just for investors, are we talking about dozens of programs, hundreds of programs, where do you sit or your main contractors, subcontractors, so forth.

Yes. It's a -- I don't know the specific number, but it is a large number of programs. And then there's, of course, general instrumentation that's sold into the private contractors and to the government agencies themselves. So it's not all programmed dollars. Some of it is general administration. I would say -- the way I would describe it is we are not relying on any single program for a significant portion of aerospace/defense revenues. It's a very diversified business.

Perfect. I do want to time -- spend some time on software. This is now roughly 20% of your revenue. It's -- there's a portion, as you sort of described, that's tied to the hardware where Keysight is the natural provider. And then there's a portion which is pure software. What's the rough split today? And then what are the sort of the strategy and ambitions on that software piece?

Yes. It's a great question. And I guess along those same lines, I tend to think of our software offerings really in 3 categories. There's the software that is kind of linked to the sale of our hardware instrumentation and software. Even though it's separately purchased, that runs on the instruments themselves, right? And then I would -- there's a second category, which I would call more solution software, which often operates in conjunction with our hardware but maybe actually running on a separate PC or computing device but not on the instrumentation itself. And then we have our pure software businesses, which are not directly linked to the sales of our instrumentation. And right now, the largest portion of that is probably that solutions component. It's probably the largest, with the other 2 being slightly smaller. I think the main thing is we're looking to grow our software both organically and inorganically. So a lot of people don't realize. They think of Keysight as a hardware company, but more than 2/3 of our engineering talent within the company today are software engineers, not hardware engineers. And so we're investing heavily in our own software capabilities. And then if you look at the acquisitions that we've done in the recent past, there's definitely a pretty strong software bias to them. So whether or not we're buying businesses like Eggplant, which I've talked about previously, which is a pure software business, using software to test software user interfaces; or whether we're buying companies like Sanjole and PRISMA, which are definitely hardware businesses, but they have very strong gross margins because of the high software content that's a part of those solutions that are additive to our story. And so I think we continue to be successful in growing these offerings, again both organically and inorganically, and we'll continue to look to do so going forward.

Got it. And then on the sort of the organic and potentially inorganic, do you see more opportunities on the solution side in terms of the M&A pipeline or sort of the pure software side of the house?

I think it's mixed. The way I characterize it, generating a funnel of ideas is not the challenge, right? The challenge right now, particularly with these high-software-content assets is the valuations, right? And we're seeing really robust valuations in this space. And Keysight is a -- we're a very disciplined buyer, and we want to make sure that we have very strong convictions or ability to get a return on the investments that we're making in M&A. And so we're going to stay disciplined as it relates to our financial hurdles, as it relates to strategic hurdles, but we see opportunities in both of those areas.

Got it. I mean one of the -- sort of the financial hurdles you have for M&A is that it's accretive to gross margins. You had 65% gross margin last year. I imagine that it's a fairly high hurdle. And so software is one of the few pieces. I mean I'm sure there's very niche hardware providers out there as well that have very high gross margins, but software is one of the areas. So I guess in terms of the total M&A pipeline, the software just typically check more of the boxes in that funneling process.

Yes. I think that's right. I mean I think when you step back to the highest level, we really only have one financial hurdle as it relates to M&A, and that is our ability to get a return that's significantly above our cost of capital. But if you look at beyond that, the other things that we're trying to accomplish -- and you rarely check all of these boxes, but we're looking at things that are additive over time to our organic growth rate. We're looking for things that are additive to our gross margin. We're looking at things that are additive to our recurring revenues, additive to our software mix. And so if you start to think about your ability to check off some of those strategic objectives that you're trying to make, there definitely is a strong software bias to our M&A funnel.

Got it. I'll give the investors listening in one last chance here, the last couple of minutes. If you do have a question, ping me. I will relay it. I do want to talk just super briefly. There's actually a Senate bill passed last night, providing some funding for Open RAN, O-RAN, about $1.5 billion, if I remember correctly. I know this is a very positive development for Keysight in that it would expand the number of clients. I -- what I struggle with is I don't know the probability that it will happen although government funding is certainly a step in the right direction. So I guess internally, do you see it as a possibility, a probability somewhere in between, 50-50? And just sort of how do you see it? Is it progressing along the way that other things that have been successful in this industry?

Well, I guess I would say from a Keysight perspective, what's important to us is that people are investing money today, right? So we have already seen Open RAN drive new customers to our solutions, drive new demand for our end products because of the development work that's happening to disaggregate the networks. And so I don't necessarily want to offer an opinion on what I -- on where we stand on success rates because, yes, I often get the same question about millimeter wave, right? And there, we have talked about and we're definitely bullish on millimeter wave. And for that matter, we're bullish on O-RAN. But the important thing is that people are investing in the research necessary to bring these things, these technologies to market and Keysight benefits from that work. Ultimately, when those things come out of R&D and get commercially deployed, that creates a second wave of opportunity for the company.

Got it. And then I think the other thing that is a very big trend that I feel remiss if I didn't ask you a question on, honestly, is services business. You've done a nice job growing that. And I just -- this has been a sort of an organic evolution for you. What sort of attachment rates are you getting on services contracts for new equipment sales these days?

Yes. It's a great question. So if you step back and think about our services business, right, the core of the business and kind of where we started was with a baseline of repair and calibration for our very large installed base. And that provides a really nice basis of recurring revenue of folks that are coming back to Keysight for basic repair and calibration services. Beyond that, we sell contractual service things. We do things like start-up assistance and consulting and those types of things, but we also sell extended warranties and those types of contractual things that are attached to our instrumentation. And more recently, we rolled out a product called KeysightCare, which is essentially a pay-for-support model. And so the -- our KeysightCare is bundled with the initial sale of all our products. The first year is free, and we haven't shared attach rates. All I would tell you is we're very pleased with the attach rate of customers either buying additional years at the time of the original purchase or making a decision to step up and move to a higher -- it's a tiered service, right? There's a base level and then there are premium-level tiers. And so we have a significant percentage of our customers at the time of the purchase of their instrumentation, are not just taking the first bundled year that are signing up for additional years of service or stepping up to more premium levels of service. And so still very early days but you've seen the growth in our services business and improvement in the profit margins that has come with that growth, and we're very pleased with the success that we're having to date, and we expect that to continue as we look forward.

And with that, unfortunately, we are out of time. Neil, thank you so much for taking the time here and sharing your thoughts.

Thank you, David. I appreciate the chance to participate today.