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

Perfect. So why don't we go ahead and get started? I'm Aaron Rakers. I'm the analyst covering IT hardware and semi names here at Wells Fargo. I'm pleased to have with us Neil Dougherty from Keysight, the Executive Vice President and CFO. First of all, Neil, once again, appreciate you joining us here this morning.

Thanks for having us. It's great to be here. .

Perfect. So Neil, I'm going to start with the softball question. Why don't we -- for those that aren't familiar, either in the audience here or on the webcast, just give us a high-level overview of the Keysight story, maybe areas that you think are a bit underappreciated. This is a name that we just recently, not too long ago, initiated coverage on. And I think one of the things that we really emphasized is that the diversity of the business is something that we feel is underappreciated. But why don't we start there and just give us a high-level overview.

Yes. It's good to hear you say I can say. That's exactly where I was going to go is the diversity. So Keysight Technologies. We're the number one player and we define as a $20 billion-ish served addressable market focused on test and measurement, electronic design and test, however you want to think about that. And in terms of underappreciated side of the business, I think people for a number of years have really thought of Keysight as a commercial communication, specifically a 5G story. And that's certainly a market where we have done very well. We've taken significant share in that commercial communications market since our spin out from Agilent back in 2015. But I think what's underappreciated is the growth that's come from other aspects of our business, particularly our electronic industrial business, which I think is an underappreciated gem, right? So focused in the automotive markets with the big secular driver in the electrification of the drivetrain and the move towards increasing levels of autonomous driving. We have a semiconductor business which is benefiting now from obviously, not just capacity shortages in the semi space, but the efforts -- the recognition of a lot of places around the world that the semiconductor supply is a security issue, right, in both economic and in some cases, a true security issue, this idea of reonshoring fab capacities going in is a long-term driver of that business. And then we have this broader general electronics business, which is just benefiting from the electronic proliferation, that is going into so many different things, right, everything from IoT to health care to education end markets. And all of those businesses have been growing very steadily. Our EISG business in total grew its revenues strong double digits each over the last 2 years. In fact, it was 30% growth in 2021, backed up by 14% reported growth, but again, with a significant currency headwind here in fiscal '22, which was just recently completed. And so I think that's the underappreciated side of things. It's not just a 5G story. There's a lot more under the hood once you start to take a closer look.

Yes. And I think a closer look, I mean, not to paraphrase what you just said, but you play at the front end of digitization, if you will, right?

That's right.

And we'll get into this, but not only that. But moving from just the test and measurement piece of it into much more of the R&D side of the equation, which I think where I'm going to go with this next question is with that mind, maybe level set us on how you're seeing the current demand environment had various companies talk about elongated decision cycles and some macro concerns out there. So I'd love to hear kind of your current thoughts as we think about Keysight.

Absolutely. And I like the way you introduced the question because we've been on a decade or more long effort now to kind of change the mix of our business and really change it across a couple of different factors. The first one being, as you mentioned, this move into the R&D lab, right? If you were around 15 years, maybe a little bit more than that we were probably 60 or some percent of our sales were going into the manufacturing lines of our customers. we're now 30% manufacturing, 60% of our sales are going into the R&D lab. And that's important because we know when you enter uncertain macro times that tech companies really work hard to protect their R&D investments because that's what's going to enable them to succeed when macro conditions improve. So it's a far more stable revenue stream. It's less price sensitive, it's higher gross margin, higher levels of technology. So therefore, easier for us to differentiate in that marketplace. Other things that we've done, increasing our software and services content. Software and services today are a full 1/3 of our revenues, 20% of our revenues are recurring. These are fundamental shifts from the key side of a decade or more ago. And I think it's going to make us much more resilient as -- over a wide variety of economic circumstances. Now turning that to the current environment. First, I focus on our recently completed fourth quarter, which ended October 31. I think getting to that resiliency point, unlike many companies in technology, we actually saw steady demand through our fourth quarter. The 3 months of orders across the fourth quarter were very even, and we did not see a falloff in demand over that period of time. That being said, we are starting to see some early signs. And when we had our earnings call, we did caution that there could be some demand weakness here as we look forward into Q1. And so what are we seeing? Well, we're seeing customers take a little bit longer, right? That time between us providing with code and getting it turned around into a book order is lengthening a little bit we're seeing caution. You can see it in the earnings announcements of tech companies. We're seeing them just being a little bit more cautious with their spend. That being said, I think we're a bit uniquely positioned because of the strong backlog position that we're in. We have $2.5 billion of backlog here entering our fiscal '23 that's up well over $1 billion over the past couple of years, driven obviously by the supply imbalance. But that's a short duration backlog for with very few exceptions, we don't put an order on the books unless it's convertible to revenue within a 6-month period of time. So it's a very high-quality short duration backlog. And so what that means is we can absorb some softness on the demand side without it impacting our ability to continue to grow revenue. If you actually look at what we've done over the last 3 years, we've had 3 years running where our book-to-bill has been 1.09. We've known that's unsustainable. There has to be some sort of renormalization of book-to-bill back closer to 1. And so the thought that we might see that a return of bill closer to doesn't really worry me and I don't think it's going to impact our ability to continue to drive revenue growth.

Yes. And so Neil, you brought up the point that I was really going to get at is that backlog that you're carrying is really -- it's deliverable over 2 quarters. So how are you thinking about some deceleration of that book-to-bill if it returns to on? How do we think about the pace of that normalization? What's a normalized backlog in your opinion, kind of look like?

So I think because of some of the things I've talked about, right, the move towards software and higher levels of recurring revenue, you can see it under deferred revenue on a frankly to move towards R&D with more complex systems. I think is putting an upward trajectory on our backlog. So I don't think you can go back to what our backlog was running, say, going into COVID and saying, that's what normal is. I think it's above that because of this trend. That being said, I think we're clearly an elevated backlog situation. And to your point about a book-to-bill of our book-to-bill returning to 1. If we're -- if in Q1 or even over the first half, I have a book-to-bill of 1, I'm still going to enter the back half of next year with $2.5 billion of backlog, which is back to my point, the -- this softening of demand either driven by the macro or currency headwinds, trying to trade some of these other things that we might be facing, or frankly, just the fact that our own lead times are starting to come in as a result of the supply chain easing, is not going to impact our ability to continue to drive the top line.

And I think kind of one last question on the backlog discussion. I mean the quality of your business, I think, is one thing that stood out to us. When you look at that backlog, cancellation rates or scrubbing that backlog, would you say how do you think about any changes in cancellation rates...

Cancellations rates remain very, very low. The other thing I would say is, again, given the R&D focus of our backlog and of our business, in most cases, there isn't a drop in compatible kinds of replacement, right? It's not like -- I know one of the things that people worry about in tech is that people have double bike orders and supply chains are going to improve and you're going to see cancellations. Well, when you're selling into the R&D lab, that's just not the case. And these companies that have adopted Keysight platforms broadly for their R&D tools, switching costs are high. So as long as they look to sustain their R&D investments and again, given the relatively short duration of the backlog, we believe the quality of the backlog is extraordinarily high.

That's perfect. And then kind of thinking from there in the macro environment, given the uncertainties, you and I have talked about it in the past a lot, which is the resiliency of the business, the ability to flex the model.

That's right.

I'd love for you to kind of share the thoughts around that.

Yes. So just reiterating the points I've already made about the kind of a reset resiliency of the top line driven by R&D driven by software, driven by services. So I think that in and of itself is going to get to top line resiliency. But even as you think below that and say, well, if there is a macro correction, how is Keysight going to behave? And I think we have a structural and highly flexible cost structure that enables us, in many cases, to outperform what others are able to do. The single biggest component of that is that 100% of my employees have a portion of their pay that flexible business performance. The 2 drivers are organic revenue growth and operating margin. And so if we do get into some sort of a macro correction that starts to impact either of those same things, I have a structural and automatic governor in the single biggest component of my cost structure. Beyond that about 50% of our manufacturing is outsourced, about 20% of our sales flow through an indirect channel. So I have significant buckets of costs that I can flex downward if I need to. And I'd point you to our results back in Q2 of 2020, just as an example, obviously, not a macro correction but a correction nonetheless, as in Q2 of 2020 when COVID started to go global, we actually closed our manufacturing facilities. And in that quarter, we saw our revenues because our manufacturing facilities were closed decreased 18% on a year-over-year basis. Our operating margin, however, only decreased 500 basis points, and I still delivered 19% operating margin because my salary cost came in, my -- and I was able to scale back on things like outsourced manufacturing. And so the business is highly flexible from that perspective.

That's perfect. That's a great overview. When we think about 2023, and I'm not asking you to give guidance or anything, but maybe walk us through because -- you mentioned it earlier. I think one of the takeaways that we had early on was that a lot of people consider this a 5G story and 5G matures, but there's a tremendous runway still with 5G. But on top of that, I'd love to hear kind of how you think about some of the key secular top-down growth drivers that we -- investors should be thinking about for Keysight into next year even over the next couple of years.

Absolutely. Yes. I mean I think that is also a great part of the story is that you set the macro side, there are secular growth drivers across our portfolio that I think if they don't fully protect us or at least going to provide some immunity to what's happening in the macro environment. And so starting in the commercial communications business, as you said, we're still very early in the global rollout of 5G, right? Still a small percentage of the world population wakes up and has a 5G signal on their phone at any given point in time. And in addition to that, we have additional revs of 5G, which are still to come to move to higher frequencies some of the use cases beyond the cell phone industrial IoT, automotive as private networks. 5G.mil as an example, of all things that are really still to come on. So we continue to believe that these are long cycles. And even beyond that, as the 5G network gets deployed and as the network traffic starts to charts to exclude, it's going to necessitate a complete and total overhaul of the wired network as well. And so we're seeing that with the rollout of 400 gigabit network today, but we're also seeing an investment in the R&D lab in 800 gigabit and 1.6 terabits. So these are trends that are driving that communications business going forward, staying within our communications group for a minute on the aerospace defense side 1 of the few things, there seems to be some political alignment in the U.S. around is the need for increased defense spending. We've got 6 consecutive budgets across 2 administrations of different parties with increased defense spending. And specifically, they're investing increasingly in defense technology, which is good for us. And then unfortunately, obviously, we're seeing some unrest in other parts of the world, which is causing native allies to increase their investments in defense as well. And so I think the long-term trajectory for our $1 billion plus defense business is also strong. Then moving over to EISG, I think we have equally strong drivers, right? We think about the auto opportunity, both in terms of the electrification of the drivetrain and the move towards autonomous driving is a decade-long opportunity, right? It takes a long time to turn over that installed base, you're getting government legislative help in terms of efficiency standards and requirements, an ultimate obsoletion the obsolescence of ice vehicles, right? And so there's a long-term secular trend there. On the semi space, we've talked about it, the need to re-onshore semi production and the fab capacities that are going into place. Some of those fab equipment manufacturers have a backlog now out through '25 and '26 and beyond, and that's going to continue to drive demand in that space. And then finally, general electronics, I think it's probably our most kind of GDP-ish kind of business. But what you are seeing is proliferation of electronic content in all things, right? And so we see it in education markets. We see it in IoT. We see ways for Keysight electrical engineering company to participate and digitalize health care as an example. So even within this broad market, there are submarkets which have very favorable trends for us.

And like in the context of what you just laid out, semis in particular, because one area, obviously, I'm very much involved in. And where Keysight's role is in the semi market? What exactly do you guys do? Any kind of framing of the size of that?

Yes. There's really 2 primary aspects to our business, right? The first one is something called parametric test, and parametric test is essentially a set of a tool that is used both in R&D and production to assess the electrical properties of the wafer itself. So we're not testing the die themselves, we're testing how electrical current or RF frequency travels across the surface of the wafer, again, both in R&D and in production. And we have some pretty highly differentiated solutions in that space, and bring tremendous value to our customers in that space. The second thing that we do is we do some very you could think sub nanoscale as 3D positioning. And so we actually sell components into the big photolithography equipment manufacturers so that when they're etching wafers, their equipment knows exactly where it is across 3 dimensions to a sub nanoscale. And so it's actually a component in some of these wafer production machines.

That's perfect. Kind of, again, sticking to the higher level. You guys have executed very well on a strategy of diversification, changing the business model. And one of the things, if it's Ixia -- some of the things that you've made acquisitions around over the past several years, talk about moving from the physical layer to the protocol layer, and what that looks like for the company?

Yes, absolutely. So I mean obviously, Keysight, we've been in business since the 1930s. We were the original business of Hewlett-Packard. And our roots, our history is really 1 in physical layer test. But increasingly, we've moved up into the protocol layers of test, most notably with our acquisition of Anite. It was the first acquisition we did after our separation from Agilent. That has got us protocol layer solutions for the wireless side of the communications network. We then went out which got us protocol layer solutions for the wireline side of the network. . We've done acquisitions to get software capabilities in the auto space to help with the autonomous driving problem. We've bought the egg plant business, which moves even beyond the protocol layer up into the application layers in terms of software tests. And what we're finding, particularly as we've moved from manufacturing test more into R&D that a lot of the value comes from the ability to emulate systems and to do so in a lab environment, and that requires software. And so a big part of our 5G success, for example, comes from the fact that we're able to provide our customers with a 5G protocol stack that allows modem and device manufacturers to test in a lab environment, how their device will perform in a deployed 5G network, but to do so in the lab. And it allows base station manufacturers and radio access providers to understand how their equipment will perform when flooded with call traffic and video traffic and data traffic, again, all in a lab environment and all done through software.

Perfect. So one of the questions I got kind of shifting gears here a little bit. One of the questions we got a lot of post the initiation was just the China exposure, the geopolitical risk around that. Maybe help us appreciate how you would characterize that risk in China? And what's going on?

So China is a high teens percentage of our revenues currently, and that's been pretty stable over time. I guess the way I think about that is that we're now pushing 6 years into this, right? It started early in the Trump administration with tariffs, and we had ZTE and Huawei and military end use, multiple rounds of additions, the restricted party list, we have the recent set of trade restrictions that are focused on China semi industry and really through -- I mean, all of those things are industries that we serve. But through all that, we've continued to grow our business, right? We compliant with all of the trade restrictions that are out there. But I think China continues to invest broadly in technology. We have tools that are direct alignment with the types of things that they're investing in. And I just continue to believe that you've got the world's 2 biggest economies that are very much reliant on one another, and you're going to likely continue to see incremental trade things happen. But I think as long as it stays in that incremental phase, I think we're going to continue to find ways to meet the needs of our customers and to provide technology.

Perfect. What about China from an employee perspective for Keysight? Any risk around that?

No, I don't think so. I mean I think we -- a lot of our China in terms of R&D, a lot of our China employees are really focused on localization of tools for the China network. I think a lot of our core R&D is happening either here in the States, Japan, Germany or our core R&D centers. And so I don't have any significant insurance.

Okay. That's perfect. So it's been a little while since you guys have given a longer-term model kind of framework update and certainly, we would think eventually you guys do. But I'm curious about 1 component of the business model, the software component. And remind us again where we're at today. And if I were to have a 3- to 5-year kind of horizon? How should I think about software growing as a proportion of Keysight?

Yes. Softwares in the low 20-ish percent portion of our business. I think the interesting thing is we've done a very good job of actually hitting our software objectives. I think the mix has actually shifted a little slower than we've modeled because other aspects of the business are growing so aggressively. I mean, particularly within which of the 2 groups has the lower software content, we tend to see higher software content at least currently on the communications side. But with EISG growing 30% last year, 14% this year, it slowed that mix shift. That being said, I think within our communications portfolio, some of our 5G solutions are 40-plus percent software content. Some of our O-RAN solutions that I've already mentioned, are 50-plus percent software content. So those are obviously at the high end, but I think it's indicative of the kind of value that we can add. And I think we're also continuing to use M&A as a tool to increase the software mix of our business. You saw that with our acquisition of eggplant, a relatively small business. but it's a software specific business where the sale of those egg plant tools is really totally disconnected from the sale of our hardware. We have a few of those kind of software-only franchises. And so I think we'll continue to look for opportunities, again, relatively close to home for us to add additional software content via the acquisition.

For kind of existing customers, is there an ability as they upgrade to latch a software component to that, that upgrade cycle or...

Yes. I mean, it depends because we obviously have a very broad portfolio. But if you think about 5G, for example, some of our customers have kind of gone in from the jump and bought millimeter wave tools. Others have taken more of an incremental approach where they bought tools that are really tuned for the sub-6 gigahertz 5G deployments, but with an upgrade path. That upgrade is typically primarily software but there's also, in some cases, some hardware that goes with that. And so clearly, there are opportunities for us to upgrade our customers and allow them to extend the use case of the tools that they bought through software additions.

That's perfect, Neil. I've answered -- asked a lot of the questions I had, but on the services side, again, kind of thinking about the recurability of the business model, just remind us again of the subscription component of the business, Keysight Care, how you've seen that attach rate kind of move through the business model?

Yes, I'd say 2 things about our services business. So first of all, we have a very large installed base, right? We've been in this business a long time. Our equipment lasts a long time. So a portion of our service business is not contractual, but we still consider it to be recurring because we have a repair and calibration business that we run along a very large installed base. So it has very much recurring revenue types of components to it. in terms of its steadiness over the cycle. And then obviously, we've transitioned our business over the last couple of years from a free support model to a pay-for-support model via this Keysight Care initiative. And the only thing I would say there is that our penetration rate is ahead of our own estimates. We're doing very well in terms of getting our -- driving customer adoption of our Keysight Care initiatives.

That's perfect. And a couple of minutes I have left, I want to take 1 step back and just think about Keysight again. We talked about diversity of the business. We talked about the change in the mix of the business. You talked about some of the growth drivers going forward. I guess the simple question that comes around all of that is who is your competitor? Like how do you think about the competitive landscape? It seems to be fragmented. There's been some noise around some competitors seeing some pressures in certain areas, might be more concentrated. So I'd love to hear your thought on when you guys sit down and like who's the competitor that you're most notably thinking about .

Yes. I mean I think it is a fragmented market. I think when we think about our top competitors, we think Rohde & Schwarz in Germany and Raichu in Japan, and AXIe competitor would be Gigamon or Spirent, those types of companies. Again, these are much smaller players. They don't have the diversity and breadth of portfolio that Keysight has, but they're very, very good competitors and different niches of our business. And I think for us, we've taken a little bit of a different approach to the market. I think the breadth of our portfolio allows us to take this solutions approach to serving the needs of customers based on the problems that the industry is trying to address. And we're going to continue to focus on being first to market. We invest heavily in R&D, $800-plus million a year. The benefits of scale enable us to do that. It's difficult for a lot of those competitors given their scale to compete with that breadth, the ability to invest in R&D, the ability to drive high-end solutions that really combined tools across a broad portfolio to solve the complex problems of our customers.

And not to add what you said because, obviously, you know much more than I. But one of the things that I thought was interesting in traveling out to your headquarters a couple of months ago, is that when you talk about digitization and this kind of continued proliferation of higher and higher frequency pieces of device on the end market, you guys actually do, I think, proprietarily some of your own silicon around that. Is that a key differentiator ...

It is. So we have our own tabs gallium arsenide, indium phosphide fab in California. And it is a differentiator because if you think about what Keysight does, we provide tools, hardware and software tools into the R&D labs of the best technology companies in the world, which means we need to be that much more precise. We need to be there 2 to 3 years earlier, which often means that a lot of the components that we need to achieve those levels of performance are not readily available on the open market. And so the Packard many moons ago were visionaries and started this fab, and it enables us to achieve levels of technology that I think others have to find unique different ways to do, but we have the a unique differentiator and that we control that aspect of our supply chain. It's also been really important over this past year because of the supply chain situation, right? If you were looking for highly specialized is very, very difficult to procure. But because we control the significant portion of our supply chain for those highly specialized components. I think we've done a good job of managing the supply chain situation that we've been on over the last 18 months.

That's perfect, Neil. In the 1 minute I got left. I'm going to ask you just kind of the obligatory capital allocation question, which is how do you think about capital allocation? How do you think about M&A? You've been very successful in some of the M&A things that you've done over the past few years. So just kind of level set us on how you think about shareholder return, capital return?

Absolutely. So first and foremost, we want to continue to invest in the organic growth of our business. We do that through R&D. We do that through sales. do that through CapEx to make sure that we're making the investments that are going to drive this Propel's business going forward. I think beyond that, we do have an appetite to do M&A. Most of the M&A we've done has kind of been tuck-in in size. . I think we have appetite for bigger things, but we have a very disciplined process requiring a cash-on-cash return that exceed our cost of capital, right? And so we've been very patient, and we've seen valuations come in, not necessarily seller expectations. And so we continue to be patient. Beyond that, we're returning capital. We're big believers in our own story. We returned almost 90% of free cash flow to customers last year to investors last year via buyback program. And so I would describe kind of our approach right now is we're we're maintaining significant balance sheet flexibility via our cash balance and our leverage while at the same time actively returning cash to our investors.

That's perfect, Neil. I appreciate you taking the time this morning.

All right. Thank you so much.