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

Good afternoon, everyone. Before we get started, if you are a member of the press or media, please disconnect at this time. This is a restricted line. Any unauthorized party in this meeting or any unauthorized use of the information communicated in this meeting is subject to prosecution to the fullest extent of the law. Any unauthorized person, including the media, that is on the line at this time, please disconnect. Please note, today's call is being recorded.

Perfect. Thank you, everybody. Good afternoon or good morning to those of you that are still in the morning hours. I'm Aaron Rakers with Wells Fargo. I'm the IT hardware and semi analyst here for the company. Pleased to host a conversation with Keysight, Neil Dougherty, the CFO of the company. Neil, you've come to this conference the last couple of years and always a great discussion. So looking forward to hearing more about the Keysight story. I should mention for those in the audience, there's a safe harbor statement, I believe, on Keysight's website for reference. I think we're going to leave it at that. If that's okay, Neil.

That's perfect. Thank you.

Thanks for coming. I'm going to actually start off with a little bit of the softball question of, the company has performed extremely well, the business model has progressed as, if not quicker than expected in some respects. We saw results recently. So it begs a question of, as you see the stock perform so well justifiably, what do you still think is kind of underappreciated or maybe just not well understood in the Keysight story at this point.

Yes, Aaron, I think it's a great question because I do still think that we periodically run into folks on the investment side that are still anchored on a story about Keysight that is really reflective of what we were prior to spin 7 years ago and not what we've become over the course of the last 7 years. And I would suggest that the company is just a dramatically different company than the one that spun out of Agilent 7 years ago. And so we fundamentally transformed the business from one that was very heavily skewed towards hardware tools that we've largely sold into our customers' manufacturing lines to a company now that is selling software-centric, complete solutions primarily into our customers' R&D labs. And that, in and of itself, along with the level of investment that we're making in growth, either via the field or our sales force and R&D has fundamentally changed the company, right? We're a much stabler secular grower at this point in time, having grown at a 10% compounded annual growth rate from our spin to today. We fundamentally changed the profitability of the business. We've added over 800 basis points to gross margins, 1,000 basis points to operating margins over that 7-year window. And I really think that is an indication of the value added that we're providing to our customers, right, the differentiated solutions, the value added that we're providing to our customers via this transition from selling hardware tools to selling software-centric solutions into the R&D lab has fundamentally changed the way we service this customer base. So I think that's probably #1 is that we're just a dramatically different company. Now we have a full 1/3 of our revenues coming from software and services. We have $1 billion of software. We have $1 billion of recurring revenue, annualized recurring revenue. Those weren't the characteristics of the company that spun out of Agilent 7 years ago. And if there was a second, if I was just going to add one more thing to the list kind of. So one is that we've fully transformed the company. And the second one is that we're more than a 5G story, right? For a long time, now we have spent 80% to 90% of our discussion time with investors focused on 5G. I think this year, given the really strong performance of our electronic industrial business, people are starting to finally realize that, man, there is more to this story than just 5G, whether it's automotive or semi or Internet of Things, that there are a number of other growth drivers that are supportive of the story.

Yes. And we're going to touch on some of those. And definitely, I think on 5G, I'll probably ask this shortly, but it's not just 5G as we see it, traditional handsets. It's also deepening as far as what 5G is from a core platform perspective and the drivers, opportunities of monetizing that for longer. Is that fair?

That's absolutely correct. Yes.

Yes. So on the heels of that lead-in, one of the metrics that I think maybe is underappreciated is that you've had some pretty good customer expansion numbers, right? You've added 2,000 customers this past year. It was 1,900 customers the year before. And I guess, if I were to ask you, how much of that customer expansion or how much of your revenue growth is replacement of existing solutions versus net expansion of new customers and maybe expanding digitization of everything as an underlying driver for Keysight's business?

Yes. I mean, I certainly think if you think about that expansion of customers, over 4,000 new customers to Keysight's portfolio over the last 2 years, that is really being driven by this electronification of everything, this digitization, this need for more data throughput, lower latency across a broad range of applications. And so if I look at specific drivers, like where are we finding new customers at this point because I certainly hear from investors, it seems like everybody out there in electrical engineering world would know about Keysight. And I think that's largely true, but you're seeing new customers show up as technologies evolve, O-RAN being a great example, right? Prior to the last couple of years, you thought about the network access side of these wireless networks as a 4 or 5 company opportunity for us. And as soon as you disaggregate that radio access portion of the network, we now have dozens, if not hundreds, of companies that are looking to pick up various pieces of that radio access network. They're all hiring electrical engineers. They all need measurement tools and capabilities. And in fact, the tools we're providing into the O-RAN network have about the highest software content that we've seen across any of our solutions portfolio. There are other examples. I think automotive is a great example. In the world of the internal combustion engine, largely a mechanical engineering device. And in its core, Keysight makes tools for electrical engineers, right? And so we didn't have a lot of value to provide to the legacy automotive world. We serviced that industry around the fringes. But as you move towards electrification of the drivetrain, hybrid vehicles, electric vehicles, autonomous driving, advanced infotainment systems, complex sensors in the car, blind spot detection, tire pressure, again, all of this electric content has to be developed and manufactured. And so there's a whole array of companies that are popping up to service that auto industry. They're all hiring electrical engineering talent. They all need tools and solutions. We now have close to 100 solutions that are focused at this next gen auto market and the companies that are supporting it. You can look at IoT. You can look at digital health as areas that we didn't use to really think about that are now providing significant opportunities for the company.

Yes. Yes. And so what it sounds like I'm hearing from you is, again, just overall TAM expansion. How about the dynamic of Keysight vis-a-vis competitive replacement or competitive positioning in the market? I mean, I guess what are you seeing on that front? Who are Keysight's winning, who's losing? And have you seen your win rates change?

Well, I mean, I do think, certainly, over the last 7 years, we've seen a dramatic trajectory, a change in trajectory. I mean, we've been taking share now for 5 or 6 years in a row and are continuing to win in the marketplace. I think Keysight is a company that spun out after a period of underinvestment admittedly, but with great bones as they say. We were #1 market position. We had the broadest portfolio of equipment and solutions in the industry. We just haven't been investing at the right rates. Once we fix that, I mean, I'm now investing at close to $800 million per year in R&D. That is a level of investment that's very hard for much smaller competitors to compete with. They can't compete with the breadth of our portfolio. So as we have effectively changed the industry from one where we used to sell tools to now where we're selling complete solutions that we are really capitalizing on that breadth of portfolio because the question is not what tools do you need. The question is, how can Keysight bring all of the tools and capabilities that we have under our umbrella to bear on solving the problems of specific industries. And that breadth, you need that breadth to be able to provide that complete solutions content.

Yes. Yes. That's perfect. I don't know that I've sat on any conference call over the past couple of months and not heard supply chain come up multiple different ways, multiple different questions. You recently mentioned, I think it was $300 million or $400 million of kind of abnormal backlog build for Keysight. You've reported record backlog. So I guess the high-level question is, just update us on what you're seeing in supply chain. Do you have any crystal ball that says, hey, things start to normalize again. And I guess the final part or the third part of that question is, how has it changed your engagements with your customers asking them to give you longer lead times and the underlying duration of that backlog, I guess, is the question with that.

Yes. So there's a lot in there. So let me just kind of talk about supply chain and how Keysight is being impacted and navigating the current supply chain environment. So first of all, I would say there's some characteristics of Keysight that while they don't protect us totally from the current supply chain situation, there are some characteristics of Keysight that provide us with a little bit of immunity and potentially having us weather the storm better than others or certainly better than we might have had those characteristics not been in place. And so those things are, first of all, we have our own fab, right? And if you think about the highly specialized ICs that we need for this ultraprecise equipment, much of those ICs or many of those ICs, the vast majority are made in-house by us. So we control that supply chain. And if you think about semi shortages right now, where people are really getting squeezed is low volume, highly specialized production. And we do a lot of that, but we do it in-house. And so if we didn't have that in-house fab and we were out relying on the open markets for these small runs of highly specialized Keysight specials, that would be problematic. And so that is a differentiating factor. The other thing is just the nature of our business is one where we are a high mix, relatively low volume provider of equipment. And so what that means is when we're working with suppliers, I don't need 1 million of anything, right? I need relatively smaller allocations. And we have been relatively effective in working with our suppliers to get the size allocations that we need to keep production moving forward. That being said, while we have some immunity, we're not totally unimpacted by this current situation. We have seen our backlog grow. I mentioned on our call last week, $300 million to $400 million of what I would call abnormal backlog build over the last 2 years. Last year was really a function of the COVID shutdown, right, closing our factories for a couple of months and then a slow ramp out for which we never recovered fully before the supply chain situation happened. And now once again, we're in a situation where our ability to deliver is lagging demand in our industry. And so what we have seen, though, I think, again, relative to the problems that are out there more broadly. So we've seen our lead times for kind of the core of our product set shift out kind of a mid-single-digit number of weeks, right? And so that's not great, but that's not something that's unmanageable for our customer set, right? And so that's what's leading to that increase of $300 million to $400 million of backlog. Customers are ordering from us a month or so, plus or minus, earlier than they previously would have and that then those dollars are sitting in backlog longer than they previously would have. So again, I think our goal is certainly to return to the norms of 2019. But again, I think as long as we have an open line of communication with our customers, that push out is not something that is so long that it's unworkable for them, right? And so I still can't point to a single example where a customer has canceled an order with Keysight to go with a competitor because of our inability to deliver. That's just not a problem that we're having at this point in time.

Yes. That's great. That's a great overview. And kind of on top of that, appreciating that you have a lot of internal attributes with your manufacturing and your supply chain, but there are inflationary pressures on component costs and stuff. How has that been managed by the company? What have you done there and the stickiness of those price increases to the customers as you, I'm assuming you've invoked some.

Yes. So obviously, that's our goal, right, is to pass on the input costs. And we're seeing inflation impact just a number of different ways, right, most notably in supply chain inputs, logistics costs, the things that you're hearing across the industry, people cost, right? Certainly, we're seeing higher levels of salary inflation globally than we've seen in the recent past, right? And so our goal is to not just maintain margins, but over the long term, we've been on a nice run of expanding margins. We've added 1,000 basis points of operating margins over the last 7 years. And so we're looking to pass those increased costs on to our customers. And I think by and large, you have to be careful. You have to understand where you're differentiated in the marketplace and where you have some ability to do that. And there might be some areas where it's more difficult. But I think by and large, we've been successful in doing that. I think the only other thing is there sometimes can be a mismatch in timing, right? Inflation is happening real-time, but we're sitting on almost 2 quarters worth of backlog. We've got other order quotes that are already out with our customers. And so it does take time from the time a price increase is actually enacted to the time that it's actually flowing through and appearing in your revenue line.

Yes. That's perfect. Speaking of the P&L and the company's solid execution against some of the targets you've laid out. I mean, you've reached your operating margin target, I think, it was 2 years ahead of schedule.

Yes.

So I can fully appreciate that you're not here to give us an updated long-term model. But I'm kind of curious of how you think about the drivers of continued leverage within the Keysight model as we move out over the next several quarters or whatever time horizon you want to think about.

Yes. I mean, I think it's a great question. And I think it's, to some extent, it's more of the same, right, I think, across our end markets we have. So first of all, we're in an environment right now, right, where you've got a strong macro backdrop, right? GDP is growing at pretty strong rates relative to the relatively, let's say, the intermediate past. But layered on top of that, if you look at our specific industries, you've got a number of secular themes that are driving our end markets kind of above that, beyond what the macro would do. So in the case of commercial communications, it's obviously the 5G rollout, which is in full steam, but for which we very much believe we're in the early innings. On the wireline side of the house, it's the 400 gigabit investments that are happening in deployment today. And in the R&D lab, it's 800 gigabit investments. If you move over in aerospace, defense, we've seen, depending on what happens with the current budget, which is under consideration, it looks like we're on top of our fifth consecutive year of aerospace, defense budget increases as it relates to the areas where Keysight serves. So that's really good stability and growth in that industry. And then over on the EISG side of the house, you've got the semiconductor industry, right? A lot of things going on there with regard to, first of all, the component shortages that are just driving capacity to be put in place. But on the technology side, you've got the move to smaller sub-5-nanometer process architectures. And then you've kind of got this geopolitical thing about assurance of semiconductor supply causing re-onshoring of fab production into the U.S. and in Europe. And so all of those are additive. In automotive, you've got EV and autonomous driving. And then in our broader general electronics space, it's IoT. I mentioned digital health earlier. It's Industry 4.0. That general electronics business tends to have a little bit more of a manufacturing bent than some of our others. And so this general electronic supply shortage is helping to drive that business. And so you've got this kind of market and demand side of things that is driving things. While at the same time, Keysight is continuing this progression towards providing complete software-centric solutions, which are more highly differentiated in the marketplace. And we can monetize that differentiation. I started by saying that a lot of this improvement really goes to the value that we are providing to customers, right? We are increasing the way we're servicing the market, expanding the SAM by changing the way we look at our customers, the problems that they're facing and trying to take on more of what is context for them so that they can work on their core and make their context our core, right? And by doing that, we're able to contribute at a higher level and drive a higher margin contribution.

Yes. And kind of before we go into some of the segment comments, I mean, you touch every secular trend that I think I've talked about on many calls. Over 30% of your revenue is from software. The software-centric motion of the business model, I think you've said $1 billion of ARR. What's the next layer to that? How do I think about the, remind us to the extent that you provided, the progression of that 30%-plus contribution? Do I think about a company X number of years from now that's double that? How are you laying that out for people?

Yes. So today, we're a little bit more than 1/3 software and services, about 20% of that software. I think about $1 billion of software on roughly $5 billion of revenue. And the balance, 13%, 14% is our services portfolio. I'll start on the software side, right? And we're coming up on tripling our software content over the last 7 years on a dollars basis. And it continues to grow at a rate that's above the company average. But I think if you're thinking about where it can go, right? On the one hand, we're seeing some of our cutting-edge solutions, 5G solutions, they're 40-plus percent software content. In the case of O-RAN, it's 50-plus percent software content. So that's at the high end of what we're doing. But as these industries move forward, I think that's indicative of the role that software can play in some of these industries. And that's a fundamental change from what Keysight was doing previously. It's really, our move into the software aspects of these markets has really been seeded by the acquisition activity that we have done, right? It started with our acquisition of Anite that moved us into the protocol layers of wireless. Then we did the acquisition of Ixia that's moved us into the protocol layers of wireline and has really helped to shift this mix from one that was mostly pure hardware with a little bit of software applications layered on to much more that is really, a lot of the value add that we're providing for customers is coming from the analytics that are embedded in the software. And then just kind of taking that M&A theme forward. We've done other deals like the acquisition of Eggplant, which we did a year ago, August, which moves us into software test. And so now we're in a market where we're selling software to test software, completely disconnected from the sale of Keysight's hardware tools, right? And so I think as we, and we're interested in those markets as opportunities to stay within our core test and measurement themes but in pure software-type solutions. And so as I look forward, I just think there's a lot of room for us to continue to grow our software business at a rate that's significantly ahead of where Keysight grows.

And remind us again, how is that software licensed? Is it subscription? Is it perpetual?

About 50-50 today. So I think it's a second opportunity for us, right? We have about $1 billion of ARR today as well, about half coming from software, about half coming from services. And I think as we think about growing that, obviously, the ARR, that is growing the ARR, there's 2 opportunities. Grow software and services makes a lot of sense, right, but they're also changing the way our customers buy that $1 billion of software from us. And so again, about 50% recurring today, about 50% still perpetual. And so I don't know that we ever get to 100% recurring on that, but there's certainly an opportunity to get much closer to 100% than where we are today, right? And so I think that gives us 2 levers with which to think about growing our recurring revenue base. And it gets back to this stability of the business, right, is much different than it was a decade ago.

You mentioned on the end market side, and I think people are starting to realize that 5G is more than just, hey, we're at 500 million 5G phones going to 700 million and therefore, we're past the peak and assigning you as a story of being, hey, when peak revenue of 5G play out. So you talked about O-RAN, I think 5G networks around edge and stuff like that. But that aside, I think one of the questions that I come back to is the semiconductor market for you guys, can you just help us understand and appreciate what drives, where Keysight sits in the semi market and how we think about the drivers there as it becomes, I would imagine, a bigger piece of the story going forward?

Yes. So Keysight, we're not a broad semi tool provider, but we do have a couple of highly differentiated positions that are important to the overall semi capital equipment markets. And so one is around wafer test. We make a product called the parametric tester that is used to test the electrical properties of the blank wafers both in R&D and production. And so we've been, I talked earlier about all of the different kind of secular things that are driving the semi industry. And again, that's a pretty unique tool, highly differentiated tool that provides significant value added to our customers, and we're benefiting from those secular drivers. I think then the other thing we make is we make essentially a component, an ultraprecise, again, nanoscale precision 3D positioning component that goes into some of these big photolithography machines. So if you think of the bigger fab equipment providers, they're buying our 3D positioning equipment as a component in those devices.

Interesting. And so the drivers of that, I mean, we could pick the secular end market drivers but at the very lowest level, I mean, wafer start expansion.

Fab capacity and then on the R&D side, it's the move to smaller process architectures, right? As you go from 7-nanometer, 5-nanometer, 3-nanometer, now 2-nanometer, all of that work in the R&D lab needs tools from Keysight.

Yes. And I'm sorry to go on this kind of tangent, different direction a little bit, but is that an opportunity where you see more other adjacent opportunities evolving for Keysight over time? Is that the expansion?

Potentially. I mean, I think we like the solutions where we're at. I don't think we have an interest in being a broad semi equipment provider. But if there were other niches where we had technology to bring to bear, I certainly wouldn't rule it out. I definitely see it as an opportunity, though. I mean, we've been on a very nice run within the semi industry driven by these growth drivers. And as we look out over at least FY '22 and increasingly looking like FY '23 as well that the semi industry is going to remain quite strong from a demand perspective.

Yes. And then you've mentioned a couple of times on, back to the 5G discussion, O-RAN. For those that aren't that familiar, we've heard some. The Dells I cover start to talk about telecom and this disaggregation of the 5G network around O-RAN becoming more important. Where are we at in that cycle, that opportunity for Keysight because I still think we're relatively early innings there.

Well, I mean, we're definitely, again, maybe just to drive the point home, right? Keysight in total today is selling about 60% of our solutions into the R&D lab, about 30% into manufacturing and about 10% into kind of post-deployment operations. Our 5G business is even more heavily skewed towards R&D than that, right? So we're very much focused in the R&D lab. And we are seeing very active investment in getting O-RAN technologies ready for commercial deployment. I think when you think about that radio access side of the network, that's traditionally been a 4 or 5 customer opportunity for Keysight. But now that it's disaggregated, there are literally dozens, maybe hundreds of companies that are looking to pick a piece of that pie. There's all this interoperability that needs to be tested, which drives the high software content of these solutions. And we're seeing the first indication, particularly in Europe, we are seeing indications from some of the European service providers that they intend when they deploy the 5G to take this O-RAN approach to their network development. So I would agree with you, it's still early innings, but from a Keysight perspective, we're generating real revenues today from this opportunity and adding significantly to our customer base because of this opportunity.

That's great. Kind of same question, different secular theme. 400 gig, I think everybody is now starting to see that coming to fruition. That's going to be a long cycle. I know speaking with Arista, they think that's going to continue for multiple years as far as 400 gig ramp. But you guys being on the R&D side, 800 gig. So I guess my question is, the complexity involved in making these next-generation moves, how do I think about that in the context of driving incremental value or dollar content for Keysight?

Yes. I guess I'd maybe even step back further, right? We see what's happening in the wired evolution as being complementary and really intertwined with 5G, right? And ultimately, all of this is being driven by the need for higher data throughput, lower latency and massive expansion of data traffic, right? And so as you said, right now, we are enjoying right now the investments that's being made in deploying 400 gigabit and the investments that are being made in getting 800 gigabit and ultimately terabit ready in the R&D lab, right? And again, it's a similar theme to what has played out on the wireless side, where Keysight, legacy Keysight is just traditionally a physical layer provider, bought Anite and got into network emulation and protocol test and providing our customers with a way to simulate a 5G environment in a lab setting. We're doing very much the same thing on the wireline side where again Keysight has always had on the wireline side strong physical layer presence. It was the addition of Ixia that allowed us to move up that protocol stack and serve this wired network side more completely and move up into the application, first into the protocol layers and now increasingly into the application layers as well. And so again, I think if there's a theme here, it's Keysight changing the way we view the market and changing kind of the narrow scope that we used to play in, in terms of our way to serve those markets and expanding up the protocol stack into the software value-added because our customers really see value in our ability to tie that together.

Neil, I think we're right on time. I want to keep you on schedule. And I, as always, appreciate it, a very insightful discussion.

Thank you so much, Aaron. We look forward to seeing you in the near future.

Thank you.

Take care.

You too.