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

Hi. Good morning. I'm Samik Chatterjee, I cover hardware companies at JPMorgan. For the next session, I have the pleasure of hosting Keysight Technologies. And with me is Neil Dougherty, the CFO. Neil, thanks for making it to the conference. Thank you for participating.

Let me get started here with some of the common questions we're asking companies just to get more of a sentiment check. The biggest one sort of being macro as you look through the remainder of the year, what are the biggest macros as you see to your business?

Yes. I think there's just a tremendous amount of macro uncertainty, and there's a lot of moving parts, whether it's inflation, interest rates, debt ceiling. All of these things are creating a tremendous amount of uncertainty in the marketplace. And I think that uncertainty breeds caution on behalf of our customers. And it's contributing to relative slowing of demand. I think the good news is, obviously, from a Keysight perspective, we're not facing anything that the broader industry isn't facing. But the sooner that we can get clarity as to direction on some of these large-scale macro topics, I think, the sooner you're going to have a catalyst for positive change.

Okay. Okay. One of the other aspects I've been diving in with the companies is there is some level of demand moderation on account of inventory in the different markets, and there is some sort of real demand slowdown. As you sort of go through your portfolio, how much of this is inventory challenge, maybe a bit more short-lived versus a real sort of slowdown?

Yes. I think a significant portion of it relates to inventory, particularly on the commercial communications side of our business. which is one of the areas that's relatively weaker within our current portfolio. The softness that we've seen in commercial communications has been largely concentrated within our largest customers. And some of those big customers within the communications ecosystem have been very public with their statements around trying to deal with the inventory indigestion issues coming out of the supply chain disruption of last year. They have been taking action, not including in response to perceived overhiring in the previous period and having to adjust workforce. And all of these things obviously are disruptive and are causing a positive investment. I think again, the positive thing from our perspective is given that Keysight is largely focused in the R&D lab, particularly in the communications segment, where our business is even more heavily skewed towards R&D, we know that for this customer set that their new product pipeline is really their lifeline to future growth. And so while they can pause investments in R&D for a period of time, we know that ultimately, those investments are going to pick back up, and they're going to remain focused on continuing to drive technology development in their own spaces. And that bode well for us.

Okay. The last of those questions, just AI is a big theme, obviously, all around and sort of at the conference as well. Any early thoughts in terms of how AI impacts your business? Do you see any areas of disruption? Or is it sort of more tailwinds that you see for your business?

Yes. I think generally, at this point, we see it as a market tailwind. I think, first and foremost, just the amount of compute power and bandwidth that's required for these AI/ML-based solutions, I think, creates opportunity for further need for expansion of the network and the ability for both the wireless and wired networks to handle data traffic. And so first order, there's that. But then I think beyond that within Keysight, we're looking at how can Keysight as a company help the folks that are developing these AI-based tools to continue the development. And I'm probably not the right person to address, we'll very quickly get beyond my ability to talk about these things from a technology perspective. But suffice it to say, we do believe there are intersection points between our capabilities and the work that's happening in the AI/ML space.

Okay. Okay. So let me dive into something more company specific here, slower demand in communication, you mentioned that. But generally, electronics, overall as a market, seems to be doing a bit better for you. What drives your confidence that this is not a structural change in sort of the growth rates between those 2 segments? I know you mentioned communication, you sort of see that pipeline for your customers being very important. But there's a difference in sort of growing high single digit versus growing low single digit, right? That can still sort of -- they can expand R&D and still sort of grow at a more modest pace than they were. So when you think about sort of even going back to the Analyst Day and sort of your guidance there, what sort of indicates to you that this slowdown is not a structural shift in the growth rates?

Yes. We don't believe it's a structural shift. We continue to believe that there's a tremendous amount of work that still has to happen in these commercial communications ecosystem to enable even the current wave of technology, specifically 5G, right? We're working out Rev17 of the standard today. Rev18, 19 are still to follow. There's a lot of work that has to happen around ORAN. We're seeing their early seeds of research into 6G. And so again, you're bringing this back to kind of an insatiable need that the public seems to have for data and the communications industry is going to have to continue to evolve to meet that underlying demand, I think, again, bringing it back to our Analyst Day, we have highlighted some changes where we believe our markets are now growing faster than we previously thought, notably in our electronic industrial markets largely as a result of the broad scale adoption of EV-based technologies. And so as that auto business, which is a fast-growing business, it has become a larger portion of our overall market exposure that enabled us to take up the growth rate on our electronic industrial business. And then similarly, on the other side, we believe that the aerospace, defense businesses are now positioned to sustain a faster growth rate, going forward. Not only have we seen multiple, I think, 7 now consecutive budgets within the U.S. with the increasing defense spending and again, across 2 presidential administrations of both political parties, so there does seem to be some political alignment around the need to invest in defense technology. But we're also seeing our NATO-based allies commit to spending on defense at a higher percentage of GDP, and we believe these are long-term trends that are going to be good for our business, moving forward.

Okay. One of the questions that I've been asked to ask you around the communication group is when you look at the -- maybe even when we look at some of your peers who have already reported along with you, we can see sort of different buckets of customers that are spending slower. So there's the smartphone sort of chipset suppliers. There's the smartphone OEMs themselves, and then there's the sort of base station companies and sort of more on the radio side. When you think about your communication group, like is there a bit more sort of there where you can [ flush ] it out for us in terms of what that mix looks like? How much of your communication revenue is really aligned to mobility or sort of the mobile segment overall versus other drivers when you talk about sort of 5G standards, et cetera, those are more sort of outside of the smartphone chipsets or the smartphone OEM? So any more color there in terms of what the different big buckets of customers are?

Yes. Well, when I -- when we think about the wireless ecosystem, we tend to think about it in kind of 4 segments, right? There's the component and chipset manufacturers, there's the device manufacturers. There's the folks that are working on the network access piece, the legacy base [ station ] manufacturers as well as the folks that are now working on a piece of that solution via ORAN. And then there's the service providers. And I think for Keysight in terms of the opportunity ourselves, the service providers is the smallest of those from a market perspective. I think the other 3 are all reasonably on par with each other. We do significant business across all 3 other aspects of the ecosystem. And that's not to deemphasize the service providers. That's an important part of the ecosystem, they're important [ customer stress ]. Just on a relative sizing basis, they tend to be smaller than the other 3 pieces of the pie.

And then just to clarify on that, so when you're seeing the weakness in terms of orders coming in, is that across the 3 big segments? Or are you seeing one being more pronounced than...

No, I think it's pretty uniform across the segments at this point. I think, generally speaking, the industry itself is dealing with a period of maybe a little bit reduced customer demand and these inventory issues that are -- it's all heavily correlated, right? So to the extent that one piece gets a cold, I think it tends to flow.

Okay. So for the last couple of quarters, you've highlighted the spend challenges from your smartphone chipset supplier sort of customer group, right? Order trends, can you sort of give more color on the order trends from that customer vertical? How much of a sort of sequential moderation are you seeing? And one of the popular questions that I get from investors is if they're not if they're starting to cut back on certain R&D projects, what are they really prioritizing at this point? Are they now sort of saying, "Okay, let's sort of look to 6G and sort of start working on that", and that's probably years out and hence, less of a priority to spend immediately? Like when you look at them in terms of projects that they're still running, what are those priorities looking like?

Yes, absolutely. So first of all, with regard to kind of the short-term order dynamics, obviously, orders are at a relatively lower level. I think as a positive note, we just announced last week our second quarter results, and we saw pretty good stability, not just at the Keysight level, but within the commercial communications business as we moved from the first quarter into the second quarter. So good news, no incremental deterioration as we move from one quarter to the next. And then similarly, as we cast the lens forward, and look into the back half of the year, again, based on the -- it is a highly uncertain environment, so I'll give that caveat. But based on the data points that we have and what we can see, the communications that we're having with customers, our sales funnel, we see the second half of the year looking an awful lot like the first half from a demand perspective. And that's true both at the Keysight level and at the commercial communications level. So on the downside, we are not ready to call an uptick, and we don't have a significant upswing baked into our expectations. But similarly, we don't see a further downward catalyst at this point either. So a little bit of a wait-and-see approach as the industry is working through some of these inventory dynamics that we've already discussed. As for prioritization, we have seen, as we've said, a general slowing in the level of investment. I think they're just being more deliberate with their buying decisions at this point in time. Certainly, the R&D markets have held in significantly better than the manufacturing markets, which was one of our core thesis for the company, generally. And I think within the commercial comm space, it's really probably a deprioritization of kind of legacy-based technologies and a focus on the future, so the coming revs of the standards, Rev17, Rev18, Rev19, which are in various phases of definition at this point. And then early 6G research, I think, is continuing. I think this customer set realizes that new product pipeline is critically important, and they have to stay on track with the fundamental research that is going to enable these broader technologies over the longer term. So we are seeing that investment in early 6G research continue.

You brought up the deprioritization of legacy technologies. And I know when you've talked about sort of commercial comm revenues, 5G has been an expanding part of that revenue and 4G has been declining. I mean how much of a change has that -- this sort of deprioritization made to 4G declines that you've seen on the revenue side?

Yes. I don't think it's that significant. I mean I think the -- you are right. I mean as we move from one generation to the next, you do eventually go from a growth phase to a deceleration phase. And we have -- we've seen our 4G and frankly, 3G and earlier technologies contract over time. But I think maybe the more relevant fact is here we are 10-plus years after the introduction of 4G, and I still have a very significant 4G business, right? And so it just goes to the longevity of these cycles and the prolonged level of investment and the fact that the market positions that you carve out early on in these cycles really pay dividends for a long time. And you would argue that in 4G, maybe we're relatively less successful. But again, 10 years on, still have a significant business. And I think that bodes well for the longevity that we'll see from the market position that we've carved out in 5G.

Got it. Got it. One of the interesting technologies that we used to talk about on every earnings call before was millimeter wave and your [ content ] opportunity on that. I think just the amount of interest and the amount of discussion around that has dissipated a bit over the -- sort of moderate a bit over the last few quarters. Is it really just because of limited interest outside the U.S. to really adopt that technology? Or -- I mean, in your sort of forecast that you laid out at the Analyst Day, what you're now assuming for millimeter wave rollout?

Yes. And I think the question is why is there maybe less investor interest in the short run on millimeter wave. And I do think as the commercial deployment of higher-frequency technologies is pushing out, obviously, that is reduced -- may be reduced investor interest. But I think from our perspective, it's a virtual certainty that the frequencies have to move up, right? I mean it's really the only way in the wireless space to deal with the demand for data throughput to be handled as through increased frequency. So over time, that is the direction things are headed. And so the question is, what is that timeline? Does it happen as part of 5G? Does it ultimately happen as part of 6G? I think we'll need to take a wait-and-see approach to how this thing ultimately commercializes. But I think from Keysight's perspective, primarily as a provider of tools and solutions into the R&D lab, the key is that the ecosystem is working to solve the fundamental physics-related challenges with higher frequency. And I think it's ultimately going to be a necessity that the frequencies move north to deal with the demands of the industry.

Okay. Okay. Maybe just moving to sort of the order trends in a bit more near term of a question. But as you talked about, you sort of seeing stable demand in terms of orders, going forward. And you're sort of expecting some seasonality with 3Q orders coming -- pulling in a bit, 4Q being a bit better, from what I gathered. . Within that, though, EISG, I mean our general expectation would be that EISG orders continue to improve. So maybe just help us think through that because EISG should -- looks like to be on a much better trajectory and improves through the year. So it almost implies that commercial comm or communications overall has to be down a bit. How should we think about it?

Yes. I mean it's -- as you think about Keysight, right, there's -- there are numerous secular market growth trends that we're exposed to. So within EISG, certainly, the auto business is -- continues to be very strong and actually improved as we moved from the first quarter to the second quarter, and we're continue to be very optimistic about the growth potential for that business as we look forward into the back half of the year. The general electronics business may be surprisingly stable, if it surprised to the upside with its stability because that is a business that benefited favorably from -- on the manufacturing side from the supply chain disruptions of the past say 18 months. And so as that manufacturing piece has fallen off the fact that, that business has remained stable, driven by things like investments in advanced research, IoT, Industry 4.0, even med tech helping to keep that business stable has been a positive surprise. We've seen relative weakness on the EISG side as we've moved from Q1 to Q2 on the semi side, which I don't think is terribly surprising, given what others in the industry are seeing. And I think as we look forward, certainly, the move to 3-nanometer sometime next year, I think, is a next potential catalyst for our semiconductor business. On the CSG side, I think we've already talked about it, right? The commercial communications business, fortunately, appears to be stable, albeit at a lower level, and we largely see that continuing through the back half of the year. While at the same time, we're seeing relative strength in aerospace, defense. That actually improved as we went through from Q1 to Q2. And given that the U.S. government fiscal year-end falls in our fourth quarter, we'd expect continued strength in aerospace, defense demand here throughout the end of the year. So it's a little bit of a mixed bag, but that's not uncommon for Keysight, right? Given the breadth of the portfolio, there are typically puts and takes as we think about the various secular drivers that we're facing.

Got it. And again, a near-term question on commercial comm. But I think in the last quarter, you generally had orders on the wireless side being a bit stronger sequentially than the wired. Any changes in the landscape there? Is wired now sort of more on -- going to see some weakness because of the spending intent from like either the data center customers or that ecosystem is starting to be a softer? How are you seeing that mix play out within the overall sort of stable backdrop? What's going on underlying between wireless and wire line?