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

Hi. Good afternoon. I'm Samik Chatterjee, and I cover hardware at JPMorgan. The next company here for the afternoon session is Keysight. And we have the pleasure of hosting Satish Dhanasekaran, who's the Chief Executive Officer; and Neil Dougherty, who is the Chief Financial Officer. Particularly Satish, I know this is your first JPMorgan conference at least as a CEO. So thank you for making it here, and I'm sure we'll see you more often going forward.

I do want to start with a few questions that are more standard that we're asking everyone, but I do feel that's a good exercise just to get a good poll about where things are. And investors are quite concerned about a potential recession here. And just wanted to see how you're thinking about the likelihood of it given what you're seeing from -- in relation to customer demand?

Thank you, Samik. And as you know, Keysight has a broad exposure to multiple end markets, commercial communications with both wireless and wireline ecosystem, aerospace, defense and government spend through our aerospace defense business and then broad industrial market exposure. So we get to see and sample our customers across these diverse end markets we serve. And so from our point of view, in discussions with customers, I would say, the first 10 minutes of our discussion is focused on getting them supply because they all want their tools and solutions. And clearly, our demand is outpacing supply across all our end markets at this point. So it's very favorable. And then customers want to talk about the road maps for the next 2 to 3 years. And so we're in the strategic discussions with customers. And I would say that as we have pivoted the focus of the company to be more focused on the R&D spend of our customers, the road map and the adherence to that road map from our customers, the imperative for them to innovate is very high. And so from a Keysight point of view, we're engaging in these discussions, investing with our customers for the future. But as we do that, you look at our backlog position that I referenced before, we have over $2.4 billion of backlog building this year, which should help us provide additional resilience if there is any macro situation that you described. And our margin picture at the company level is very positive. We have had a strong quarter again, over 28% operating profit. Gross margins are continuing to be resilient because of this -- the mix of the portfolio being more weighted towards R&D and the engagement model of the company focused on leading-edge innovations such as 5G and 400-gig and terabit Ethernet and automotive with AV and EV. So a number of secular drivers are pointing to stability in demand.

Okay. Great. You mentioned supply, and obviously, that's been constrained for the entire industry. But how are you thinking about the China supply situation or the COVID shutdown there? How material is it to your supply chain?

Yes. Right now, we don't have direct exposure to Chinese suppliers. You need to go upstream a level or 2 to our suppliers, suppliers or even their suppliers to get to start to measure those impacts. But I think certainly, if you look at across broader technology ecosystem, it's having an adverse impact on already strained supply chains, right. And so I think we -- Keysight continue to weather the supply chain environment very well while not totally immune, we're vertically integrated. We have our own fab. We do some of our own packaging technology, things like thick films and thin films that provide internal control over some of our most highly customized components that go into our instrumentation. So I think relative to others, we've weathered the storm pretty well. We continue to get product into the hands of our customers on time lines that they're able to work with and expect to continue to be able to do so as we look forward as well.

And are you expecting supply to normalize anytime in the near term? How are you thinking about more normal supply environment?

Yes, certainly into '23, we're not expecting much improvement in the back half of this year and don't really have much visibility beyond that. So I think it's certainly going to carry into '23. The question is how far?

Okay. Thank you. Let's move to some of the more company-specific questions here. We met and talked with a lot of networking companies and most would agree that in communications, there's a super cycle at this point relative to some of the drivers that you've already mentioned, Satish, like 5G. How are you thinking about Keysight's positioning relative to not only the super cycle in communications, but the increase in complexity within that?

No, you're absolutely right, Samik. As we've sampled different customers across the wireless and wireline ecosystem, what we see is every part of the communication systems is getting redesigned for higher throughput, lower latency, better service reliability and equally important, new applications that are coming on board. And this rapid pace of innovation, combined with the increased complexity of each of those technology changes or upgrades, is a big opportunity for us that we're camped on. The other dynamic, I'll say, is all the way from silicon to the cloud, you look at the number of new wafer starts that are occurring as supply chain diversifies. You look at new fabless semiconductor design houses that are being -- that are starting because every company wants to own its own IP. I think these drivers are secular and long-term oriented and not to mention the complexity associated with each of these technology cycles is a favorable dynamic for our business.

Yes. Okay. You've delivered really strong growth in the last 5 years. Obviously, the supply situation, Malaysia excluded. And I think the perception is that large part of that came from deleverage to 5G R&D over the last few years. How should we think about sustainability of that growth driver? I think a lot of questions about when does it peak in terms of 5G R&D cycle, et cetera, how do you sort of think about the length of the investment cycle here?

No. I think that's a great question. But as we think about the portfolio, we have pivoted the portfolio to focus more on the R&D applications of our customers. And we're doing so by offering complete solutions often led with software -- with the software stack we've developed. I think this is a very favorable dynamic. We look at the long-term growth rates of R&D budgets is a great indication across the different end markets we serve. And clearly, if you look at the performance of the companies in spend, we've been growing at high single digits through a confluence of factors, right. We've had 5G play a key role. The wireline technologies have been also ramping. And even aerospace defense business, which is typically a GDP bag, has actually outperformed its benchmark and our industrial business continues to benefit from the continued stability in PMI. So we've had a number of these factors that are working in our advantage -- to our advantage and so the business has outperformed. And our goal is to wake up every single year and figure out how do we continue to out-execute and drive for things that our customers are asking for. So we see more opportunity ahead as we continue to invest with our customers.

Satish, if I just focus on the 5 GPs there and the growth driver, you have more leverage to the R&D pipeline within that. Now in terms of, obviously, the different phases of test and measurement equipment, you have R&D, you have validation production. So how are you thinking -- sort of what's your latest thinking on the time lines around the sort of investment focus moving from R&D more towards production and deployment?

Yes. I think the way I view it, Samik, is we've been growing our 5G business pretty steadily at double-digit growth rates even this year, and we continue to see near-term demand drivers being very robust with the C-band deployments that are occurring in the U.S. playing a big factor in that -- in driving up that demand. Congruent with that, the standards continue to progress from an R&D perspective with Release 16 right now scaling. So we're benefiting from a combination of the C-band deployments and Release 16 feature sets that are being deployed. As I look at the medium term, I would say, the millimeter wave opportunity continues to be a very favorable dynamic for us, even though the millimeter wave of -- version of 5G might be a few years before it gets deployed, there is considerable R&D spend being focused by our customers to make sure they are ready for it. And the millimeter wave content in our own tools continues to grow. And with that, there's growing ASP, and we're well positioned to capture -- capitalize on that. And longer term, it's about -- once 5G gets deployed, what are those applications, whether it's private networks or in security with aerospace, defense vertical, taking a keener interest in deploying 5G or commercial communication technologies or open standards like O-RAN continuing to scale, and we see these are not perfect short, near-term and long-term catalysts. They all overlap. But we see these as a confluence of factors that continue to position us for growth. And our leadership in the 5G space is unparalleled in the industry because we have both the wireless and the wireline technology stack, so we're able to create solutions for our customers.

If I was going to add just to put a little bit more context on it, Keysight's total business is about 60% R&D. But within commercial communications, it's closer to 70%. And we don't think about -- we think about those R&D investments of our customers is growing over time and evolving, right. So right now, it's evolution from relatively low frequency 5G to higher frequency. It's going to be from Rev16 to the alternate use cases in Rev17 and Rev18 and ultimately to 6G. And so with this focus on R&D, it's not a question about when you transition from R&D to manufacturing. Is Keysight going to be there, continue to evolve with our customers as their R&D investments involved, and we have the broadest portfolio of tools and solutions in the industry. And we're there, we intend to service that customer base as those R&D investments grow and evolve over time.

Okay. I mean I had a follow-up for you that I was going to ask later, but since you went into how -- the exact thing that I wanted to talk about, which is how can Keysight remain relevant in that sort of road map for your customers. How do you assure investors that the share gains that you had in going from 4G to 5G, you can translate that share into 6G or even continue to expand share into 6G?

Yes. It's all about our customers. And as I mentioned, from an R&D point of view, the priorities shift from Release 16 to Release 17 and to Release 18. If you look at the Release 18, which is touted as 5G advanced, which would be a -- look at the feature sets being deployed, that's 40% higher than Release 16. So it's a very robust innovation pipeline as we look at the next couple of years. Beyond that, we expect the industry to start to think about Release 21, which would really be the first version of 6G, if you will, from a standards point of view and that's still quite a bit of way. But different countries in the world are starting to invest in early research capabilities to advance 6G's vision and mission right now, and we're engaged with a number of the standards bodies very early on to help define it. We're engaged with a number of university consortium right now to help shape the future, and we're well positioned, given the breadth that Neil just mentioned, of having both the wireless and the wireline capabilities to continue to enable the industry to be successful with 6G.

How should investors think about the time line of that 6G sort of R&D pipeline? Like when does Keysight ideally want to have products in the market commercially available for customers? What do you need to deliver to sort of beat competition on that front? And is there a big first-mover advantage in getting the products out for your customers to use?

I think the continuity with the 5G stack as it evolves into 6G is a big deal for our customers. So I think having a leadership position in 5G is a plus. But we're already -- we've already booked some small business in 6G with the lead research consortiums, which I think positions us well, and I expect that to continue to scale. Materials 6G revenues, we're thinking maybe '25, '26 time frame given where the industry will be, but that's just our best estimate at this time. But we're well positioned given the breadth of portfolio we have to be able to navigate and lead in 6G.

Okay. Got it. So just moving to -- changing gears here a bit. And I'm sure Jason sees this as much as I do is amongst the investor base, there's a lot of confusion about what each of the test and measurement companies do, how they're different from each other, how they compete against each other. So just to sort of iron that out a bit here, how do you -- how should we think about how Keysight is different from your usual competitors? Investors are more aware with, like [ 1002 ] Teradyne, Advantest, or National Instruments. These are the more popular sort of tester measurement companies' investors look at on a day-to-day basis. How is Keysight different in that competitive landscape?

No, thank you. We are the market leaders. We serve $5-plus billion in revenue in a $20 billion market. We have only 25% share, and we have the scale that we need of investments needed to sustain that leadership and grow it over time. We invest $800 million in R&D in a given year and because of the breadth of the portfolio we have and the amount of innovation megatrends that we participate in is also pretty large. So this has positioned us to really be the solution provider for the industry. The way we think of what we do that's different is we think of solutions first to customer problems. The more complex challenging ones are ones we focus on, which enables us to provide better margin profile to our investors. And our focus is really around time to market for our customers whereas when you look at some of the other competitors, their stated intent will be to optimize cost of test. So I think our focus is to be on the front end of the technology, take on the most challenging challenges -- the biggest challenges for our customers and go ahead and solve them. And so that's sort of the way you would differentiate, and we'll continue to shift left in the design cycle and provide more solutions earlier to our customers so they can go faster. That's our focus.

Yes, just wait for the mic, maybe sorry.

There was some reference to the peaking of 5G. I had a friend who was in Italy with a 5G phone and the network gave them 4G service. So can you elaborate a little bit if all the service providers have to upgrade? Will that help you? Or is that already sort of done?

Yes. Thanks. Well, I think...

Even in the U.S., I don't think we're getting real 5G service.

There's still a bulk of the C-band deployments in the U.S. to happen. You look at the deployments outside of China to date, there's still substantial deployment activity ahead of us. As Neil mentioned, 70% of our 5G business is tethered to the R&D labs of helping our customers be successful. And customers are still continuing to work through the challenges regionally associated with those deployments. So it's fair to say that the deployments will continue to scale over the next few years. With the existing sub-6 gigahertz technology, the millimeter wave will come after. So there is increasing -- I would say, increasing investments to come, especially driven that big change the millimeter wave will bring.

[indiscernible]

The IoT -- in Release 17 and beyond, there is increased emphasis on what they call reduced capacity or reduced capability for 5G to enable more of the industrial IoT applications, and that will play very nicely with the private 5G networks that are being talked about. China has actually taken a lead position with private 5G networks and deploying millimeter wave for those applications. So I think we'll learn a lot in the next year about where that evolves.

Okay. Satish, to go back to sort of just the overall business portfolio here and one of the things I was curious if you can dive into a bit is you service different end markets, communication, defense, general electronics, semiconductors, transportation. How should investors think about synergy that you get from being in test and measurement across all these markets? Like why do you need to be across a broad range of end markets? How do you sort of find synergies in terms of what you spend for one end market with the other?

Yes. We have -- I would say, starting with the customer, we have a great service and support infrastructure in place across all the big major metros where technology innovation occurs. And so that's one -- first form of synergies that we gain by having a sales force that can be redeployed. And many of you may know that when the U.S. government sanctioned Huawei, we were able to redeploy that sales force and grow our business in China in that given year. So that points to the agility and the leverage you get. The second form of leverage that I see is in the R&D function, right, having a much more centralized R&D where we can design products with the right view of where the opportunity is 3 to 5 years out, but also customize it for different end markets allows us to gain the solutions growth that we've been seeing much above the market growth rates that are there for our industry because of our focus around solving customer problems. So those are really 2 big leverage that we see. Neil, I don't know if you have anything else to add.

Yes. I think the second one is the one that comes immediately in mind that we fundamentally make fundamental tool categories for electrical engineers that can be applied to a wide range of applications across industries, and we start with that tool set. And then through software and use case identification, how are those tools going to be used by certain industries, we can customize the capability and ultimately help our customers with their time to market challenges.

Got it. Okay. Going back to the -- I think...

[indiscernible] Yes. Just can you review how that went? Because I think right after you bought it, I think maybe things went downhill, but are you interested in other acquisitions at this point?

Well, thank you. I'd say the first point is, obviously, the integration of a scale asset like Ixia, we learned a lot. It took us a while to stabilize the operations. But now we have, even this fiscal year and last year, our wireline business, which includes both the physical layer pieces that were there organically, but the integration with Ixia, which has been completed, are growing very nicely, and we continue to gain new customers in that space because of our uniqueness in the ability to solve problems up and down the stack. With regard to the M&A, we continue to remain disciplined as we evaluate new markets, which are adjacent to our current strategy, but fit the strategy very nicely. So we'll remain disciplined. We look at valuations right now, the valuation expectations have not really come down in any material way, but we continue to do the homework and stay disciplined.

[indiscernible]

Yes. I would say it's probably B+ trending higher and enabling us to address new opportunities that we would not have been, if we do not have those capabilities.

So when you're not at an investor meeting here and back of the conference room in your offices, what are the topics that you 2 are debating the most about the future of the business?

You want to take it?

Yes. I mean I think right now, there's -- everything starts with supply chain and revenue maximization and what do we need to do for the short term. And then at the same time, it's a question about investing to make sure that we're making the investments in sales and in R&D to fund the long-term growth of our business. I mean, it ultimately, those are the 2 things that we're focused on a short-term execution and long-term growth.

The other area is as we have -- as we were in the past, tethered to a much more product-centric view, we saw the -- our, let's say, our value typically associated with the product. As we move to more solutions, we constantly debate what is the right value of things that are -- that enable our customer to be first to market. And so how do we build that sustainability into our margin profiles like through the software and the value we create. We're adding tremendous value, and you see our gross margins are doing well because of our focus on value pricing.

I was wondering, could you speak to the visibility that you have in the business? How much is it -- you mentioned the backlog that you guys have, but how much is it -- how much backlog coverage do you have in any given quarter when you guide and just the visibility that you get? So contractually and just in terms of the relationships you have and the pipeline you have and how much repeat orders do you get?

Yes. Certainly, that visibility has changed over the course of the last 18 months. I mean right now, from a backlog visibility, we have much higher coverage -- approaching 100% coverage coming into the quarter. And so while we're very high on that side, where we've gone the other direction is on the supply side, really now it's a question of not what the visibility of the backlog is, it's a question of ability of what's driving in our factories and are we in fact, going to be able to turn that backlog into revenue within the quarter. And so that question about visibility has changed. I think beyond the backlog, we still continue to have a robust sales funnel that looks out is pretty strong, I'd say, 6 months out, and we have pretty good models in terms of how we convert funnel into orders and then orders into revenue. And then I think one of the benefits of this situation that we're in the supply chain situation that you're in is, I think, customers, ourselves included with our suppliers, are erring on the side of over communication with the customers -- with the vendors that supply to them. And so we have increasing levels of visibility to demand signals going forward. We've always within our largest, say, 100 customers where we're working under NDA on a kind of co-development basis, our engineers working with their engineers had good visibility to R&D road maps, but I think in this environment, visibility has increased because of the supply chain constraints and people's desire to overcommunicate to ensure they're spot in line.

And we think it's a good dynamic. So when you think about the backlog position, we're putting in just enough capacity. But I think given the different order scenarios, the backlog -- we would like to see the backlog continue to grow because I think it's a good thing, especially as our portfolio continues to churn out more software, more services, software and services today represents 1/3 -- roughly 1/3 of the business and is growing faster, and we'll continue to drive that higher.

That was going to be my follow-up question. Just you said 1/3, like how much of the revenue is recurring in nature and how has that increased over time? And where do you see that going?

We have about 1/3 of our revenue that's coming from software and services today and about 20% of that is recurring in nature. We are in the process of changing the way our customers buy software from us. Today, about 50% of our software sales are recurring, and we think there's an opportunity to push that number much higher.

Okay. Bring it back to one of the segments then. When I talked to different test and measurement companies, one thing that I've noticed over the last 12 months is this huge optimism about the transportations market and the opportunities that it has. Can you sort of talk about where you are more focused when you got planning out sort of how this business looks like for you in the transportation segment? How you're sort of focusing your portfolio there?

Yes. Clearly, the automotive and the transportation end market is increasing, I would say, across the board, increasing its emphasis on engineering in-house, right? So we see that as a dynamic that's very favorable. A lot of the OEMs are starting to build labs. We've seen that play out, and they're starting to scale that lab activity, hiring more electrical engineers, hiring more software engineers. So that's an opportunity for our entire portfolio to be positioned for that end market. The big mega trend is the increase in the number of chips of silicon that's getting into cars. I think we all see it. I've seen -- I've read some reports would say that the number of silicon, not only as a sensor but also as something that controls more of what a car does in an automated manner or EV will go up. It's expected to triple in the next 5 years. And so as that silicon content grows, I think a lot of the solutions that we have today and the ones that we're creating will find applicability to that end market. So I would just summarize by saying bigger R&D opportunity with both autonomous vehicles and electrification trends that are playing out across automotive.

Okay. Okay. Moving to another sort of driver for the company, can you talk about software mix? And how are you thinking about sort of longer term, where you want to be in relation to software versus hardware mix in revenues? And how much of that is really realistic organically through your investments? Or do you need to sort of go out, acquire certain capabilities before you can really scale up the software side of the business?

Yes. As we have said, software is roughly 20% of the mix today. And across our portfolio, it's providing us a vehicle to continue to engage faster with our customers. One of the things that has changed for us in the last few years is the rate at which our customers expect us to respond to them, right? In the past, in a typical test and measurement, customer would get software releases once a quarter. We thought once a month was a good start. So we started there. And now our customers once a week and now it's like once a day. So the connectivity lag is just not acceptable. Our customers want it directly from our developers if they could have it. So we've actually created our own PathWave platform that allows us to interact with our customers directly. And it's a big difference as we scale that across the company over 60% of our R&D resources today are software in the company. And so we'll continue to push more content and also lay the case for faster ARR conversion like Neil talked about. So now we look at some of the newer solutions, especially in the -- like in the O-RAN space that we've created. Software is 40% to 50% of the total sale. And today, we're at 20%. So I see opportunities organically, but we're also evaluating -- we also made a small acquisition of Eggplant that got us into the software test space to test user interface, which is helping some of our automotive customers test the user interface in your front panels in autos. And we continue to see adjacencies with that business where an M&A or an acquisition may make sense if the valuation is right.

[indiscernible] Yes, I'm asking about the metaverse reluctantly, but is that good, bad and different for you, Satish?

Yes. I think it's another step function. If you think of the final vision of metaverse right, I think you start thinking about the communication systems. I think the 5G communication systems are not going to -- are barely going to scratch the surface of what's needed. So you start thinking about 6G and beyond. What it does paint for well is a long-term road map of continuous development that has to occur across all of the wireline and wireless technologies and maybe much more heightened focus on latency and user experience to go with it. And so I view this as very favorable, no matter how long that vision takes to realize. But I think the fact that there are use cases and applications that are real, like the metaverse and there are big companies spending to help realize it is a favorable dynamic for us.

Okay. So if I take a step back here at the last Analyst Day that you did, I think the underlying market you had projected to be about 3% to 5%, I believe. And you had an outlook of 4% to 6% on the top line. You've clearly exceeded that in most years where supply hasn't been an issue. Firstly, how much of that has been more market share than you really embedded into your outlook versus the underlying market growth being better? And as we sort of look forward, the second part to that would be with software mix increasing, et cetera, like there seems to be a naturally higher level of share or more share gains that you should be positioned for. Is that the right way of thinking about what drives our performance to your targets?

Yes. I mean I think you're right; we've outperformed our own goals. That's always our goal, right, is to come in and figure out how to outperform. I think in addition to the underlying market growth, we've been asking ourselves how we can do more for our customers than we've traditionally done. So that's a market expansion opportunity and has resulted in us moving up the protocol stack, adding software content, increasing margins, increasing the underlying growth rate. I think we're in a unique position right now where there are strong secular drivers across a wide range of our end markets, 5G, 400 gigabit, 800 gigabit aerospace defense, semi, AV, EV and all of those things are in phase and that is proving to be very beneficial. And I think as long as we continue to execute, leverage the breadth of our portfolio, we're positioned to do very well in the end market.

The other dynamic, maybe if I can add is the number of new customers that have entered our platform, right? We have been able to add about 2,000 new customers every single year, providing us greater stability from a revenue perspective. And this is driven by the increased spend that's occurring by multiple nations around the world to shore up their own organic R&D capabilities. So it's probably an underrepresented part of the story, but we see that in that dynamic of our ability attract new customers, which provides us greater stability and expansion.

Okay. I guess the last one here for Neil. You've typically communicated with investors about margins in relation to an incremental margin of 40% when you have growth in excess of, I think, 4%, right. As you have a higher mix of software coming through the business, does that need to change in terms of how much of a benefit you get from that incremental dollar of revenue, particularly if it moves to recurring revenue over time?

Yes. I mean I think we'll need to see. As you know, certainly, the margin benefits of software, but those high -- the software businesses typically also have a higher level of R&D spending than the one that we've been, right, at 16%. It may be high by certain standards, but certainly relative to pure software companies, that's a relatively low number. So we'll need to see how that balance shakes out over time. I think right now, we've done a good job executing and in fact, exceeding to the 40% commitment. There's unique challenges right now in the inflationary environment that put additional pressures on your ability to execute to that. And so we're continuing to manage our business to that 40% incremental. And I think we believe it still applies to our business as it's structured today.

Okay. Any other questions in the audience? If not, we're very close to our time as well. So I'll close it there. Thank you both for coming to the conference. Thank you, everyone, in the audience.

Thank you.

Thank you, Samik.