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

Perfect. Welcome, everybody. I'm Meta Marshall. I cover the networking names here at Morgan Stanley. We're pleased to have Keysight here. We have Neil Dougherty, CFO; and Kailash Narayanan, SVP of the Communications Group with us. I'm going to read a brief disclosure. And if you have any questions, contact Morgan Stanley research disclosures website at morganstanley.com/researchdisclosures. And if you have any other questions, reach out to your sales representative. So welcome.

Thank you. Thanks for having us.

Great. So we recently initiated on Keysight and one of the attributes that was most beneficial to the story and got us most excited about the story was just the exposure to kind of key megatrends. As a just a refresher for those in the room and online, can you just kind of give a brief overview of Keysight's value proposition and kind of key end market exposure?

Yes. I appreciate the question because I think we do have significant exposure to multiple kind of long-term secular growth trends across our business. And so the business is organized right now into 2 solutions groups, one focused on commercial communications and then the other focused on kind of high-value electronic, industrial end markets. But within those, we further subsegment. And so if you think about the communications side, we've got a commercial communications business with big secular themes around 5G. I know you just mentioned that you were at World Congress next week and one of your takeaways, so it's pretty clear [indiscernible] deployment of 400 Gigabit. And on the R&D side, it's the investment at 800 Gigabit and Terabit speeds for connectivity. Aerospace defense, obviously, a lot going on in that space. Even prior to the unfortunate recent conflict, we were seeing increased investment in the United States and pressure on the NATO allies to increase their investment in defense spending, and that's obviously only increased here over the course of -- with the events of the last 10 days. On the Electronic Industrial side, we've got a business focused on next-gen auto, AV and EV trends that we think really have a decade -- we're measuring the runway there in decades, not in terms of years given the length of time that it takes to turn over the installed base in the auto space. We have a semiconductor business I think, again, events of the last 10 days have really even ratcheted up. It was already a tense situation around insurance of supply for semiconductors and they need to re-onshore semiconductor production, combine that with the supply chain and just the investments that are happening capacity and the investments to move to smaller process architectures. We see a long runway for semi growth. And then on our broader kind of general electronics business, that business is maybe more so than our other businesses tied towards manufacturing. And given the current supply shortages, you've got across technology, big investments that are happening in capacity. We're benefiting from that. But other themes as well, IoT technology education are themes that impact that business as well. And so really provide a great diversification for our business, but a number of growth themes that we believe have significant legs in front of them.

Got it. That's appropriate. I think it gives us a lot to dive in on. But a lot of investors in this room will kind of point to you guys as a play on early 5G with 50% of your revenues coming from communications. What do you feel like just summarizing you guys as a 5G play misses. And I was at multiple congress last week, 5G is definitely not at peak. But just refreshing folks on why is 5G cycle different than 4G?

Yes. So I'll let Kailash talk about the difference between 5G and 4G, but just to make a couple of comments on kind of people. First of all, I don't have a major problem with you thinking of us as a 5G play. I mean, I think we've got a really strong 5G portfolio. We've clearly carved out a leadership position in 5G. I do think that maybe disproportionately investors are focused on that side of the story. And the only risk there is that you missed a lot of other great things that are happening, I think Keysight, and I touched on what some of those things. So we are a very diversified business. Even within commercial communications, it's not just 5G, but it's still legacy 4G business and wireline technologies and other communication standards. And so the business is more diversified than people realize.

Yes. And as you've kind of pointed out, it is a big portion of our comms business. But we've invested in 5G for almost 10 years now since 2013. We started engaging with the research labs and then it's sort of diversified into lead market players from silicon vendors, all the way to service providers. And then now we're also taking that technology and applying it to some of the other segments, including automotive and aerospace defense. So the durability and the robustness of the underlying technology trend is just getting started. If you look at what's different between 4G and 5G, I mean, 3 things come to mind. From a technology complexity perspective, 5G is a lot more complicated. With 4G, you just dealt with the FR1 or the sub-6 gigahertz technologies. And with 5G, you're talking about FR1 -- many, many bands even within FR1. And then you're now talking about extending the FR1 technologies to 8 gigahertz. So there's that theme. Then there's the whole concept of millimeter wave communications or the FR2 band. So a lot of investments in that theme. Relative to 4G, you also see transformation on the wireless side, the wireless communication side but also on the core network side. So you have 2 versions of 5G, the non-stand-alone version and the stand-alone version. So technology complexity is certainly 1 big theme. That's creating opportunities for us, opportunities for customers to validate their designs and complete their test, which means activity and opportunities to contribute for us. The other piece is just the applications. There are about 1,200 devices, I think, that have been announced on 5G, about 800 of those or something you can purchase, 22 different form factors. So there are different types of applications for 5G. And we're only talking about release 15 of the standard, and we're not even talking about industrial applications, factory automation, applications of 5G and automotive and defense. So multiple applications for 5G. And finally, these things are coming together, the wireless networks and the wireline networks coming together, creating more opportunities, things like cybersecurity. Now you just needed to worry about in the previous era, you just needed to worry about your IT infrastructure in your wireline network on your premise. And now with 5G connectivity anywhere, anytime, you've got to worry about those kinds of things in the wireless domain as well. So there is a little bit of a convergence of wireless and wireline going on creating additional opportunities for us. So everything that we've done organically, the acquisitions that we've done with Ixia, PRISMA Telecom, Anite Telecom are further adding to our arsenal of an end-to-end portfolio that puts us in a good position.

Got it. I mean on 5G, what has also helped you guys? Is that because you've been investing for 10 years, you were able to gain a fair amount of share in 5G. How do you think about either maintaining, continuing to grow that as 5G continues to roll out and we move towards 6G.

Yes. When we think of 5G, like I said, the technical complexity and all of the different attributes that come along with it, it's really multiple sub technology waves, if you will. I mean you've got Release 15, you got Release 16. 17 and 18 are not even in play yet, and then you're going to talk about 6G. So there is a continuous theme of investment in each of these cycles result in simulation, things that you need to model in the lab, then you need to build your prototypes. Our customers are building their prototypes. Those have to be validated, then you deploy them, you have to produce them at mass scale. Then you have to -- when you deploy them, you have dynamics associated with the live networks that you have to deal with. So there is a continuous theme here that we can leverage into based on our position. It's still early days with 6G, but we are seeing a lot of activity and interest than any other previous technology wave, 4G or even 5G, there was a lot of focus on Sub-Terahertz research. While the technology deployment itself is 8 to 10 years out, work begins on those technologies. Now we are able to leverage our market-leading position in 5G to have these early conversations with customers. With the 6G, it's not just sub-terahertz but then there are also a lot of greenfield areas like hyper cloudification, you have artificial intelligence and machine learning types of technologies coming in to support communications. So those are new areas that present opportunities for us in addition to all the core areas that we're involved with in 5G today.

Got it. Neil, maybe turning back to you. Keysight has undergone a transformation towards more software-centric solutions kind of over the last 8 years since the spin-off. Can you just touch on what catalyze this transition and what kind of changes organically or inorganically kind of helped move along this process and why that was so kind of [indiscernible] .

Yes. I'll start and then I think Kailash will have some interesting comments on this. I mean I think it started with the realization that as technology got more and more complex, an increasing level of the value added had to come from software. And I'm going to draw a really extreme example. But at the very earliest days of our company, and now we're talking going back to the 1930s, engineers literally sat and looked at an instrument, and they watched the needle move and they tried to measure how far that needle move, right? Now we now have instruments that will make hundreds of billions of precision measurements in a second. And if you don't have software analytics to be able to deal with the massive amount of data that are coming off the machine, it's almost useless. And so more and more of that, you've got to take a measurement, but getting from the measurement to the insight to taking an action in your lab is increasingly happening through software. So it was just -- it was the recognition of that investments in people, about 2/3 of our engineering headcount is now -- is now software-related, investments through M&A. As we looked at the opportunity at the time of the spin, we were looking forward to the growth opportunities and recognizing the 5G transaction -- transition is a significant inflection for the company. and realizing that we needed to build on our historic strength in the physical layer and move up into the protocol layers. We bought Anite, got us protocol layer level solutions for wireless. We bought Ixia, got us protocol level solutions for wireline. We've moved it into pure software businesses with the addition of Eggplant, which is software -- using software to test software. And so we've made a whole series of investments and they're still kind of within this core T&M space but really focused on those software applications. And I think it's creating tremendous value. You've seen it in our gross margin expansion, which are up, I think, 900 basis points over the last 7.5 years. You've seen it in our recurring revenue. About 20% of our revenues are now recurring. A full 1/3 of our revenues are coming from software and services at this point. So we've seen a fundamental shift in the makeup of our business. And I think we see a long roadway ahead for us to continue to migrate our business more heavily towards software.

Yes. Just to add a little bit more color, what our customers are expecting and the work that they're doing to enable all of the wireline and wireless innovations is really driving a lot of software content. I mean you think you take something like the protocol space, that's largely software. When you look at anything about the 5 layer where you're measuring digital and RF signals, how does the mobile communicate with the network? And how does the network hand off a cellular call from 1 network to another. All of these are software activities and software workflows that are occurring in our customers, and we serve that space, now with 5G. When you look at things like O-RAN with the network getting virtualized, what we mean by that is you've got more and more compute power available and more and more things can be done with software. So when our customers are actually building software to enable these new networks, we've got to provide software to design and test that software. And that software may have to sit on the cloud. It may have to get deployed on a regular basis 5, 6 years ago. We used to deliver software maybe a couple of times a year. And these days with many of our customers, we're engaged with them almost on a weekly basis. So this, again, sets up opportunities for monetization and the way we engage and the solutions that we develop for our customers have more of a software mix, and we continue to see that grow, as we move forward with 5G deployments and into 6G.

Maybe I want to stick with that for a second before we kind of circle up to supply chain. And just one of the biggest themes in a World Congress is like the inevitability of O-RAN, mostly due to people wanting to diversify the supply chain and finding that there's just -- you can't sustain having 2 radio kind of providers within the space. What are you guys -- like how do you see that as an opportunity? And how are you advancing that ecosystem that clearly needs some polish to really take root at a larger level?

Yes, it's a great question. And we do see this, O-RAN, as a multidimensional multiyear trend -- you touched on it. Really what's driving it is scale of 5G. 5G really cannot scale without something like O-RAN taking hold. And this is one of the reasons why -- you're seeing a lot of focus on it. A couple of vertically integrated providers cannot supply to cater to the needs of all different types of applications of 5G. So there's 5G scale that's driving it. And the other reason, frankly, is the number of vertically integrated base stations flyers has gone down for the world, and O-RAN is a compelling alternative. And O-RAN brings 2 dynamics. One is the disaggregation of the network, which means that network is now made up of components and subsystems from different players. So it's attracting a lot of players. And then the softwarization aspect of it. So we're enabling both of these dynamics. So we have -- we engage with people that build these subsystems and components whether it's the radio unit or the distributed unit or the central unit. So we have our traditional conformance solutions, the interoperability test requirements as these people put their components and subsystems together to create an O-RAN base station. That's driving a lot of vectors of test and design activities. So we're supporting that. We also have the opportunity to test the core network side of it to our software capabilities, through our Ixia acquisition. So we got some of the core network capabilities. Our classic Keysight portfolio allows us to bring in some of the radio conformance capabilities. And the PRISMA Telecom acquisition that we did back in 2019 brings in the ability to test the base station stack so collectively, we've got a great umbrella portfolio. It's called Keysight Open RAN Architect, which we launched about 18 months ago. And we were -- and the O-RAN alliance, we joined that alliance back in 2018. We didn't quite realize that it was going to take off so fast so quickly. But this comprehensive portfolio is allowing us to serve the needs of the market, and we look at this as a multiyear trend.

Got it. So maybe circling back on supply chain. Clearly, it's had an impact throughout the year. Just how are you quantifying that impact? And just what gives you kind of confidence about that loosening kind of in the second half of this year?

Yes. So obviously, the supply chain situation has been difficult. I mean, really going back towards to the original manufacturing disruptions that happened at the onset of COVID 2 years ago. And then continuing as all the money flooded into the economy and the recovery happened, but people aren't really ready to ramp production at the same scale. On the positive side, end market demand remains extraordinarily strong. We've already talked about that 4 consecutive quarters of 20-plus percent order growth. Now the reality is we are unable at this point to keep pace on the revenue side of things. I think -- the good news from a Keysight perspective, is if you think about our own lead time, so think about it in the context of our customers, on average, we've seen our lead times extend about a month, right, which is in this industry is not an unmanageable hurdle for them. They've adjusted their ordering patterns. They're ordering earlier so that they still get product from us on a timeline that is largely within their needs. I think you asked about -- specifically about quantification of it. I did say 2 quarters ago on our Q4 earnings call that I estimated over the prior 6 or 7 quarters at that point that we generated probably $300 million to $400 million of what I call abnormal backlog as a result of this kind of disconnect between our ability to generate revenue and the actual demand as measured through orders. That number has probably gone up a little bit because we added another $200 million of backlog in the first quarter, which, again, a portion of which would be kind of abnormal. So I think as you turn this forward, I think the quality of our backlog is extraordinarily high. We have a relatively short order acceptance policy. We're only putting orders on the books that are convertible to revenue within the 6-month period of time. And so we have a high degree of confidence in our ability to get that product into the hands of our customers. And I think what you're going to see is, again, hopefully, in the second half, we'll start to see some loosening of the supply chain situation. By that, I mean loosening, I don't mean a return to normal. I'm not expecting this thing to normalize in the next 6 to 9 months, but we'll start to see some softening. And we'll start to work that 1-month extension and lead times back down and that's going to happen probably over the next 18 months as a starting point, maybe longer, maybe less, but that's kind of the context of how we're thinking about it.

Okay. Perfect. We'll circle back on the financials in a second. But we've spent a lot of time on 5G and kind of the O-RAN ecosystem. But I wanted to talk a little bit just more on the auto side and the EV and AV opportunity. And just where you are seeing the biggest opportunity and where you can kind of increase the content and a chance to participate in that opportunity?

Yes. So I mean, I think the biggest opportunity, particularly as you look forward for us is in the R&D lab focused on EV and AV technologies, Kailash and his team are providing solutions to auto manufacturers, so they're looking to incorporate 5G and other communications technologies and eventual ADAS solutions. We just came out with a radar test simulation program to help our product, to help our auto customers migrate towards ADAS. There's another opportunity kind of if you went back 2 years again before all this started, our auto business was maybe 30% focused on manufacturing. And obviously, with the big push right now, I mean, I don't know if you've tried to buy a car, but you can't find a car anywhere there's investments that are happening. And that manufacturing piece, it's a lot around the electronic control units and these big complex boards that go into cars, either ICE vehicles or electric vehicles. And so that business is very strong right now as well. But I think as you look forward, it's really focused on AV and EV. How do you build better battery? How do you build a more efficient hybrid or electric vehicle? How do you have a communication system that's robust enough for ultimately, Level 5 autonomous driving. Those are the questions we're helping auto OEMs, Tier 1 suppliers to the auto industry try to answer.

Got it. I mean on the last quarter, you had mentioned A&D budgets were kind of in the process of getting signed off on. Clearly, we have a heightened geopolitical environment right now. So there's probably not going to be a lot of budget cuts in A&D. But just how does that impact kind of what would traditionally have been the kind of approval timelines of budget?

Let me take that. So the projected 2022 budget is actually up 5%. It's north of $770 million -- billion, sorry. And that has been signed into law by President Biden. What has not happened yet is how is that budget really appropriated. And that's set for -- that set for signing here in March. We hope it gets signed. But hopefully, it's going to happen sooner than later. That's not an atypical situation with the U.S. budget. The U.S. Defense Department and everybody has gone in into a fiscal year without that budget actually getting signed. It's only about 4 or 5 times in the last couple of decades that -- or more where you've gone in with a signed budget. So the -- what it means is it's getting pegged to the previous year. So new program spends will not start until the appropriations have been completed, but the activity still goes on. But we really look at some of the longer-term trends from a defense perspective. There is a focus on defense modernization. There is focus on satellite networks there is focus on a lot of radar and 5G coexistence. We see -- we launched an engagement [indiscernible] with Lockheed Martin. We did a press release here in our Q1 about them selecting as a 5G solution provider. They're modeling different things. They're testing different capabilities of how to incorporate 5G into AD. So these are the longer-term trends that we expect. And we don't expect the appropriations itself to have an impact on the business. Over the last couple of years, we've had pretty steady growth in aerospace defense, and we expect that to continue through this -- a longer-term focus on defense. The Appropriations Bill or a Russia-related activities are more short-term perturbations, but it's really the longer-term thing that we're focused on from an AD perspective.

Got it. Usually circling back at the end, but just given you mentioned it, and we've kind of circled around it a couple of times. Just any Russia Ukraine impact worth calling out or?

I appreciate the opportunity to lease set the record straight on it. So obviously, Keysight at this point is to spend it all sales into Russia. We suspended all contact with our Russian customers. but it was a pretty small portion of our business, sub-1% even prior to all this breaking out. And given the current backlog situation and supply chain situations we can pretty immediately deploy anything that was going to be heading into that geography to other customers. So I don't expect really any disruption on the revenue side of things and -- but on the demand side of things, again, it was about -- think of it a sub-1%.

Okay. Perfect. Maybe circling up to margins. You raised your earnings guidance kind of on fiscal Q1 earnings call. We've talked about a various amount of pressures due to supply chain, you're already kind of operating at operating margin targets. I guess just -- what are -- what is giving you the confidence on margins and what are things that we should be mindful of as we head into the next fiscal year?

Yes. So obviously, we have a very strong backlog situation. I'm in a much stronger backlog situation than I typically in. So I have more visibility over the next couple of quarters than I typically have, so that gives me confidence. I think the underlying demand certainly gives us confidence, and it's not just the order rates, but it's the conversations that we're having with customers is one of the byproducts of the supply situation, even if they're not placing orders, your customers are erring on the side of over communication because they want people to be able to do the capacity planning that's necessary. And so I think we have a high degree of confidence in the continued growth of our business. And from a margin perspective, we have visibility to what's in backlog and then we have an operating model that we manage pretty tightly too. And so we have -- even I'd say on the downside, maybe one of the things that's clouding peace is obviously inflationary impacts, but we're doing our best to stay out ahead of that and pass on those cost increases where we can. And so far, we've done a pretty good job protecting margins.

Got it. I mean, should investors expect any normalization as we've certainly had very little T&E over the past couple of years. Just any normalization investors should be mindful of as we had...

Yes. I did talk a little bit about that on our fourth quarter earnings call. We generally manage our business to a 40% operating margin incremental anytime our top line is growing mid-single digits or better. And I think over the longer term, that's still the right way to think about the business. I did communicate that I expected maybe some pressure on that year -- during this year because of that, this kind of return to a normal working environment, travel being a big one, our facilities cost being the other big one, right? It costs a lot more money to run a facility when there's actually people at it versus everyone working from home. So we expected some of those costs to start coming back in the first quarter and then Omicron hit and nobody got on planes. We delayed yet again our return to the office, and so that hasn't happened yet. That was a contributing factor to our outperformance in the first quarter, along with some favorable gross margin driven by software in Kailash's business more than anything else. So at some point -- and I'm knocking on wood because we're starting to see the relaxation of mask mandates and some signs that this kind of return to a pre-COVID normal is starting to happen. There are going to be some costs they come back into the system for -- let's call it a period of a year, we're going to put some pressure on our ability to deliver that 40% incremental. But once we get through that, I think we're kind of right back towards thinking about our operating model is the right long term long-term vision for the business.

You got it. Are there any questions from the audience?

There's a mic right there, yes.

You did mention it. But when you see the price increases from your supply chain -- you're saying you're able to pass those? I mean, I'm assuming a small percentage of our [indiscernible] you're passing accretive fashion, dilutive fashion. What is -- can you give us a feel for the price?

Yes. All I'd say is we're constantly assessing our own competitive environment. And in certain portions of the portfolio where particularly at the lower end where things are more competitive, it can be challenging. But everybody is facing cost ups right now. So we're not alone in executing price increases. In other places, we have a highly -- more highly differentiated portfolio and you have more ability to adjust pricing. But we're constantly evaluating that. And again, I think we've done a pretty good job at this point, at least making sure that we're offsetting cost increases.

Maybe just last question is a question I most often get is when's the next Analyst Day.

When's the next Analyst Day? Well, we haven't announced 1 yet. Obviously, we're coming up on the 2-year anniversary from our last Analyst Day. So it's something that's on our discussion. Obviously, we're going through a CEO transition at this point in time. So we'll need to get through that. And then Satish is excited to be taking the reins at Keysight. And once he's fully on board in May, we'll sit down with him and talk about when he wants to hold an Analyst Day and share with the world his plans for Keysight going forward.

Great. Well, Neil, Kailash, thank you so much for being here today.

Thank you so much. Take care.