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

Hey, good afternoon, everybody. Thank you for joining us for our next session at our Tech Conference. I'm Matt Niknam, communications analyst here at Deutsche Bank. We're very pleased for our next session to have Keysight's CFO, Neil Dougherty; as well as SVP and COO; Satish Dhanasekaran. Guys, thank you for joining us.

Thank you for having us. Pleasure to be here.

Thank you.

So for the purpose of everybody on the line, I'm going to start with some Q&A for our fireside chat. If you have any questions, there should be a Q&A box at the bottom of your page, type them in. I'll see them, and I'll relay them over into our discussion. So maybe just to start, from a high level, and this is open-ended question either for Satish or for Neil. Can you talk about the top priorities on your plate? And what you're most focused on at Keysight as we close out fiscal '21 and start thinking about fiscal '22?

Yes. Thank you, Matt. I'll get started and then Neil can add as needed. First of all, it's an incredibly exciting time to be at Keysight. As you've seen, the trajectory of the business since we've spun, and the strategy of making contributions to customers beyond products with solutions and the focus of how we do it through software-centric approaches is really resonating with our customers. And you see that more in this year's demand, as we've seen in their markets. And if you average it with 2020, even you'll see that we're back to our long-term growth rates. And across our end markets, we see these continuous waves of technology innovations, really giving us additional growth vectors for the company. So our priorities are through this pandemic, which is an unprecedented situation, is to take care of our employees. We're very proud of the work the team has done to make sure that our employees are staying safe, adapting our innovation practices and the way we work. And I think as this pandemic emerges, we'll continue to do more in that regard. And second, it is about taking care of our customers. Our customers are innovating across our end markets and they need our support more than ever, and we're continuing to engage with them through our innovation. And this is -- our value system has always been this way since our -- since days of HP, and we continue to live true to those. You might know that in Malaysia, we've arranged for vaccination, not just for our employees, but also for our partners and our supply chain folks. And in India, we did the same through those tough times in those countries. But -- so we -- those are our 3 priorities. But if you take it at the business level, we see tremendous momentum across our end markets, and we continue to remain focused on executing to those priorities. Our first-to-market strategy is key to our continued success, and we see more opportunities to expand our margin as we move forward.

Great. So maybe just to touch on that demand. That's actually -- maybe we'll start there. It's a good place to begin. You've seen accelerating growth in revenues across several key end markets in recent quarters. So from a high level, maybe, Satish, if you can talk about the drivers of demand strength. And then if there's any color or updates you can share in terms of how that's trended so far into fiscal 4Q?

Yes. I can talk about what's happened this year. And if you take a big picture view, no doubt demand and order demand at double digits that we've seen continues to be very strong and outpaces revenue. So we're continuing to build a steady backlog or increase our backlog is -- as we go through the year. And that should give us greater confidence as we look into FY '22. If you break that demand out, there's a couple of factors, right? One is you've seen the macro rebound that's happening in Europe and other parts of the world, which were depressed in 2020 fiscal year. And so we're benefiting from that GDP rebound. But the other are factors that Keysight's creation, if you will, things that we have done to keep our business strong. And those have been the strength of our growth initiatives, whether it is our focus on automotive, semiconductor, 5G and then enhanced contributions we're making in quantum and 6G. All of our growth initiatives have continued to position us strong. And finally, from a business model perspective, the focus we placed on innovating with softwares and expanding our contribution to our customers with services continues to pay rich dividends with double-digit growth there as well. So if you break it out and you look at the performance of the business, this year's strong double digits, obviously, from an order perspective year-to-date, and then you average it with last year, and you look at it, we're back on track with our long-term growth trajectory that we've -- and above our, let's say -- above about the targets that we rolled out at Investor Day.

Got it. When we think about the test and measurement industry, this is maybe a little bit of a question maybe morphing into the TAM discussion here. At the Analyst Day last March, which seems like a world ago, but it was, I guess, in the context about 1.5 years ago, the company laid out a served addressable market that was about $17.5 billion, growing about 3.5% per year. As you think about some of this proliferation of technologies like 5G across newer end markets, you've also done some tuck-in M&A, more geared towards software as well. Do you sense that Keysight's addressable market is now growing more meaningfully?

Yes. I think it still remains to be seen. Obviously, we look at the market. The broad market, we sell roughly $18 billion, growing on an average, we have set at 3% to 5%, I believe. And if you look at that marketplace and you look at the competitor landscape, there's a lot of product-based competitors, niche competitors that fill that whole landscape. And what we've been able to do, I believe, is keep our core business, which is to supply tools. And if you look at our core business, that's growing largely in line with those growth rates we put out from a long-term perspective. But what we have been able to do is capture additional opportunities inside that market by deploying our software-centric solution strategy by starting early in the innovation cycles around big mega teams, engaging with our lead customers and providing them solutions to enable their time to market. Now this is a different -- this is creating, I would say, a differentiated position for Keysight. And that's why you see our growth rates looking back have been a lot higher than the market growth rate, and we continue to execute to the strategy to keep our growth rates strong.

Okay. And so if I sort of contextualize what you're saying there, is it fair to assume then that areas like software, analytics are sort of outpacing the 3% to 5% growth that you're seeing for just the traditional test and measurement market? And that's why it's able to maybe take more?

Right. It's our strategy that's allowing us to outperform. And -- but if you look at the long term, I think the market growth rates for that $18 billion market you referenced, we still think it's in line with the 3% to 5%. It remains to be seen. We still have to update it, but I think that's our current thinking.

Okay. Great. One of the interesting points that surfaced on your last earnings call, I thought was -- you talked a little bit about new customer engagement and how that's accelerating. I think last year, you added about 1,900 new customers, and it sounds like you're going to surpass that number this year. So I'm wondering if you can give any more color on the profiles of some of these new customers, whether it's by vertical, whether it's in CSG or EISG. Maybe talk a little bit about what the catalyst is for this acceleration in new logo growth.

Yes. I think it's a great question. One is, you recall, we made a concerted effort to focus on doubling our sales force and then augmenting that sales force with modern marketing capabilities. We rolled out some of this messaging at Investor Day. I mean this has been a big success factor for us every year is addition of new customers because of the ability to find these new companies and service them. But if you take a bigger picture view of what's driving that new customer growth, it's also this ecosystem expansion that's happening as technology becomes increasingly important for many, many economies around the world. There are investments in organic technology that are happening around the world. The defense spend remains robust. There's a lot more focus on using commercial off-the-shelf technologies and funding those things for even defense applications. So a congruence of these factors are resulting in, along with, I should say, new applications that are coming out like O-RAN, which are incredibly exciting, are resulting in expanding the number of addressable customers for Keysight. And with this feet on the street and our strategy to have this modern marketing, we've been able to capitalize on that and bring in new logos into Keysight every single year.

Got it. Okay. Let's talk about 5G. I know that's something that always comes up as it relates to Keysight. Obviously, we were having this discussion -- I think I probably asked this last year, so it's going to sound a little bit of a repetition. But as we think about 5G deployments becoming more widespread globally, what inning of this opportunity would you say we're in? And then maybe to take it one step further, as we sort of compare this relative to 4G last decade, how is 5G different so far?

Yes. I would say the first thing I would say is that the technology complexity in the software stack of 5G and the proliferation of technologies under the 5G umbrella definitely, we long believe that is much more complex than 4G, and I think that's proving itself out. So the technology complexity is one big factor there. As far as the deployments are concerned, I think we've stated there's about GSA has recorded about 174 commercial networks globally, which is up 92 -- from 92 a year ago. So still a few hundred deployments in the commercial networks, I should say, at some scale. So still considerable room ahead for deployments to happen. And even though our business has smaller -- larger concentration of our business is in R&D and then in manufacturing and deployments are the lower percentage of the business, the fact that there is this continuous runway ahead give -- from a deployment perspective, bodes well for continued investments in R&D and in manufacturing ramps that will occur as those deployments scale. So that's the first bias opportunity. The second is this new focus on taking 5G into new verticals. We've talked about that through Release 16, Release 17 and now Release 18 is being talked about. It's pretty exciting from a road map perspective that has continuous streams of innovation that we see ahead. Third is the need for test. If you just look at it as test insertions in R&D, there is over 9,000 band combinations now today with the heterogeneous nature of the spectrum with active testing being done around 1,800 to 2,000 bands. So you can sort of project that and say, well, are we in the 33rd percentile of the opportunity? Just from a test insertion perspective, that gives you some landscape. And lastly, I would say, as 5G rolls out, there is new applications in new verticals and new ways of doing things like O-RAN, which is expanding the pie for us. And I'm very pleased with the progress we're making on our O-RAN strategy. We're establishing a differentiated position, thanks to the acquisitions we made. And I also want to point out that the work that we have done to repurpose our stack to take it into new areas such as aerospace, defense customers and automotive customers is yielding results already, and we continue to see greater traction there as we look ahead.

Yes. I want to touch on this O-RAN point because I feel like every day, I'm checking e-mail, and we hear more and more about operators embracing this technology and these standards globally. What does this mean for Keysight? I'm wondering if you can maybe help us in terms of, in layman's terms, help us think about what this shift to O-RAN over time means for your business.

Yes. It's just at the simplistic level, opportunities beyond what we have started to do well in, such as the physical layer and the protocol layer. Expanding into the application layer is a new expansion opportunity for us. That involves going into new verticals and new applications like O-RAN are part of that growth equation. So at a simplistic level, you could say, what gives you confidence that you can do better than the runway that is painted from a CapEx perspective, I think these new applications are incredibly exciting. The second point I would bring up is the O-RAN has got considerable legs. Number one is there's a lot of European operators looking to replace Huawei base stations and O-RAN provides a new way for them to sell their, operations. And the partnership that we have with Vodafone is an example of that trend. And then O-RAN in general, because of the virtualization aspect, which is heavily software based, because of the fact that the networks are getting disaggregated, we believe there's a lot more new players entering what was traditionally a 5 customer base that used to invest in our capabilities. So it is this expansion that it provides with a longer-term horizon. So it elongates our runway with this technology.

You touched a little bit on Huawei. And so it's actually a good segue into my next question. As we sort of start moving past some of these headwinds associated with the loss of Huawei revenues, I'm wondering if you could just update us on the latest you're seeing in China, where are you seeing more strength? And then what do you see as sort of the main growth drivers from that geography going forward?

We're very pleased with our business in China, given the significant headwind, we're still registering year-over-year growth in China through this year, even after accounting for it. And if you exclude the impact, we're growing at strong double digits there as well. So no shift in momentum for us. We see broad strength across all our end markets that we serve, and we're very pleased with the businesses all so far. But the big story in China is really all about the indigenization of technology that is a national priority, and we don't expect that to change anytime soon. And our strategy around being first to market positions us well to [win] in China and win globally as well.

On -- I just have 2 follow-ups on the China discussion. One is around 5G. We've heard, I guess, some signs of maybe moderating 5G builds in China, at least to start the year. I think first half, new base stations added may have lagged some expectations. So are you seeing anything similar in terms of maybe communications slowing down as they may be a little bit farther ahead the 5G cycle in China?

Yes, they may be further ahead. But from our business point of view, it's -- we don't see the immediate correlation typically. We're often working with customers, just a mix of our business being so much more in R&D. We are often working with them on their road maps that are 18 to 24 months out in some cases. So we don't expect to see it. But there are some reports out there that they are lagging. But you look at -- the picture is Europe has been so far behind on 5G. So there's increased efforts there. Americas, with C-band is providing a short-term catalyst, and we see that in our business as well as the business from the sub-6 gigahertz has picked up dramatically after the C-band auctions have been put in place. So overall, we're very pleased with the performance of our 5G business and of our commercial comms business as well, which continues to grow despite the significant headwind we had from trade.

Got it. And then just last one on China. We've seen obviously Chinese tech stocks under pressure lately due to increased regulatory scrutiny. I'm wondering, does this maybe tougher stance on regulation over there have any implications at all for Keysight, given you are sort of a U.S.-domiciled business?

Yes. There's none we see at this point. We are obviously watching as everybody is. But our role, it's really about enabling innovation and providing support for a lot of these standards-based global technologies. So I don't expect a big impact from that at this point.

Got it. Okay. I want to pivot to the financials. And so maybe, Neil, I've got a couple of questions that I want to dig into. First off, as we think about growth. So Keysight historically -- when you laid out your plan at the last Analyst Day, you talked about 4% to 6% growth, roughly 100 bps better than the broader market. I'm wondering, as we begin thinking about fiscal '22, and I know you haven't guided, so we'll sit patiently and wait. But is the 4% to 6% growth now, sort of a good start point to think about for next year? Or do you think that the backlog you've built up and the higher book-to-bill ratio implies maybe we could stay above that 4% to 6% level, at least as you sort of work through some of that backlog that's been built?

Yes. I think about that a couple of ways. So first of all, as Satish mentioned, if you look over the past 2 years and kind of take this from 2019, which is kind of our last pre-COVID year through the end of -- projected end of FY '21, we think the markets over that 2-year period have more or less grown with the long-term model that we put out, kind of mid- single-digit growth in the markets. And that Keysight has, as we have expected to do, outperformed those -- outperformed the market performance. I think if you look based on our guide for FY '21, we're going to, over the 2-year stack, grow at about a 7% compounded annual growth rate over that 2-year period. It's a little bit better than our long-term model. I think -- as you -- I did say on the call that as we look forward to '22 and noting that we haven't guided yet, that we remain comfortable with the long term model that we put out there. So I think it is a good starting point. I think normally we would look at the backlog that we've built over the last couple of years and say, at a bare minimum, it derisks the situation going into FY '22 and may, under normal circumstances, provide some upside. I think -- you've got to caveat that, though, with the fact that the supply chain situation is still ongoing, and it is somewhat regulating the revenue upside. We're going to put a very strong year-over-year growth here in FY '21 with revenues up mid-teens kind of percentages. And so we're going to be lapping some tougher comps with those supply chain constraints still in place as we enter FY '22. We'll have to remain and see -- wait and see how that plays out over the year. And hopefully, by the end of '22, things are much more freely flowing. And then the other kind of complicating factor, as we've all seen over the past couple of months with the Delta variant is it's easy to get ahead of yourself with regard to COVID, right? And we're not out of the woods here. And I think we need to wait and see how that plays out. So I think we're cautiously optimistic. I think the underlying demand in our markets remain strong. It's -- again, over this period of time, it's at least as good as the long-term model we put out. Keysight has continued to outperform. We've built some nice backlog but there are some offsetting factors here that I think are going to keep things in check a little bit as we enter FY '22.

Great. I want to weave in one investor question that came across. And the question goes, what kinds of logistical challenges are you facing? And could you lay out a timeline and strategy for resolution?

Yes. So I'm assuming this kind of gets to the supply chain logistics question, right? And so the first thing I would say is, I think Keysight's fortunate in one very significant way. And that is that, as many of you that follow the company know, we are -- our supply chain is vertically integrated. And that we run our own fab. We manage and develop a lot of our own packaging technologies that go into the kind of front-end components that go into these instruments. And so, while not all of our highly specialized components are built in-house, a significant percentage of them are. And if you look at the supply chain problems that people are having, where they're most severe is when you're looking for something that's special, a one-off that's unique to your particular company. And again, we control a lot of that manufacturing for Keysight. So a lot of what we're out procuring is more generic, commercial, off-the-shelf, high-volume type production parts. And that doesn't mean that there aren't supply chain constraints. It just means that there are more degrees of freedom and how you solve those things. And so I think we certainly have a reasonably long list of the -- a hot list, if you will, of supply concerns that we're actively managing. I think, the [other] benefit for Keysight is relative to some other industries out there, we're a relatively low-volume user, right? We're not out building millions and millions of cell phones or televisions or something. We're building a much lower volume of precision instrumentation. So in many cases, our suppliers can satisfy our need with a very small relative allocation, right? And so, it's -- in terms of the logistics challenges, it's very actively managing each of those supply chain relationships. So when you get one resolved, you're not done, you just move on to the next one. And we literally have dozens of these balls that are in the air at any given point in time, but I think we've done a very good job of managing it to date. While it is true that if you look back over the last several quarters, our revenues would have been incrementally higher if we were in an unconstrained supply situation, it's also true that I can't point to a single instance where we've lost a substantial deal because of our inability to deliver. We are successfully getting product into the hands of our customers on a timeline that they find acceptable. And so I'm pretty happy with the way we've managed these challenges to date.

One other -- I want to go back to revenue for a second. We talked about top line growth, but one of the interesting angles here that I think we're seeing come to fruition more and more the last couple of years has been this increasing share coming from software and services. And I think the market is really beginning to appreciate that as well the last couple of months. So maybe, Neil, if you can update us on what percent of revenues now come from software and services. And if you can maybe even help break those 2 out individually? And then how far along are we within software in terms of pivoting towards subscription relative to license?

Yes. So a little bit more than 30% of our total revenues now are coming from software and services. You can think of that as roughly 20% coming from software with the balance coming from services. Both of those businesses have been and continue to outgrow the broader companies. They're increasing as a percent of the overall total. It's -- particularly on the software side, that's been a significant contributor to our margin performance. The other part of your question was where are we in kind of changing the way that our customers buy software from Keysight right? From one that's historically been perpetual or onetime in nature to one that is increasingly subscription-based. And right now, we're -- basically right around 50% is kind of where we're at today. And so there's significant opportunity for us as we move forward. And it's a key area of focus for the company. The other thing that's important, if you look across that portfolio of softwares and services, there's over $1 billion of ARR today. And so if you think about the durability of our business, the durability of our revenue streams, not just that roughly 1/3 of our business coming from software and services that, but that $1 billion plus of that is actually recurring in nature at this point in time.

Got it. And so having touched on top line, having touched maybe a little bit on the underlying mix shift that's improving within that, operating margins have recently exceeded that 27% level that I think was the top end of your guide you previously laid out by fiscal '23, right? I think it was 26% to 27%. So given that, how should investors think about the trajectory for operating income margins heading into fiscal '22? And then maybe can you help us frame the potential for greater margin lift from here?

Yes. So first of all, we're absolutely thrilled that we've achieved the long-term operating model that we laid out at our 2019 -- March 2019 Analyst Day, and then we did it, as you noted, 2 years ahead of schedule, right, getting to -- we will be at basically 27% operating margins here. for fiscal '21, and we believe that not only is that sustainable, but as I said on the call, our most recent earnings call, we believe that there's room for us to continue to drive margins northward, right? As we focus not just on gross margins, but continuing to leverage our G&A infrastructure as the business grows, we do believe there's opportunity to continue to drive that forward. In terms of how to think about it, I'd point people back to the operating model that we've been talking about now for 7 or 8 years since our separation from Agilent, right? When this business is growing in the mid-single-digit rates, we can deliver a 40% operating margin incremental. We manage our business to that hurdle. And so I think that's a good rule of thumb to think about as you turn the lens forward as well.

That's excellent. So maybe let's pivot now to the balance sheet and capital allocation, because I do think that's also another pretty interesting angle where the company is now generating pretty significant and sustainable cash flow. You've traditionally maybe -- been fairly active in terms of tuck-in M&A. I guess we've heard some questions around whether you may go for a larger scale M&A. We've also seen a little bit more allocation towards share buybacks in recent quarters. So maybe just to sort of set the stage, how are you prioritizing uses of excess free cash flow? And then maybe we can sort of dig into some of the different use cases.

Yes. We've talked a little bit about the framework that we use to think about capital allocation. And the #1 thing that we want to -- our first priority is always to continue to invest in the organic growth of our business. We do that through the roughly $800 million worth of R&D investment that we'll make. We'll do that through our investments that we've been making in the field organization, doubling over the last several years the feet that we have out on the street selling Keysight products. And so we want to make sure we're making those organic growth-driven investments through our P&L. Beyond that, we do have an appetite to continue to grow the business, bring in new technologies, new tools, open up new markets via M&A. You've seen us do that over the recent past, a couple of acquisitions in the quantum space with Quantum Benchmark and Quantum Labber. We've done a couple of acquisitions to round out our 5G portfolio with our acquisition of PRISMA and more recently, the acquisition of Sanjole. And then we've used it to enter new markets, right? Going back to our last large acquisition with Ixia kind of getting into the protocol layer of the wired side of the equation. But more recently, with our acquisition of Eggplant, still keeping Keysight within the broader envelope of tests, but moving out of kind of the hardware or hardware linked test into using software to test software, right? We think it's an attractive market, kind of continue to keep us under that broader portfolio of tests, and it's one we're encouraged about. And so, I think you'll see us continue to look to add to our portfolio via M&A. We will remain disciplined. I think that's the challenge, right? The challenge is not so much idea generation, but it's really about finding targets that are actionable at a price that will enable us to meet our return hurdles. And then beyond that, we're returning capital, right? We're committed to at least remain anti-dilutive with regard to our share count. But as you've noted over the past couple of years, we've actually taken steps to reduce share count via increased buybacks. And allocating again, over the recent past, roughly 50% to M&A and roughly 50% to buybacks. And so the -- we haven't made a commitment about that ratio. But if the recent past is indicative then I think you can see -- you expect to see continued behavior from Keysight that aligns with that. I think we do have -- we are open to doing acquisitions that are larger. Again, it comes back to finding targets that are actionable for Keysight at valuations that make sense.

Got it. And then maybe just a follow-up on that. As you think about the business growing its net cash position, is that something maybe you measure to or think about as you sort of -- we said 50-50 split between buybacks and M&A. But obviously, margins are growing. Profitability is growing. I'm wondering is there sort of a framework you use when you think about maybe limiting the growth in that net cash position? Or are you okay maybe letting that grow a little bit and giving yourself a little bit more cushion to be opportunistic should a larger-scale opportunity surface?

Yes. I mean I think right now, Keysight, not only do we have significant excess cash on the balance sheet, but we also are underlevered relative to our own target leverage in the kind of low 2 turns of EBITDA. So I think from a capacity standpoint, there's plenty of capacity. We do actively monitor and actively discuss the cash balance. And certainly, our goal is to not have the cash balance continue to grow unchecked. I think if you look over the last 5 or 6 quarters, we've kind of been treading water in the high $1.8 billion, $1.9 billion range for quite -- for several quarters in a row. We did tick up a little bit this most recent quarter. But again, I think we've been trying to manage that cash and the growth of that cash pretty conservatively, while at the same time, given some of the disruptions from COVID and other things, recognizing that now might be in a time to be a little bit more defensive from a balance sheet perspective than we would be in other periods of time. So certainly something that we're paying attention to, and that we do not intend to just let cash kind of grow unchecked. That's not the objective.

Last question because I do know we're coming up on our allocated time. And this is probably one for Satish. What would you say are 1 or 2 incremental growth opportunities for Keysight that are underappreciated by the market today, whether it's on quantum computing, 6G. I'm wondering maybe as investors and analysts, what should we be focused on that maybe you're more focused on right now that will become a bigger deal over the next several years?

I think there's a couple of things that come to mind. Number one is the way we think about our portfolio is we want to make a meaningful contribution to a lot of the disruptive innovative teams that are going to define the future and Keysight's got the diversified portfolio and that's what we're working very hard to continue to do, whether it is 6G, whether it's quantum, whether it's EV or AV, we have the portfolio and the breadth of the portfolio to make a difference there. So that's number one. But the way we recognize value for our shareholders is not just by being first and investing in R&D, but it's really all about getting better than market growth and then sustaining that through our focus on life cycle value capture. You've noted the software and services is becoming an important -- bigger and bigger part of our portfolio, 33% of the business, and we continue to feel like there is more upside for us just in the way we engage with our customers, which should continue to give us margin expansion -- continued margin expansion over time.

Great. Okay. I think we are just about out of time. So we'll go ahead and end it there. Again, Neil, Satish, thank you so much for joining us, and I'm really looking forward to doing this in person next year in Las Vegas. Thank you.

Thanks, Matthew. We appreciate your time.

Take care.