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

Okay. Great. Well, thank you, everybody, very much for joining us. My name is Mark Delaney, and I have the pleasure of covering Keysight for Goldman Sachs. With me today, we have Satish Dhanasekaran, the President and CEO; and Kailash Narayanan, the President of the Communications Solutions Group. I appreciate you both joining.

Thank you, Mark.

Thank you, Mark.

I thought to kick things off, Satish, we could cover the longer-term outlook that Keysight gave at your last Investor Day, you have a target to grow revenue at a 5% to 7% CAGR, and to reach a 31% to 32% non-GAAP operating margin by fiscal '26. Maybe you can talk about what some of the key things are that you expect to drive this.

Yes. Thanks, Mark. Is this working? Yes. Okay. Thanks, Mark. I think I would say at the highest level, a Keysight since its spin-off from Agilent in 2014 has successfully -- can you guys hear me at the back? Keysight since its spin-off from Agilent has successfully grown its served addressable market by the strategy we deployed, which is really to focus on higher-value software-centric market segments by offering total solutions. So that's resulted in us expanding our SAM and today, which stands at about $20 billion. But as we look forward and as I outlined at the Investor Day, we see 3 big trends moving in our direction. One is the technology waves, we see them accelerating as we look ahead, and that is a big opportunity for Keysight that builds on our strengths that we've had from 4G to 5G and to 6G and beyond. The second one is we see transforming industries, right? New customer sets now becoming addressable such as what we saw in automotive will continue to expand into other segments such as digital health that are coming our way. And the third one is industry dynamics, whether it is the geopolitically driven environment that we're in today, where many nations around the world are investing in organic IP with increased research spend or even defense budgets in the Western nations getting more priority nationally. All of these trends support the -- our thesis that our markets are positioned to grow 4% to 6% over the long run. And Keysight will continue to outperform its markets by growing 5% to 7%. So that's on the growth front. Our strategic focus is to grow our software and services mix as a percentage of revenue. Today, that's at 33%, software at 20% of revenue, and we'll continue to focus on more software-centric parts of the market to continue to grow the value of the company which will enhance our gross margins and we'll maintain the operating discipline that we have maintained all along and that we'll continue to drive the operating profit to higher levels than -- that we've outlined at Investor Day.

That's a super helpful overview. I wanted to double-click on one of the things you just said, and that's the company's exposure to some of these key areas. You just gave us the software and services figure, about 33% of revenue, I believe. How much is R&D test, as I think you're also overweight on the R&D side relative to production test?

Yes. We estimate right now, R&D is roughly 60% of the mix of the company. That has been a big transformation from 40%. So obviously, we're focused on growing our contributions to the R&D customer. And with the trends in innovation where our customers are trying to go faster with each technology cycle, I think the contribution that we make with solutions gives us a higher value proposition with our customers.

In order to be early in these key technology trends, and you mentioned several already and be so exposed to R&D test. Maybe you could talk about how helpful it is to have your own semiconductor fab because I think that's a part of the innovation proposition you can bring to some of your customers?

Absolutely, Mark. I think we have long recognized that we're at the core of it, we're a systems company. We put hardware, software and expertise together, and that's the value proposition our customers are buying. And in order to make your own hardware, you have to have just enough silicon capabilities organically. And we're very fortunate since the times of HP to have invested in a fab technology, which is not state-of-the-art fab, which is more of a boutique fab, but gives us the ability to forward integrate where it makes a big difference in performance. And the advantage for speed is huge. We're not relying on, let's say, an external design house, we're able to organize our own design capabilities, giving our engineers the ability to lean in when our customers come to us with a challenge. And so to a large extent, having that capability in-house feeds into the hardware value proposition. That's why the gross margins across the business today are 66%, and we can continue to drive it higher.

I definitely want to cover the margin opportunity in a bit more depth later in the session. But I want to talk about orders as well, and you gave an update last week, I believe, when you guys reported. The company has seen a pullback along with the market. I think some weakness in communications infrastructure and semiconductor tests. And I think orders were down 15% year-on-year last quarter. Maybe you could help us dissect though in a bit more detail. What does the bookings trend look like in some of the more macro-sensitive areas like production test? And how is that trending relative to areas like software and R&D? And then any sense on when you think orders may be approaching the bottom?

It's a great question, Mark. I mean you take a big picture view and you say exiting COVID, obviously, was a downer for the market, but the market had 2 very strong years. And Keysight continue to outperform the market on both these years, gain share on the uptrend of the market. And so it's not totally surprising that we see a number of our clients pull back in response to their own earnings situation. What's a silver lining that is -- I don't know if I will call a bottom today, but the silver lining that we see is customers, as their earnings have improved, come back and spend -- increase your spend level. So that's one favorable dynamic we saw in Q3 as well with customers. And no one wants to fall behind. Even in today's world, customers are committing to longer-range strategic programs because they don't want to short-change their innovation and competitiveness. And I think those things bode well for the recovery. What we, as a business, remain focused on is ensuring that the investments in R&D are well aligned with our customers' strategic direction. So that will capitalize on the market recovery. And history shows that whenever we've had pullbacks like this lasting 4 to 6 quarters on average, well, the climb back will always result in a stronger bounce back. And that's what we're focused on. As we continue to navigate the environment right now, and I think we're executing well in this tough macro environment.

You mentioned the very strong gross margins that the company has north of 60%. But in these sort of macroeconomic and market conditions that are a little bit tougher, we get the questions from investors about, has there been any incremental pricing pressure, sometimes that can persist if it does occur, maybe you talk a little bit about the pricing environment.

Yes, I think our customers in a tough environment, as you would expect them to be, they're pulling back on the levels of spend. So if they were in a lab environment in R&D, which is holding up better than the production environment where customers are pulling back on capital much more heavier. We see customers scaling back on some of their needs and just getting enough for now. So obviously, that is the constraint that we see right now. But as you see from the gross margins or differentiation in our portfolio continues to be strong, that maintains margins at a strong level, even in this environment.

Maybe we could focus a bit on the CSG business, in particular commercial communications, in particular, is about 45% of Keysight's total revenue. Kailash, I thought perhaps you could give us a bit more sense within commercial communications, how does that split between wireless and wireline applications?

Yes. Thanks, Mark. This is a pretty important part of our business, a very sizable between -- and it's grown in the high single digits, going all the way back to 2015, this is organic growth that this business has exhibited obviously driven a lot by 5G. The business roughly split 50-50 between wireless and wireline. In the wireless part of the business, we deal with silicon vendors, chipset makers. That's where all of the innovation starts. Device makers, contract manufacturers that support the device makers, mobile network operators. This is in the certification and test labs. These are the base station vendors. This is the ecosystem. This is an industry that serves the wireless segment. And clearly, we've seen a lot of growth due to 5G in that segment. But it's also noncellular communications with WiFi and other types of technologies, ORAN now is a tailwind and is a growth driver in that segment as well. On the wireline side, we primarily deal with network equipment makers like the Ciscos and the Junipers of the world. Security companies like the Palo Alto Networks, also networking silicon vendors like the Marvells and the Broadcoms and of course, webscalers and cloud service providers.

Maybe we could double click on the networking piece of your business. There's a lot of enthusiasm and investment taking place at the moment in AI, Keysight has some test products in the past for things like 200 gigabit and 400 gigabit, but I think increasingly 800 gigabit and eventually, even 1.6 terabits. So maybe you could talk a little bit around what your products do. How does that change as you go to those higher speeds? And does AI catalyze some increased investment in those areas?

Yes. We're excited about AI, and it is a growth driver for us in the long term, and we think this is a multiyear, decade-long opportunity, right? You think about what has happened that's driving AIML. It's availability of big data. It's availability of all the sophisticated algorithms. And now most recently with ChatGPT and these types of things, it's the democratization of AI tools that's now available for everybody to monetize. So all of the verticals can take advantage of this AIML. So that's driving a lot of data explosion throughout the networks. It's starting largely in data center and cloud networks. And you can imagine that customers now have to do their computation in a very rapid fashion. You've got compute capabilities aggregate -- disaggregated throughout the network. So you need to connect those compute capabilities with high-speed links. You have to connect memory -- disaggregated memory and storage devices through these high-speed links. You have to drive for a low latency. And this is what's driving expansion in 400G and 800G. It's largely within data centers and hyperscalers now, but we think that, that's going to continue to expand towards the edge of the network. So you have enterprise AI where people are going to put AI capabilities on on-prem data centers. And that's another growth driver longer term for us, right? So we're seeing expansion both in -- we're going to be seeing expansion both in 400G and 800G driven by AIML.

And for a customer that wants to do that kind of test, is it an all-new set of equipment they need, both hardware and software? Is it software upgrades? Maybe just talk about how the product set changes as you move up those different speeds.

Yes. So let me maybe back up a second. For AIML, we would participate in a few different vectors, right? You look at -- it starts with silicon and chipset technology. So we have exposure to -- in our semi business, we have exposure to sub-5-nanometer technologies. Most of the GPU technologies require that type of a smaller node size capability. So we get exposure there to our wafer acceptance test. And there's also a lot of chipset-based functional test that comes as a result of AIML. So at the silicon level, you see silicon photonics, you see Universal Chiplet interface, these types of capabilities leading to more functional chip design capabilities. So that's 1 vector. Those are expansion to what we have, and it also provides us opportunity to drive new solutions into that space, particularly chipset functional space. The second vector is you're going to see more AIML accelerators and server cards. This is both for data centers as well as for the Edge. This would lead to expansion in functional and workflow solutions for those customers, and also create an expansion in our contract manufacturer ODM business, right? So that's sort of the second vector. And then the third vector is what I talked about earlier, where you have a disaggregated set of compute and memory nodes and you have protocols like CXL, Compute Express Link that connects all of these resources together creating additional opportunities for us. 400G, 800G and testing protocols like the Gen 6, Gen 7, these are all new solutions. It's going to require the ecosystem to upgrade their capabilities for this, right? And finally, there's a lot of benchmarking tools that the industry now requires. Customer conversations indicate today that the only way they test performance of AIML workloads is by building a network. They have to build a network to determine the performance, latency performance or speed performance. And that's something that we can provide capabilities for by allowing them to model that within their lab and a lot of emulation and simulation solutions are possible that we're working with key customers on that's exciting for us.

So maybe just to add one more technology that it's not directly associated with AI, perhaps, but is one of those enabling technologies to watch for is quantum computing. And you might remember, we did discuss it at one of our Investor Days and started to see that as a long-term opportunity. And we continue to grow that business every year, including this year as research spend across many nations of the world are starting to build more, let's say, a nationwide research focus on quantum computing as an enabler for AI.

Lots of exciting stuff and a lot of hard work ahead for all of your engineers to develop these products and bring them to market. In terms of your wireline business other than for data center, you spoke about some other -- the broader ecosystem, but things like maybe long haul, any other areas that maybe you can speak to and any key catalysts on the horizon that we should be keeping in mind?

Yes. We think about our wireline business as business that impacts data centers, which we just talked about in AIML is a driver. And then you have these data center interconnects, which is really about connecting data centers separated by over 100 kilometers. And then you have a long haul. So this is sort of how we view the business. So with the data center interconnects, I think we're really seeing the driver, there is transceivers, coherent transceivers. So you have this quadrature amplitude modulation, which is a little different from what you see within data centers, which is mostly pulse amplitude modulation. So the challenges are a little different because you have to maintain the data speed over a longer distance. And the test challenges, the cost per bit challenges, the energy consumption per bit and the data rate per bit brings in an increased amount of challenges that we support with. Customers are trying to make their digital -- DSP algorithms more efficient. Keysight is the only company that can emulate these DSP algorithms for these types of customers. So we're excited to be participating in that. AIML is a driver, but also just traditional data center and data bandwidth explosion moving all the way to the Edge is another driver. In the long-haul photonic side is also exciting. Nobody wants to put more fiberoptic cables, very expensive. So the focus is really on proprietary solutions that increase the number of bits and the data rate per bit. So you're always trying to squeeze more bandwidth from the existing fiber, and we're the only company that can provide greater than 80 gigahertz bandwidth solutions for this market. So those are -- there, you have the traditional drivers of data rate explosion and the new drivers like AIML helping.

Very interesting. Maybe we can turn to wireless. And perhaps you can give us a sense of where you think 5G spend will go from here and what some of the key drivers of future 5G investment may be?

Look, I mean we're excited about where 5G has taken us through its journey. You look at where the world is today, 250 networks more or less are 5G ready. There are about 1 billion subscribers. Most of them are in China. And reports would have it that 5G covers about 30% of the world's population. But we all know that when we go out, it's not like you're getting very strong 5G signals and quality of service. So there's still -- we're still in the early stages, right? So we're seeing networks go from 250 to 700-odd, subscribers going from 1 billion to 5 billion in the next 3 to 5 years. So there is still a lot of deployment out there. And when consumers increase their subscription, when the number of consumers with 5G subscriptions go up, these networks are going to get exercised. They're going to get stressed. And that's going to cause operators to spend more money to develop and optimize those networks. So that's one side of the picture that we see. The second thing is standards continue to progress. We're now in the middle of Release 17. Release 15 is what's been broadly commercialized. Release 17 focuses on new capabilities like industrial IoT, private enterprises, non-terrestrial networks. We see Release 18 coming up, which would focus on a multi-SIM technologies, network optimizations, energy savings, both on the device side and the network side. So there's a lot of focus on Release 18 and Release 19 is coming up in the '25 range, where AIML is going to become part of the network, leading all the way into 6G. So there's standards progression, and then that's a driver. And then the -- and this is where we see R&D activities with our customers, right, long-range R&D programs that Satish touched on. we're seeing a lot of activity. And this verticalization of 5G and other networks outside of smartphones, I think that's a growth driver that's ahead of us. These industries like industrial networks, they're new to cellular technology. So it takes a little bit longer to mature relative to the 5G for smartphones. So those are the things that we're looking at.

Also it might be helpful to watch for millimeter wave inflections if that adoption happens because that's still largely in front of us.

I was listening to the Ericsson presentation a couple of hours ago, their CTO is here. He made some very similar comments and the majority of the network still not being 5G capable. I promised you some difficult questions, and so I will live up to that promise. And so that's on 6G, and when do you think that will become more meaningful?

Well, we're already seeing investment in 6G. It is early. It's early stages, and we're seeing research dollars primarily from research institutes, universities, some commercial customers, right? And Satish talked about this earlier. These technology innovations are longer term, so they go concurrently with the current generation of technology. So while there is 5G deployments that's going to continue, there's standards progression of 5G, 6G research is already underway. We're enabling a few dozen customer collaborations. We -- 6G is a technology that's far bigger than wireless. So it touches wireless, but it's wireline, high-performance computing, satellite networks, cybersecurity. The scope of 6G is so broad that we're excited by it, and we're also looking to see how we sustain our 5G leadership going into 6G. I'd say we're still a couple of few years out in terms of this becoming a meaningful portion of our business, but we're already seeing some business today.

Maybe one that's a little bit more meaningful, though, in the near term, Open RAN. You alluded to it a little bit, but how meaningful is that for your business?

It's meaningful today. It's one of those exciting things that we didn't -- we anticipated back in 2018, we became part of the ORAN alliance, but it has surprised us in terms of how sustainable this has been. It is a -- we believe that it's going to be secular growing in through the rest of the decade. So when you think about ORAN, clearly, a vertically integrated base station is getting disaggregated. A lot of different pieces now have to be put back together and that's software pieces as well as hardware components. So it's bringing in a newer set of customers. It's bringing in a lot of system integrators. It's bringing in software customers. We recently demonstrated our RIC, which is artificial intelligence-driven RAN functions with Juniper Networks. We have demonstrated energy savings. This is a focus in ORAM, cybersecurity, energy savings, load balancing and interoperability. So generally, looking at these dimensions, there's a lot for the industry to learn about ORAN and with a number of players expanding, we're in a good position to take advantage of that. But it's a longer-term driver, and it's a good alternative for vertically integrated base stations.

Maybe switch gears a little bit to aerospace and defense. I think it's about 20% to 25% of the company's total revenue. Can you just give us a sense of the breadth of that business? Is it driven by 1 or 2 big military programs? Or is it more diversified? And how do you see that business progressing over time?

You think about aerospace and defense business, about 50% to 60% of the business comes from direct government spend and prime contractors. That's -- I'm speaking globally. There are multiple defense programs. It's not 1 or 2 big programs. We do get exposure to tens of programs. And then there is also reprogramming involved when we sell -- when the U.S. sells capabilities to other nations are prime sell to other allied nations like South Korea, Japan and Europe. So that's about, I'd say, 55%-ish of the business. There is still about 45% of the business that comes from the supply chain and research activities. So the aerospace defense business is fairly diversified. You've got electromagnetic spectrum operations, that's the market segment that's growing, driven by different modernization, increasing RDT&E budgets in the U.S. as well as in other nations. You've got -- even in the U.S., there's a call for nuclear-based recapitalization. These are initiatives that drive business for us. Patent satellite is a -- it's been a traditional stable factor for us. But now with the LEO and commercial satellites, governments are trying to figure out how legacy satellite networks are going to interoperate with commercial networks. There's a lot of spend there, definitely space exploration. So there's -- that brings in another level of diversity. And then 5G, 6G is being studied very actively because it brings in new modulation schemes. It allows for more customization. These are new communication technologies that can be applied to aerospace defense applications. So it's pretty diverse.

I think, Mark, the 1 other point I'll make to add to Kailash's point is what we're seeing now, given the geopolitical dynamic is bipartisan support for budgets in the United States, which is great, right? I think this is a business that's been a peg on GDP for a long time as a market basket for Keysight. But even more importantly, the focus on RDT&E, research and development, test and evaluation budgets is highest that I've ever seen. So I think the focus on these new technology development and enablement activities in the U.S. and Western nations was good. I was just in Japan. I think they've announced that they want to double the defense budgets in the next 5 years. Again, we all hear about stuff that's going on in South China Sea and all the stuff. So I think given the situation, the investments in technology are poised to grow, and that's why we took up the long-term growth rate for that market from 2 to 3 to 3 to 4, and we continue to have a portfolio that will outgrow it. What's also important at Keysight is we've diversified the business from comps to aerospace defense focus to industrial end markets, and we get considerable leverage in our R&D spend across all of these end markets. So at the core of it, we serve an electrical engineer or software engineer. And a large part of what we do at the R&D level is common mode to serve all these customers.

It sounds nicely something I wanted to speak next on Satish, which is the EISG segment. And I think there's some technology synergies with what you guys do for EV and ADAS testing and some of the signals and radar that perhaps is similar to aerospace and defense and comms. How big is automotive test for Keysight? And how do you see that business growing?

Yes. Last year, I think we said publicly automotive was one of the smaller segments in the ISG but hit $500 million or $0.5 billion threshold. And this is again a business where we had almost no exposure and when Keysight was formed in 2014. So it's been a newer expansion opportunity for us. And I would say that 1/3 of the business is in manufacturing as electronics content is increasing, that business continues to grow as more and more EV and AV capabilities become part of the automotive car. I think that continues to grow. But the 2/3 of the business is all about enabling the innovations that are happening with batteries and innovations that are happening with autonomous vehicles. So that's the focus right now. And if you look at all of the giga factories that are coming onboard across the globe, we have had several key wins this year with a number of these automakers that are setting up their own battery test facilities. And these are large integration projects that we're very pleased by. But equally, the long-term trend there is for automakers to not just rely on their contractors to provide them capability, but their own -- hiring their own electrical engineering pool, setting up their own labs. I think as they start to see that software and electronics becomes a bigger part of the differentiation, we'll continue to see increasing content of Keysight become more relevant to that customer base. So again, well positioned there. But we call it automotive and energy because we see a common set of solutions that go into battery for an automotive application become relevant to as people go and upsize into trucks and potentially into other form factors. All of this feeding that energy and sustainability trend that I think is a megatrend for the next decade, given our focus on climate change.

No, it's super interesting. I think a lot of growth ahead there. In terms of the semiconductor business, you guys touched about how you're tied to some of the advanced development that occurs 5-nanometer, 3-nanometer. Is that more new line with that drive spending? Or is it more tied to new fab build-outs?

Yes, what we're seeing is, obviously, a very highly optimized ecosystem from our wafer and fabs. Now every country around the world wants to have some capacity. And I think that's where it will end up being is some capacity that's more regionally located. That capacity expansion is a positive dynamic for our business. And concurrent with that is this shift towards more slow progression from 7 to 5 to 3. And as you go from 7-nanometer to 2-nanometer, I've seen reports where the spend levels for a design is 5x in some cases that our customers have to put in. So the complexity of moving from 7 to 2 is exponentially higher, the cost points are higher. The number of measurements that our customers need, the high-precision measurements they need are greater as they've gone through. So the capacity needs there have increased. We're also equally excited by the new material progressions that are happening, whether it's silicon photonics that Kailash spoke about for AI applications or silicon carbide for high-power applications in energy and automotive, all of those are driving up the demand. And as we speak with customers, even as this near-term pullback has occurred and some of them have pulled back capacity, as you've seen from TSMC announced some pullback there. We see continued investments or discussions with them on the next-generation technology needs. The industry appears to be solely focused on this $1 trillion milestone that future state is going to be, given all these trends that I laid out. So we have a highly differentiated position, still 10% of our total revenues today, but we're well positioned to capitalize on the rebound and this trend for the next 5 years.

I can keep going, but we've got a few minutes left. I want to see if anyone in the audience has a question for the Keysight team.

[indiscernible].

Yes. I think one of the things -- that's a great question. It's more around the order -- near-term order recovery picture, what might be there. And I think, as I stated before, historically, whenever we've had order pullbacks of this sort of magnitude have lasted 4 to 6 quarters on average. So that's one data point that we look at. Obviously, we watch global PMI activity. We watch the semiconductor index to see how our clients are doing. And just as the inventory levels in smartphone and consumer devices come down, and the health of our customers' businesses improve, that's a sure signal for the rebound that we're expecting.

I guess one other hand, otherwise I can ask. Yes. Okay. Okay.

[indiscernible] quarters time period, are we in quarter 2 or 3 are where are we right now?

Well, so far, I think we've had 3 quarters of double-digit order decline.

Yes, one more.

[indiscernible].

Yes. I mean, I think that's definitely something that you mentioned is the bear case thesis, I suppose. But I think we look at the company's focus on next-generation technology waves across both wireless, wireline, we look at or focus on EV and AV and automotive. We look at defense modernization. We're a much more diversified company than what most people believe. And in having discussions with our customers, even in this environment right now, they're continuing to pull the trigger on long-range strategic programs. Nobody wants to fall behind in the world of technology. And I think I'm of a -- and we are of a belief at Keysight that technology is going to be a bigger driver of GDP moving forward. And the application of electronics and software technology will play a bigger role in advancing a lot of these megatrends. So I view our contribution to be greater and therefore, believe that once this current near-term economic situation recedes, you'll start to see a return to normalized levels of market growth, which would in turn -- and we're well positioned to capitalize on that.

[indiscernible].

We've looked at the long-term growth rates in our market. We feel really good about them. And I think if you let this play out, I think we'll get back to those growth rates. And -- we remain confident in Keysight's ability to outgrow the market and grow at the 5% to 7% growth rate that we've committed to.

All right. Well, thank you, everybody, for taking the time for the session. Satish, Kailash, I really appreciate you both joining us and taking the questions, and we'll have to end it there.

Thank you, Mark. Thank you.

Thank you, Mark. Thank you.