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

Hello, everybody. Thank you for joining us today. Tim Long here, Barclays' hardware come equipment analyst. Alyssa Shreves is on my team, is on as well. We're very happy to have Neil Dougherty at Keysight with us, CFO, SVP. So thank you, Neil, for the time. And let's just -- we'll dig into this. Maybe we'll start by running through some of the key businesses here and then hit you with some financial ones as well.

Let's start off with the wireless front. I know it's always been a hot topic. It's probably deemphasized a little bit. But I was hoping you could talk -- it continues to be strong and the cycles definitely lasting along as you guys have talked about over the last few years. Could you talk a little bit about how it's kind of broadening out, I think, with ORAN and into some of the other verticals that are getting involved in 5G? So can you talk a little bit about how maybe it's taking a little bit different path than some of the prior generations? And is that really helping to the sustainability of this double-digit order growth that you guys have been seeing?

Yes. It's a great question, Tim. And obviously, the 5G markets or the wireless markets today, extraordinarily complex, right, a much more complex environment that we're in here in 5G than the kind of the analogous time and 4G driven by a number of factors. But I think, as we think about the opportunity for Keysight, not just currently, but as we turn that lens forward, I think we tend to think about it across a number of different vectors, right? A lot of what we're doing today, at least in the deployment phases, is focused on the lower frequency installations of 5G sub-6 gigahertz, current driver would be the C-band -- the C-band developments here in the U.S. I think as you look forward, again, focused on deployments, you're going to see that migrate to higher frequencies. We're working on those solutions in the lab today. And so they are generating significant revenue opportunities for Keysight today. But I think commercialization and deployment of those higher frequency solutions are still broadly in front of us. And then as you get beyond that, and again a key differentiator of 5G is we still have all of the opportunity related to use cases beyond the cell phone to look forward to. And again, so we're starting to see the front end of that in terms of aerospace defense application or usage of 5G networks, private networks, automotive, IoT. All of these other industries and potentially Industry 4.0 that are looking to capitalize on the high throughput bandwidth and low latency capabilities of 5G. And so as we think about this market opportunity, we continue to believe that it is a very long-lived opportunity and growth driver for Keysight. And really, I've just talked about the wireless side, right? Eventually, all of that data traffic will work itself back into the wired network. And so we're benefiting on that side today with the deployment of 400-gigabit or 800-gigabit and ultimately terabit or faster speeds in the lab as the wired network prepares for all this increased data traffic as well.

Okay, great. Great. Yes, that's a -- it's good start there. Can you -- maybe when you think about the duration of this cycle compared to prior, just curious, you mentioned some of the things like IoT and private networks. Talk a little -- we'll get deeper into software a little bit later. But maybe talk about software-intensive nature of 5G and then separately, millimeter wave because that gets a lot of press? You talked about the higher frequency. So what do you kind of views on those 2 aspects as we look forward the next few years?

I mean certainly within Keysight's portfolio, and keep in mind, Keysight is a company today, about 1/3 of our total revenues are coming from software and services. I think within our portfolio, our commercial communications business definitely has a stronger software bias than, for example, the industrial businesses on the EISG side. And just to turn that into context, we have some of our 5G solutions, our network emulation solutions that are north of 40% software content. In the case of ORAN, where there's all this interoperability that needs to be tested as part of these ORAN solutions, we're seeing software content that's north of 50% of the build value. And so it is definitely finding ways to continue to add value for our customers through increasing levels of software. And so, yes, exciting opportunity for us in that space within commercial communications. The other thing that you asked about, obviously, was millimeter wave and higher frequency deployments of 5G. Obviously, those things are being delayed from a deployment perspective. But again, from a Keysight perspective, what that's really meaning is that we're continuing to see people across this ecosystem continue to invest in the R&D lab to ensure that these technologies ultimately become viable. I think we're likely to see an interesting test case of higher frequency 5G at the upcoming Olympics in Beijing, and we'll see what China decides to do after that. But I think from -- again, from a Keysight perspective, it's more of a question of when, not if things move to higher frequency. We're already heavily engaged with Standards Committees that are starting to think about 6G and defining what 6G is going to look like. And certainly, what we know right now is that frequencies aren't going south, right? They're going north. And so again, we believe that ultimately people work through these technological challenges. And you see this deployment of communication solutions on higher frequency bands.

Okay, great. Great. Yes, you mentioned earlier on that, obviously, the 5G traffic gets to go on to wires at some point. So curious if you could talk a little bit about optical. It seems like we're heading into a pretty good cycle there. And of course, with the Ixia deal a few years ago, you guys have even more exposure there. So talk to us how you view this move to 600- and 800-gig and beyond that on the optical realm? And how you're positioned in that end market to participate in those positive dynamics?

Yes, it's a very significant opportunity for Keysight and one where we've been seeing very nice growth over the last several quarters, right? I think on the deployment side, we're seeing active investment in getting 400-gigabit speeds deployed. And on the R&D side, it's much more about 800 gigabit and even rates beyond that. I think a key part of our thesis, if you will, or our -- is that there's this more or less an insatiable demand for greater bandwidth and throughput. 5G is going to be a key enabler of that. But Keysight is uniquely positioning itself as the one player in the market that has not just physical layer solutions but protocol layer solutions across this ecosystem, right? We got wireless protocol solutions via our acquisition of Anite. As you mentioned, we got wireline protocol solutions that allow us to move up that software stack via our acquisition of Ixia. And now with 5G being deployed and the data center moving to faster rates, you're starting to see that vision that we've had for years starting to manifest itself for Keysight. And so because of that, we're in a pretty highly differentiated position across this communications ecosystem.

Okay. Great.

Neil, it's Alyssa here. I just had -- we kind of want to dive into your Electronic Industrial Solutions Group. And can you talk a little bit about that and specifically kind of demand trends you're seeing in semiconductor and automotive businesses that were kind of behind the segment's fifth consecutive quarter of record revenue, and kind of what we think about the sustainability there?

Yes, absolutely. I mean we are in a pretty strong time right now where we see in addition to a really strong macro backdrop with global GDP approaching 6% here in 2021, strong secular drivers across most, if not all, of our end markets. We've just talked about kind of 5G and commercial communications, but the same is true on the Electronic Industrial side. We're seeing that strong macro backdrop being kind of further pushed by strong secular themes within those end markets which we serve. So starting within semi, there's a number of drivers there that are really pushing that industry. First of all, we're all very well aware of the component shortages and the supply chain situation that's impacting broader technology industries. And so that is causing waves of investment in just capacity for semiconductors. On the R&D side, we see the move to smaller process architectures, 2- and 3-nanometer process nodes, and that's causing a wave of investment in the R&D lab. And then you've got this kind of geopolitical element that's hanging out there as well, as nations and regions of the world realize that there's -- if not national security, at least economic security ties to semiconductor supply. And so this is efforts to re-onshore semi production -- semiconductor production into the U.S., into Europe. Obviously, China for a number of years has been looking to build a domestic mainland China semi production capability. And so all of that is serving to drive our semi business, which is -- again, it's about 10% of total Keysight revenues. And so as we look forward, we see continued demand at least through our fiscal '22. And increasingly, we're starting to see positive signals deeper into our fiscal '23. So we believe that there is going to be a sustained period of investment here in semi. I think within the automotive industry, obviously, that was an industry that was pretty severely impacted by the COVID situation a year ago, but we've seen a nice rebound such that we actually put up record orders here in our fourth quarter. And so we're kind of all the way back and above where we were going into COVID, which is nice to see. And you're seeing a number of drivers in that automotive space. Certainly, there's -- on the EV side, there's -- not just the battery side, but the charging side of that, where Keysight has solutions to help with the electrification of the drivetrain. On the autonomous driving or ADAS, you've got the [ CbDx ] solutions and autonomous solutions again that are being invested in broadly across the auto ecosystem. And then you've just got the kind of the third thing, which maybe underappreciated, is just the rapidly expanding rate of electronic content within the vehicle itself, whether that's infotainment systems or tire pressure sensors, blind spot detectors, all of this electronic content needs to be designed, developed and tested. And obviously, that is creating strong demand for Keysight solutions. And then the last segment that we have within that EISG business is our general electronics business. It's a really broad cross section. But as a result of that, it's a section that really tends to benefit in strong GDP scenarios like we're seeing right now with the 6% GDP growth. And also relative to our other businesses within Keysight has potentially a little bit more of a manufacturing bias than the other businesses. And with the global supply chain challenges that attempt of the global electronics industries to add capacity has been favorable on our general electronics business. And then further, within that, you have kind of sub-themes around IoT or the intersection of kind of medical and electronics, digital medical, these types of things that are -- the return of students to campus is driving our education business. So there are a number of themes in there that are driving smaller segments of that general electronics market.

Thank you. That's helpful.

Neil, I wanted to touch on something that I think we spoke about in the past. It seems like in some of your businesses, if you think about semiconductors, there's a lot more companies, big tech companies that are developing their own semiconductors. And if you think about ORAN, a lot more companies are getting involved in it now. So can you talk a little bit more broadly about kind of customer counts? And how meaningful are some of these markets where you are seeing a renewed interest from a broader set of constituencies?

Yes. It's an interesting question. If Keysight -- if you think about the potential customers for Keysight, it's really tied to electrical engineering more than anything else. So you can think about any company out there that is hiring electrical engineering talent, would we have a reason to be buying Keysight's tools and solutions. So it is an extraordinarily broad universe of potential customers for Keysight. And in actuality, we sell to -- north of 30,000 customers are buying Keysight solutions on a year in, year out basis. But if you look over the last couple of years, we've added just under 2,000 customers -- brand-new customers to Keysight last year, north of 2,000 new customers this year. And I think what you're getting at in your question, Tim, is that we're seeing multiple waves of technological innovation that are bringing new players into the market, new opportunities for Keysight to touch base, and I think a great example of that is ORAN. We used to think of that network access portion of the market is essentially a 5 customer space. But now we literally have hundreds of customers that are looking to provide the broader markets with a portion of that network access solution. And there's all those interoperability things that Keysight is able to test and help bring those solutions to market. So we've seen a pretty dramatic expansion in the customer opportunity in that space. We're adding customers in other places. You mentioned auto and other companies looking to get into the semi space. Some of those companies might not be brand-new to Keysight, they might already be buying some solutions. But as they look to do different kinds of technologies, different aspects of Keysight's broad portfolio become relevant to them, right? So an auto company that previously might be buying our ADAS or EV solutions, if they decide to get into the semi space, might have a whole new set of tools that they might look to procure from Keysight. And so, that's a very common phenomenon as well where we greatly expand the value that we're bringing to our customers because of the breadth of our portfolio.

Okay, great. Great. Yes, I have a degree in electrical engineering, but I don't think you want to be hiring me. So that was a long time ago. Maybe just pivot a little bit. You mentioned software and services before being about 1/3 of revenues. Curious if you could just kind of walk us through the evolution of how do you evolve the model from what traditionally was hardware-centric into more software recurring? And I think the recurring software revenue is about half. So the second part of it is how do you move that recurring mix within the software up as well?

Yes. It's an interesting question. I think we've almost tripled our software revenues from the time of Keysight's span back in the beginning of our fiscal 2015 to today. And so we have seen a really nice growth in our software businesses. They continue to outpace the broader growth of the company. And I think the fundamental thing that we're doing is we're taking on more and more of what has historically been context for our customers, particularly in the R&D lab, and finding that we can add significant value to their design and test efforts by taking on some of that work largely due to software or via software. Today, I want to say about 2/3 of our engineering talent within Keysight are actually software engineers. And what we found that in addition to providing our customers with the hardware tools that they need to make a measurement, we have been able to increase our value add, increase our differentiation in the marketplace, increase the revenue opportunity for Keysight by partnering software with those tools and a complete solution that actually addresses the specific issues that our customers are dealing with within their range of technologies. And I think we -- as we mentioned, just in ORAN or network emulation, we continue to find new ways to add value for our customers via software. You mentioned that today, about 50% of Keysight's software sales are perpetual in nature, the other -- excuse me, 50% are recurring. Obviously, the other 50% are onetime or perpetual in nature. And I think that really creates 2 opportunities for us. Obviously, the first opportunity is for us to just continue to grow the absolute value of software that we're putting into the marketplace. The second one is for us to continue to work with our customers to change the way that they buy software from us. And I think we're making great progress in that, and I think there's a lot of room for us to continue to migrate that. I don't know if that we get to 100% subscription, but certainly there is -- at 50-50, there's ample room for us to continue to make that migration.

Neil, I was -- we were hoping to kind of switch gears a little and look kind of at your China business. In fiscal '21, you overcame about 5 percentage points of China trade headwinds and your China business was still growing on the year. How should we and investors think about gaining confidence that KEYS can continue to maintain and grow its business in China?

Yes. It's a great question. So I think I'd start by saying Keysight has, is and will continue to comply with any of the trade regulations that are put out there by the U.S. government or any of the -- anything -- any regulations that impact us around the world. I think that being said, we are a global company with a global footprint. We serve global industries, right, and global customers. And we have a strong presence in China. And I think if you look at what Keysight does in the markets that we serve, commercial communications, semiconductor, next-gen auto, general electronics, there is a very high level of alignment, but with what Keysight does and where our strengths are and what is driving significant portions of the Chinese economy. They're investing very heavily in these areas as well. They're looking to be a leader in 5G. They are investing heavily in next-gen auto technologies to try to build the domestic semi industry. And so we have found a region in the world where there's very strong demand for our differentiated solutions, and I would expect that to continue under the umbrella of we're going to continue to comply with trade regulations that impact Keysight.

Neil, maybe going over to the financials a little bit. The company has just done an amazing job the last multiple years, growing operating margins of the business. You've hit your targets earlier than expected. You've kind of blown through the incremental margin targets that you had set. I think this upcoming fiscal year is a little bit of a pause on the growth in margins. So can you just talk a little bit about the reasons for the less leverage this year? And is that something that's kind of -- I know there's a lot of moving parts around pandemic and component prices and things like that. Do you think those things will be more transitory and then as long as we're hitting that mid-single-digit -- mid- to high-single-digit growth target, there's still pretty good leverage left in that operating line?

Yes. So it's definitely the case that we think over the longer term that we can continue to get great leverage on our growth and continue to drive margin expansion. I'll talk a little bit more about that in a minute. I think as it relates to the upcoming fiscal year, we did provide full year guidance for both revenue growth and EPS. And many people have done the math that you've done and have realized that there does appear to be a bit of a pause in our margin expansion here, [indiscernible] they were expecting in FY '22. I think there's a number of factors that are causing us to be a little bit cautious as it relates to margins in the year. First is the fact that revenue is certainly constrained by the supply chain environment, right? So we're not going to be able to deliver, at least unless things materially improve from where they are today, all of the revenue that we would in an unconstrained environment. And at the same time, we're seeing increasing cost pressures on the inputs that go into our instruments. I think in many cases, we can, over time, pass those input costs on to our customers, but the timing doesn't always match up well. We're sitting on significant backlog. We've got significant order quotes that are out in the field and there can be some timing issues there. And the other thing, and I'm knocking on wood here, is I think we are looking forward to a time when we can get back to more of a pre-COVID type of operating environment within Keysight. And that means returning a broad -- the overwhelming majority of our employees back into our offices, allowing our sales reps to be out and our R&D engineers to be out traveling and meeting with customers face-to-face, allowing our R&D teams around the world to be getting together and working not in a Teams or a Zoom environment, but face-to-face because we believe that ultimately is best for throughput. So we are envisioning that if we are successful in doing that sometime this year, there's going to be some significant costs that come back into our cost structure for travel and facilities management and other things as we return to a kind of a pre-COVID operating model. I think beyond that, we continue to believe there's great leverage that exists within the Keysight model. We've been expanding gross margins, expanding software content, continuing to differentiate our solutions in the marketplace. And we do believe that there's -- even at our 28% what we did last year in terms of operating margins, that there continues to be opportunity for us to expand operating margins as we move forward.

Okay, great. And then maybe just as far as capital allocation, I think you guys have a pretty good track record of adding key technologies that you've been able to make more accretive as you kind of put it into the broader Keysight. And I think, me and some others maybe have been a little wrong about how much buyback you might start seeing. There is a new program out there. So maybe can you talk a little bit about the balance between these different capital allocation priorities for the company? And if some of it is M&A, should we expect similar type of small and midsized deal with good technology enabled with the software and service has been to it?

Yes, it's a great question. So I think -- I don't -- there really hasn't been a change in our capital allocation priorities. Why don't I answer it that way? Our first priority is to continue to invest through our P&L, through the CapEx line and the organic growth of our business, right? I did say that on a percent of revenue basis, our R&D dipped a little bit in our last fiscal year. We'd like to see that trend back up towards kind of 16%, 16.5% of revenue here as we look forward. We are going to be making some significant investments in capacity and technology in FY '22, raise the CapEx line. Again, all about continuing to drive and sustain the organic growth of our business. I think beyond that, the team here at Keysight would -- our preference would be to take the significant cash north of $1 billion a year that we're generating and the strong balance sheet position we have and put that capital to work and growth-generative, value-creating M&A. I think the challenge that we have right now is not one around finding ideas, it's around valuation, right? Valuations are extraordinarily high, particularly for the types of software-centric assets that we are looking for. And so we have a very active M&A funnel, but we're remaining disciplined with regard to our return hurdles. And those 2 things are a little bit at odds with each other right now given where valuations are in the marketplace. And so I think to the extent that we can deploy capital to value-creating M&A, and we just recently announced the acquisition of a company called SCALABLE Networks in our aerospace defense space, and we'll continue to do those things. I think if we're not finding ways to actively deploy capital via M&A, you'll see us get more aggressive with our buyback program. We've returned about 50% of free cash flow to shareholders over the each -- in combination over the last 2 years. Our Board, just last month, approved a new $1.2 billion share repurchase authorization. I think in terms of how that authorization is going to be deployed at a minimum, you're going to see us continue with our anti-dilutive buyback and then I think you'll see us step in and be opportunistic depending on other -- how cash is being directed towards other uses.

Okay, great. I think we've probably got time for one more here, and maybe this is a tough one to jam it to 2 minutes. But I think over time, at least historically, there's definitely been a -- in some of your end markets and therefore some of your businesses, some cyclicality to it. And I'm just curious if you think, if you look at some of those markets like the wireless progression or semiconductors or even auto, do you think as the company gets bigger and has a more recurring revenue base that you guys will be a little more immune to some of these big cycles in some of your end markets?

Yes. I mean I think the company is fundamentally a different company than it was when people think about when we were more severely impacted cyclically. As you noted, we have about 1/3 of our revenue today that's coming from software and services. 20% of that is kind of what we consider to be truly recurring in nature, and that's a growing percentage of the mix. But I think an even bigger shift that has taken place within our company is to shift away from selling into our customers' manufacturing lines and more so selling into their R&D labs, right? At one point, this company was probably selling 60% of its solutions into manufacturing. Today, we're selling 60% into R&D, only 30% into manufacturing and kind of 10% into post-deployment optimization type solutions. And so we're much less manufacturing-centric than we've ever been. And it's really those manufacturing businesses that have caused a lot of the volatility in the past. People remember back to the 4G peak, which was again driven by a lot of manufacturing sales. Our 5G business today is even more heavily leveraged R&D than that 60% company average, right? Our auto business today is about 30% manufacturing and the rest heavily skewed towards R&D. So what we tend to see is if you look at the big technology companies that are our customers, their R&D budgets tend to be very stable and growing over time. They do not have a cyclicality to them that you tended to see in the manufacturing space. And so we do believe we're much more immune to those big cyclical swings than we've ever been in the past.

Okay. Great. Thank you, Neil. I think we're up against the end of time -- our time here. Thank you so much for the insights here. Good luck with the rest of the day. Thank you, everybody, for joining us. We look forward to talking to you soon.

All right. Thank you so much, Tim. Thank you, Alyssa.

Thanks, Neil. See you.