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

Good morning, and thanks, everyone, for joining us. My name is Rob Ruple. I'm the technology sector specialist here at Credit Suisse. And I'm very excited to have Satish Dhanasekaran here from Keysight, President and CEO, and thanks so much for joining us. Really appreciate it.

Thank you, Rob, and I'm also very happy with you attempting to say my last name. Most people stop with D. That's good.

Yes, good. No problem. And again, maybe before we get to get started, maybe given the current economic environment and expectations going forward. You recently transitioned to the CEO role earlier this year after being CEO for prior few years. What's sort of your vision for Keysight and key priorities going forward? Any change in areas of strategy, focus or emphasis since you've been in the role?

Yes. Thank you, Rob. Obviously, I've been with the firm for 15-plus years, and I'm an engineer -- started off as an engineer and grew up through many roles in the company. I ran the comms business, who was responsible for our -- for executing our 5G strategy, setting that up. And then I moved into the COO role and now into the CEO role. So there's a lot of continuity of strategy, results orientation, execution focus in the company that gives us a very strong foundation to build on as we look forward. And I think a couple of areas to emphasize, right? One is we're committed to doubling down on our software-centric solution strategy because not only it's working. This is what our customers are starting to increasingly resonate with where Keysight is headed. And that's unlocking more opportunities for us to play into their R&D parts of the market, which creates higher value opportunities for Keysight more stickier with software and recurring revenues over time. And so we'll continue to execute it. But the way we do it is by heightening our focus on customers and this idea of customer centricity that is focused on the multiple end markets we serve. I mean we're focused on what wireless cyclical system, wireline ecosystem, aerospace, defense, industrial end markets with emphasis on our auto. These technology end markets, technology is becoming increasingly important, will be more important in the future than it is today and there is more spend in positioning the company to tap into those secular drivers and continue to provide growth and profitable growth as we move forward.

Makes sense. Obviously, macro is a big concern for everyone these days. Given the current uncertainty, what are you seeing from a demand market perspective? Any particular verticals or areas of strength that you see kind of slowing or really showing resiliency and it seems like auto industrial or one area where we're in that resiliency.

Yes. I think one of the things that we intentionally focused on as a company is to broaden the customer base we serve, right? As we pivoted from Agilent to Keysight, we expanded our customer base every single year, and we continue to focus on that. And that has increased the diversification of the business, if you will. So if you look at it from a pure application standpoint, I would say R&D continues to be a secular opportunity for us. And when we talk to our clients, or engaged in next-generation technologies, they're not pausing, right? They're continuing to execute their road maps, and we're engaging with them. There are areas of the market, though, where customers are -- they are applying greater caution with new capital, especially in production areas. So that's at the highest level, I would say we are 60% of our business comes from R&D, and that gives us a lot of top line resiliency. Moving into end markets, I would say, in the wireless ecosystem, the focus on 5G with new applications, millimeter wave and other areas with new standards evolving continues to be strong. On the wireline evolution, I would say the progression towards the 400 gig, 800 gig, the next-gen wireline technologies remains strong as well. And the third part of this is, as we think about the comp sector, the couple of areas where we saw softness in the quarter were around the component space associated with smart devices. I think we called that out and some of the direct cloud spend from direct cloud providers that have had earnings issues. That's starting to show up in delays in programs as they try to figure out where they are going. The industrial markets remain extremely resilient, and we're quite pleased with the inflection we're seeing in our auto business, which reached a new milestone of $500 million for the year for us with AV and EV being the areas of focus. And so that strategy continues to play out for us. Semiconductor, especially the wafer stage that we're engaged in remains resilient as well. So all in all, I think we had a very strong quarter and a record on all fronts, orders, revenue and profitability. And I think we capped off a very strong year in fiscal '22, and we remain confident in our guide for Q1 as we look ahead.

Yes. And then just as a follow-on to that, is -- as you mentioned, you guided to double-digit revenue and earnings growth for fiscal Q1 and fiscal '23 despite this kind of macro uncertainty. I mean, how are you thinking about the ability to grow for the rest of the year? And I guess maybe what are the key considerations or scenarios that you think about as it relates to that...

Yes, for that scenario. Yes, I think as we look at our year, as I mentioned, we're quite pleased with our ability to navigate a pretty challenging supply and geopolitical climate that we faced in fiscal '22. We still navigated that, executed well, positioned ourselves with strength. And looking ahead, obviously, the macro environment is changing and the demand backdrop is moderating. But despite that, I think about our focus on the R&D customer base, more secular demand trends that we're engaged in, that gives us some resiliency on the top line. The strong backlog position that we have built. We've had a few good -- a few years where we've added to the backlog, and now we have record backlog position, which gives us stability moving in. And operationally, we're a very disciplined company, and we have a disciplined operating model that allows us to flex up and flex down with demand. It gives us some structural advantages entering an uncertain environment. But we remained focused as a company on outperforming, and that happens through our focus on customers and enabling them to be successful.

And just on the backlog point, as it seems it's more of a normalization type of environment, how should we think about that over the next few quarters? Do you expect that trend to continue? Or do you see it kind of a stable kind of run rate? Just curious on how you see that linear area of it.

Yes. I think at the highest level, right, as we said on our earnings call, we've had a couple of years where our book-to-bill has been running much higher, and we've accumulated this backlog with high-quality backlog. Our customers want shipments as soon as they can have it, as soon as we can make it. So we're still in an environment where supply is getting our ability to ship to customers, and demand is steady across many end markets that we are seeing, but the demand environment is moderating. So we would not be surprised if we started to see that supply and demand converge at a future point. But for now, we remain confident in our guide the strong backlog position and the pipeline that we see for opportunities gives us confidence in the guide that we put out, which is pretty strong for -- to get the year kicked off.

Sure, sure. As it relates to -- moving -- as you mentioned on the supply chain, the things have been improving over the last 2 quarters or so. Any update on that stack? What are the conversations that you're having with some of your partners around the supply chain? And maybe how quickly are you -- have you seen that normalize? And maybe talk a little bit more about how it progresses into '23 if you can...

Well, first of all, starting last year, when we started, there was a lot of uncertainty with supply. And it got compounded with China's Zero COVID where a lot of suppliers of suppliers had issues getting things in and out of China even, which added to a lot of the problems that we faced. But we executed very well, and we created our own luck in many ways by qualifying second and third sources of supply for some of our critical components, and that's really enabled us to continue to beat our revenue guidance every quarter as we went through the fiscal year, and that's positioned us very well right now. In discussions with our suppliers and our partners, I think they remain on track with some of their own capacity expansion programs that they have put out but on higher precision components that we rely on and the rest of the industry lies on still remain constrained, and we expect that to be the case for the next few quarters. So our best estimate right now is fiscal -- by end of fiscal '23 that we think the supply situation goes back to what we used to have pre-COVID, but we remain confident in our ability to navigate this period as we go through the next few quarters.

That's good to hear. Moving on to software. That's been a big component of your business, 20% of revenue. How do you think investors should think about growth of your software business over the next few years? And are you still expecting software to grow above the overall company growth rate? And really, what do you think is driving that?

Yes, first of all, our focus is to offer complete solutions to customers. So we're looking at their workflows in R&D where greater value can be created for our customers and Keysight can also benefit from that value creation in terms of what we charge our customers. So it's sustainable value we're generating. And often, we want to be able to deliver that value to customers quicker. And essentially, software is the vehicle for that value delivery for us. So we are -- we remain confident in the growth of the software business outpacing the total company's growth. That's been the case for the last few years. We think that's the trend that continues on. When I think about some cutting-edge solutions we're offering today, such as Open RAN and other areas, software as a percentage of the total value proposition is 40% to 50%. So that's almost twice the current growth rate of the company. And we'll continue to look for value-added spaces where we can look to create that value through software. And we have in-house organic efforts to do that. We're also looking at M&A and tuck-in M&As that we have done that have bought new capability to us, that will continue to expand that runway for growth. So the solution strategy that we're on inherently allows more opportunities for us to deliver value through software, and we're focused on that.

Got you. The communications part of your portfolio typically gets most of the investor attention. You talked about the diversity of your business beyond 5G and comms. For those maybe who are less familiar with your business, can you describe how you play into sort of the new mobility, the EV, AV technology innovation that you trend that's underway? And what areas are most attractive to Keysight going forward?

Yes, I think the way you think about Keysight at the holistic level is today, we are an enabler of a number of technology trends across the multiple end markets we serve. Even in the comms market, while 5G gets a lot of attention, that's largely a growth driver for our wireless business, which is -- for our wireless business. And then we have wireline evolutions happening concurrently because, again, you're thinking about data that comes from a device that has to go to the cloud. So all the way from silicon to the cloud, we're servicing the multiple technology waves that are enabling the entire ecosystem to move forward. So there's a lot of diversity in applications, diversity in customer base that we serve, even in the comms business. I look at our aerospace and defense business, over $1 billion, over 50% of that business is in the U.S. And we're servicing the technology needs of that industry. Space and satellite is getting a lot of attention from an investment perspective. New investments in Quantum are important. And customers are modernizing the way security infrastructure is handled. And I think we're in a full position to not only win business in the U.S., which is our home turf, but also in Europe as Europe raises the defense spend over time in response to the current security environment. So that's another level of diversity from an end market perspective. And we're very excited, as you pointed out, by the industrial end markets that have been on a growth inflection for us over the last few years, driven by automotive, where AV and EV trends have inflected. We've expected that this is a long-term trend that will play out with continuous streams of evolution, whether it is improving the range or lowering the cycle time of producing these batteries that the customers are [indiscernible] towards. That's a long-term trend. And Europe in particular, is leading the way with investing in this technology trend for the future. And as we mentioned, we just reached a $0.5 billion milestone for our auto business for the first time. And in discussions with customers, the programs are scaling the number of customers that are getting into EV and AV are also increasing, which really fits our strategy. We're also seeing the trend where a number of automakers are increasingly investing in in-house talent and in-house capabilities for differentiation. And that is another addressable opportunity for us from an automotive perspective. So we're quite pleased there. Equally, I would say, the progression to new node technologies in semi has been a huge growth driver for us. That business has been very strong and we expect it to continue to be strong as these new node sizes 2-nanometer and 3-nanometer scale. And as multiple regions across the world are starting to invest in organic capacity in their countries for semiconductor capacity. And that's another area of focus for us that we're continuing to benefit from.

Got you. Maybe shifting the conversation a little bit towards sort of the geographic opportunities and maybe risks, if you will. Europe obviously is a big discussion point. As you mentioned, there are some key verticals that you're playing into that have some nice drivers growth. But 16% of revenue, what's your view on the outlook for that region as we think about some of the challenges and constraints of dealing with around energy and other factors?

Yes. Europe continues to be a pretty resilient region for us despite the energy challenges that talked about. I think the government's focus there around security needs will drive up defense spend. We think those will drive up more programs, increased collaboration with NATO, I think, is going to create more opportunities. And increasingly, I think governments are taking a role of investing in technology. I think we've seen this with the CHIPS Act in the U.S. EU is funding more 6G programs, so there's more of investments that are coming in and onshoring is on its way. I think there is a need for, I think, what we had pre-COVID appears to be a highly optimized system of supply chain. Now we're seeing more localization or a hybrid type of environment, which means that customers are putting in more local capacity. And I think that's an opportunity for us. Europe, in particular, is leading the way with EV adoption. And I think that's something that we're gaining from. And the work we're doing with those customers in that region will position us also to make global contributions around the world. So things are looking good in Europe for us as we think about the future, especially our strategy continues to resonate with those customers in that region.

Got you. China trade, obviously, another important topic. The new trade restrictions have had an impact on a variety of companies doing business in China, of course. Can you describe your business in China? The impact on the recent trade restrictions and how you think about managing your China exposure and potentially for incremental restrictions going forward?

Yes. We've had a long-standing business in China, both with local companies and also multinationals that are in China. So high teens sort of revenue, and that's sort of the level of the business that we have there. We've also had a demonstrated ability to pivot in China as trade restrictions have become the norm over the last few years. Many of you remember, we had the Huawei embargo, which we were able to offset by focusing on the broader set of customers. I think having a broad portfolio like we have of tools that we offer enables us to go service and pivot and do that. We've done that repeatedly. Our team has that capability to do that. And I think with the latest restrictions, we see a 1 to 2-point sort of impact with the restrictions on semiconductor lately. But we're also seeing, I think, net impact of all these geopolitical investments -- geopolitical climate, is investments in China for organic IP. And I think that continues to play out. Our China business remains resilient. And then there's also the diversification play that a number of multinationals are having to create in this environment where they're having to onshore or reshore their investments, and that's been a net positive for our business as well.

Got you. Got you. And then you touched on it usually before, but the CHIPS Act. What are your thoughts on the implications there? And how well positioned do you think you are? Is that rolls out over the coming years here?

I think this increasing semiconductor both fab and fabless activities that we see around the world. The growing applications beyond typical logic and memory for semiconductors is a good opportunity for Keysight. And I think where there's high complexity, I think we have the depth of expertise to go address those applications. And I'll give you an example, silicon photonics is some new technology in semi that is gaining traction. We just announced a partnership with GLOBALFOUNDRIES, where we are creating a solution with them to go address that. So again, the AI chips is another area that where investments are flowing to. So it's going beyond your traditional processor and memory, the diversification of the applications associated with semi is a huge opportunity. And I think as governments around the world are starting to put more investments into semiconductors, there's going to be more fab activity and around -- in the U.S. with the CHIPS Act, and we're well positioned to support those customers and capitalize on that spend.

Great. Just want to pause quickly to see if there are any questions in the room for Satish? Okay. We'll continue along. 5G has been obviously a very important part of the story. In terms of revenue mix between R&D, manufacturing deployments, maybe you can sort of walk us through some of the initiatives there, I think, near term. On the Q3 call, you said deployments, medium-term millimeter wave and new application rollouts, maybe you can elaborate on that a little bit more.

I would say the 5G opportunity is largely played out like we expected it to. The deployments around the world continue to scale. I think 18 months ago, we called out the C-Band deployments in the U.S. We've capitalized on that. That's been a growth driver for us in the near term. And as we look forward, I think India has made a national commitment recently to deploy 5G in the next 18 months. So there is increasing demand that we're seeing from customers trying to address that opportunity. So the deployment opportunity continues to progress nicely. I would say the R&D associated with 5G is not stopped, right, with Release 16 and Release 17 coming online, new use cases such as reduced RedCap, which is for IoT applications and machine-to-machine communications is gaining traction. Release 18 and the standards is coming up, which is going to focus more on uplink capabilities. And then we're going to start talking about some of the early 6G features that are becoming interesting in the context of 5G. So the R&D road map remains very robust and solid. Millimeter wave, obviously, has been something the industry has been continuing to innovate towards because the -- as things get -- as spectrum becomes scars, you have to go higher in frequency to be able to get the capacities you need, but there are challenges with that. And the industry continues to innovate and spend money in R&D, and we're benefiting from that. So we've been growing our 5G business. Again, this year, we grew it for the last fiscal year, double digits, and we remain confident in our differentiation that we bring to this customer base. Again, heavily skewed to R&D, greater software content in our 5G business. And it's a formula that we're continuing to deploy in other areas as we create solutions from the learnings we have in this business.

Great. Another vertical sort of satellite space. Just curious just how big you think this business can be? Do you anticipate this will grow sort of above the corporate average? Maybe if you can elaborate a little bit here as well.

Yes. I think the -- what used to be -- again, we're seeing this big trend, right? And I call this the ecosystem, the Keysight services is expanding. And this takes the form of new customer adds in some dimensions for us. We've been successful in finding new customers every single year that creates greater source of diversity for our business. And we see that in Open RAN as an example, right? What used to be a 3 to 4 customer business who make base stations and networks now turns into hundreds of customers that are buying tools from Keysight because it's -- the standards have become much more open and different parts of the customer base are trying to interoperate, creating more opportunity for us. And the space and satellite, I draw the same parallel because what used to be a business, which is largely servicing U.S. primes that made satellites for the government applications, we are now able to take some of that IP and go service a broader set of private enterprises that are innovating in the space and satellite industry. So it's broadened the customer base for us in many ways, and we're very excited by the possibilities it holds. And if you look at the economic value being talked about from space explorations, it's pretty huge. And I think the investments will continue to be sustained over time. And we're well positioned because we service all of the electrical engineers around the world use Keysight tools, and as more start-up activity comes online, those become new addressable customers for us, especially in the space and satellite sector.

Interesting. Switching the conversation over to the financials. Gross margins, 65% fiscal '22, fiscal '21. And I believe you guys have said there's still some opportunity for potential further expansion. Just curious if you can kind of walk us through some of the key inputs and takes and drivers and also just your view on how you're handling inflation. And you have the ability to sort of pass on cost to investments...

Yes. We're actually doing quite well, Rob, in that regard, right? I mean, freight costs were very high this year. We've had to pay premium prices to secure capacity of semiconductor chips. Despite all that, I think we've kept our gross margin at 65%. So we're quite pleased with that. And when we think about gross margin question, I think about it long term, right? Are we adding more value to customers that they're willing to pay for? Are we developing more software content with disciplined investments that we're putting in place to be able to scale across the end markets. And the answer is yes. So as software continues to grow faster than the rate of business, as we increase our exposure into the R&D markets, I see a greater opportunity to continue to migrate that gross margin upward. In the near term, obviously, we're all dealing with this inflationary environment, which we expect at some point to moderate. And so we've been responding to this environment by having some tactical price increases to help offset this, and we've been successful in getting that. Some of that is in our backlog that we expect to show up over time. But I look at it long term, we're not done at 65%. We see more upward opportunity for margin expansion.

Great. Capital allocation. Obviously, very strong cash flow generation in the last few years. What are your priorities for that cash and going forward as we look into '23?

When I think about the company since it's -- look at the long-term performance of the company, we've been growing at a steady clip of high single digits to double digits. So our #1 priority is to continue to invest in organic R&D capabilities to continue that growth trajectory. And so we think investing at roughly 16% of our revenue in R&D is the right level for the business. It also is the right balance between servicing those opportunities that with discipline that are more platform-like that we like, and so we're able to pick those opportunities in the markets. And we're in an opportunity-rich environment today as a solutions company. And so I feel like that's a good investment, that allows us to continue this value creation track record. So that's number one. Second, we've been looking at M&A as a way for us to expand the offerings that we have in the company. We've remained increasingly disciplined as the valuations have crept up. So we did a few technology tuck-ins and bolt-ons that have progressed to our strategy in 6G, which is the next frontier of technology innovation. AV and EV, we've done a couple of tuck-ins as well that have expanded our portfolio. And we're trialing some adjacent markets, and we remain disciplined. Should the right valuations open up, we would be able to obviously invest with the cash position that we have to continue this value creation. And lastly, as our stock -- we remain committed to a buyback that's antidilutive. And then as the valuations have come down. We've actually bought back quite a bit of our stock last year and at good levels, and we remain disciplined there as well.

Great. Well, look, we have a question here.

Your EISG business has been -- had a tremendous year. Can you maybe talk to which of the subverticals was kind of the strongest driver in the past year? And maybe as we look into next year, do you see maybe passing the baton to maybe autos, the semis continue to be kind of maybe the leading driver? Just help unpack that a little more would be great.

Thank you. You're absolutely right. The EISG business, not only 1 year. If you look at the growth trajectory over the last few years it has been incredibly strong, and it's really been a story of that's contributed to the diversity of the business at the overall Keysight level. One of the things that's maybe underappreciated is how we make these R&D investments, but we get a substantial leverage between our groups, both CSG and EISG because of the nature of the tools the customers buy are similar, but we're able to then apply some minor customization and still service these end markets. So that's, again, a huge leverage opportunity for Keysight. Specifically, semiconductor is a business that we always start off as cyclical. But when we look at where we play in semi, we play in the wafer stages with very unique capabilities that we have, and that has continued to be very, very strong. The new node investments, as we look forward as well, we think we're well positioned and customers' demand outlook that they're projecting right now remain unchanged, whether it's the 3-nanometer, 2-nanometer and beyond. So that, we think, continues. We do expect some demand moderation at some point with the capital equipment of semi being -- the projections are down in '23 so that we expect that to happen. But because our focus is on the long-cycle part of the business. It takes a few years for our customers to set up wafer stages, we're holding up better. The automotive part of the business is inflecting, and I think it's a real inflection. It's a long-term trend. The increased investments that automakers are directly making to develop in-house organic capabilities is something that we think will continue to be well positioned. We also want to say that 1/3 of the auto business is production test. But that's also been strong, given the increasing electronics content. That could moderate at some point, but the R&D part of that business is long term, and we're investing to continue to develop that orientation. The general electronics business is also very exciting. I think while historically linked to PMI because it has some production type of customer base there, we've also been diversifying the customer base into education and research around the world. As government investments have flown there, that's been a stabilizing factor for the general electronics business. And we also see emergence of new customer types, I think, of digital health, where customers are investing in in-house electrical engineering capacity because IoT and sensors are becoming very important in today's world of health care. And so we look at the exposure that we have in that business, it continues to be strong and continues to surpass our expectations.

Great. Well, I think we've -- Satish, thanks so much for your time. We've run out of time, and we appreciate that everyone joining us today.

Thank you, Rob.