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

Good afternoon, everyone. Welcome to day 1 of Citi Global Technology Conference. My name is Atif Malik. I cover U.S. semiconductor, semiconductor equipment as well as communication equipment stocks here at Citi. It's my pleasure to welcome Neil Dougherty, CFO, Keysight Technologies. Also, we have Jason Kary, VP of Treasury and IR, in the audience. I'm going to kick it off with my questions first, and then we'll open up to your questions in the middle. If you have a question, please raise your hand and the mic will come to you and you can ask your question. Welcome, Neil.

Thank you.

Neil, I'm going to start with your Commercial Communications business that seems to get a lot more attention from investors, primarily based on the success that you've had in terms of the 5G rollout historically. So if you can talk about how do you see the demand profile and the recovery of your commercial communications business playing out over the near term and into next year?

Yes. So obviously, we've seen a little bit of a disruption in demand within commercial comms brought around by the end of the supply chain disruptions of last year, a little bit of an inventory go up within the industry, which has caused some pause in investment over the first 3 quarters of this fiscal year. I think as the industry works through, those inventory dynamics and there's -- investment is going to return, there's multiple revs of the 5G standard that are still to come. Most of the deployments that are -- that we're all operating on today are based on REV 15 of the standard. But from an R&D perspective, we're currently working on REV 17 of the standard, things like nonterrestrial networks, Open Ran private networks are the things that are driving investment today. And then as we look forward to future REVS and standard REV 18, for example, it's going to be how do you improve the power usage of the standard in or things are going to be included in that next rev. And so there's some short-term industry dynamics that are in play at the moment, but I think the long-term road map and the long-term need to continue to invest in R&D in 5G is there, and we'll return the industry back to growth.

Great. And could you delineate between wired versus wireless business? And where are you seeing investment today and going forward?

Yes. So I mean, I think at the margin today, the wireline side of the business is incrementally stronger than wireless. I think AI/ML obviously being a key driver of demand right now within the network. And so as you think about that, we are seeing the deployment of 800 gigabit, the R&D work on 1.6 terabit, and Keysight is working to enable both of those transitions, we're working with hyperscalers and those that are working on AI/ML learning models to help them optimize their network architectures so that they run more efficiently, ultimately reducing the amount of capital that needs to be invested in these networks. And so there are a number of different plays within our network test business that are driving relatively incrementally strength on the wireline side. On the wireless side, we've talked about some of the dynamics there already. But again, the business is predominantly focused on R&D. We're looking at those future revs of the standard and the incremental work that is happening in stand-alone 5G millimeter wave, Open Ran to drive waves of investment moving forward. And then, of course, early 60 research has already begun predominantly right now focused in university research labs, governments, a few leading -- market-leading customers have our early 60 research programs underway as well.

Great. And one of the reasons we like your stock is because you have a lot of stickiness in helping your customers do their R&D. And I think that came out in the earnings as well that the strength in the R&D business held up better than manufacturing. What are some of the other areas or end markets where you're seeing some pull relative to further end markets in terms of helping them out in the R&D side? You mentioned 6G being one of them.

Yes. I mean we've just talked about wireless and wireline markets. And in both of those cases, obviously, where we have a strong R&D bias. Moving out of the comm space, the next area that comes to mind is in the auto space, where we're helping auto OEMs, Tier 1 suppliers to the auto industry with both AV and EV applications. The bigger market driver today is current EV. We're helping, essentially helping customers build better batteries, right? How do they extend the range of an individual battery, how do they extend the life of the battery through more charge dissipation cycles, how do they improve the performance of the battery in different environmental cycles, circumstances, extreme cold, extreme heat, extreme humidity, those types of those types of situations, are all being worked in the industry focused on, again, building better batteries. As we look forward, it's really the AV side of things, autonomous driving, that we expect to become a bigger driver of our business. How is autonomous driving going to be achieved is really going to be achieved through a convergence of multiple communications technologies, wireless standards like 4G and 5G, WiFi, Bluetooth. There'll be a land network in the vehicle, which brings security implications in to play, and then a complex network of RADAR and LiDAR sensors, right? And these are all areas where Keysight has expertise, and so we'll be in a unique position to help that industry as they work to move towards higher levels of autonomous driving because of the breadth of our portfolio and our ability to bring multiple technologies to play.

Great. And then just going back to the 6G, there's a perception among investors that 5G investment cycle has peaked, and we're coming down, and -- but when we look at what you guys do, you guys still are quite involved in the 5G rollout. If you can help us understand which innings are we in terms of the 5G rollout? And what should investors be looking at for early signs of kind of 6G adoption? Should we be looking at white papers from Qualcomm? Or what are the kind of milestones we should be looking at?

Yes. I mean I think it's a really interesting question. And I think the important point is that these are very long cycles, right? We still have a 4G business that's measured in the hundreds of millions of dollars predominantly in R&D, right? And so if I was going to put innings, I'd say we're mid-innings, I guess, I'd say in terms of the 5G rollout. I've talked about some of the things that are currently driving R&D investments, stand-alone 5G, millimeter wave, private networks, nonterrestrial networks, 5G.Mil, O-RAN, there's a lot of development that still has to happen, and we're just talking about Rev17 of the standard. You don't get to 60, at least as currently envisioned til Rev 21 of the standard. So there's multiple additional ways you're going to -- putting it into the lingo prior generations, of advanced 5G or 3.9G, right? These versions of 5G development are still ahead of us.

Okay. Can you comment on your market share in 5G, I know the market is fragmented? It's difficult to gather this data, third party. But if you can comment on what is your share for testing of 5G standards and if you're seeing any opportunities to grow that share into 6G.

Yes. I mean, I think we've clearly have taken share during the cycle relative to Keysight's performance in prior cycles. But at the same time, via M&A and organic investment, we've also expanded the SAM and the portion of the market that we're going after. So while our share on one hand is -- has increased incrementally, I think it probably undervalues our success in the marketplace because we have redefined the market that we're going after, right? So again, I think we've been very successful in winning the market makers of 5G, providing that complete solution, both in the physical layer where his Keysight's has historically been strong, all the way up to the protocol layers, which we access via our acquisition of Anite, which took place back in 2015 or 2016. That allowed us to access that portion of the market.

Okay. And Neil, on your last earnings call, management commented on increasing demand for longer-term strategic customer projects. How do these commitments differ from Keysight's, typical projects? And what is the advantage to the customer with these longer term agreements?

Yes. So I do think this is one of the things that was maybe misunderstood on the call, right? So people seem to think take away from the call that we actually had short-dated projects that were being pushed out, and that's not what we were talking about at all. We were actually taking these more complex, longer-term projects on behalf of our customers. And I think the best example would be the one that Mark Wallace has tried to explain on the call itself is in the auto space where, in many cases, auto OEMs are actually looking to Keysight to essentially build them battery test lab, if you will. And so they would hand us essentially an empty facility and look to Keysight to, at the end of a project, essentially hand them a lab that has been completed. A lot of that content is Keysight's, but some of it is not. But we'd come in and we do all the electrical, all of the cooling that's required, put in the environmental chambers that are necessary to test these batteries under a variety of economic conditions. And these can be programs that take us well in excess of 12 months, 12, 18 months to execute. And so the advantage obviously to the customers, they have somebody who has expertise in this space that is developing the lab on their behalf. The advantage at Keysight is that we get we build a very intimate relationship with auto OEMs around a core part of their development program, and it's the start of a long-term relationship. And just in the auto space, we have won opportunities like this with 3 new auto OEMs this fiscal year alone. So we've actually seen very strong growth in this portion of our business. We do these types of long-dated projects in the semi space. We do them in the auto space, which is the example that I've just given and also for some of our aerospace defense customers as well.

Great. And there were 2 areas of surprises on the last earnings call, one being the deterioration of demand in China and other being pushouts in semis. Could you elaborate on these 2 areas and the change in customer behavior?

Yes, I think the two are linked, right? I think as you think about the what changed for us in Q3 and the incremental weakness we saw in the quarter, there are 2 lenses that you can look through it -- look at that through. The first would be a geographic lens where that incremental weakness was largely concentrated in Asia, China specifically, but also some incremental weakness in Japan. And what we saw is from an industry perspective, we -- the delays in putting semiconductor capacity in place are -- in China and other places are well established at this point. I think as the supply chain situation has resolved itself, the broader electronics supply chain, if you will, now is at a point where they're no longer adding capacity at the rate that they were last year. And so we've seen a pullback in that roughly 30% of our business that was manufacturing, it tends to be more focused in our electronic industrial businesses and tends to be, again, more focused in China. And so there's that geographic lens. I think if you look at it through a business-specific lens, it's tended to be focused again on our electronic industrial business, the general electronics business where this manufacturing pullback was realized. And of course, our semi business is managed out of electronic industrial as well. And so I think there's two different lenses to which to view the same problem.

And how do you see these 2 businesses kind of shape into the first half of next year?

Yes. I think China is admittedly a big unknown. I think just broadly speaking, industries were hopeful that when the Zero COVID policies were lifted in China, we would see a boost from economic activity in the region. And actually, what we've got in the short run is the opposite of that, right? There's some significant challenges right now with the China economy. So we'll be watching the actions of the local government and the local economy here over the short run and see whether or not that can turn and become a catalyst for growth. I think on the semi side, the good news there is what you're seeing is delay in programs but not cancellation in programs. Most of these big fab programs are continuing to move forward. I think most in the industry are again pointing to the back half of calendar '24 as a likely time frame for construction and for spending to reramp.

And then the EV and AV, all the comments we heard at the conference, it sounds like it remains kind of a bright spot in terms of demand. Are you guys seeing the same thing? And how big are these areas within your EISG business?

Yes. So we sized our automotive business on the order line. In FY '22, we eclipsed $500 million for the first time. Admittedly, there was, because of the supply chain, there was a reasonable gap between orders and revenue. So revenues were lower, but $500 million in orders in FY '22, we have continued to see very nice growth in the AV and EV portions of that business. There is about 30% of our auto business. It is tied to manufacturing. And what we do in the manufacturing space in automotive is actually we're testing electronic control units. It's a board test business. And so we're testing of electronics that goes into these vehicles and that can be into an internal combustion vehicle or into an electric vehicle. But in the R&D lab, the focus is on electrification of the drivetrain and the move towards higher levels of autonomous driving. And those areas have been quite strong this year.

Great. And then AI has been a big topic among investors this whole year. And can you talk about how your products can address the AI machine learning opportunity and how fast could this be market for you guys?

Yes. I think there's a number of different areas where we potentially will benefit from the push to AI/ML. So first of all, I started at the beginning -- these complex AI chips are going to require smaller process architectures out of the foundries, the 2- and 3-nanometer process architectures. And certainly, we're going to participate in the build-out of that higher end process node capacity of VR semiconductor business. And then all of that silicon is going to need to be designed. So if you think about the folks that are designing, that semiconductor content to enable AI/ML, we are a provider to them of tools as well. And then the place where we're seeing most of the development -- or most of the investment taking place today is within the network itself. And so again, I touched on this a little bit earlier. The question that the hyperscalers are trying to answer is how do they make their networks as efficiently -- as efficient as possible so that they can accelerate the learning of their learning algorithms and reduce the amount of capital that they need to invest in their networks. And Keysight through, again, our physical layer tools and our protocol layer tools is helping to optimize the performance of these networks.

And then we often get asked on the competitive landscape. There are major share shifts happening and also help us understand where Anritsu or Rohde & Schwarz some of these guys play and where you guys play?

Yes. I don't think there's been a real significant change to the competitive environment in this recent macroeconomic environment. I think we believe that particularly relative to the 2 names you just mentioned, who are big players in the commercial comp space that we have been a net share gainer during the 5G cycle. And as we look forward to 6G, Keysight is focused on making sure that we're making the investments that are necessary to sustain the leadership position that we have achieved here during this period of time. I think if you look more broadly at the competitors, similarly, it gets to be fragmented after that point in time. But generally speaking, I think if you go and you compare Keysight's results to the broader competition, we've tended to outgrow them even in this down environment.

Great. And let me pause here and see if there are any questions in the audience. If you have a question, please raise your hand.

It's all you.

All right. In June, you guys announced the acquisition of ESI Group, a software prototyping company. What are some of the key highlights regarding the acquisition? And do you expect the business to accelerate Keysight's growth in auto?

Yes. So Keysight has had an interest in engineering software tools. For quite some time, this is one of the market expansion opportunities that Satish discussed at our Analyst Day back in March. And it's already a space in which we have some presence. We have an EDA business that's focused on the RF and microwave portions of the communications network and have a leadership position there. So we're looking for other opportunities for Keysight to participate in this engineering software tools market. And the thing that we liked about ESI, obviously, engineering software tools, but focused in markets where we're already -- where Keysight is already focused. The primary focus is in the automotive space, but with the secondary focus in aerospace defense. Obviously, 2 important verticals for us. And so we see as an opportunity not only to add significant software resources to our current auto product portfolio, but as you suggested, over time, we do expect that this will be accretive to growth. We believe that there are opportunities within ESI's existing markets as well as opportunities for Keysight to leverage its spans sales force. It's reach into aerospace defense to potentially give ESI product to visibility that they have not been able to achieve on their own. And so we're very encouraged. We look forward to getting the transaction closed beginning the integration process and beginning to drive value creation.

Okay. Moving to the model. When we looked at you guys during our initiation process, we were actually surprised that your gross margins are actually right behind some of the leaders in semiconductor industry like Broadcom and so I'm very high stickiness to what you guys do on a lab level. But if you can just kind of walk us through the disruption that the COVID and the supply chain went through over the last 2, 3 years. Are you kind of half the normalization stage from the disruption? Or is there a room for margins to improve as you guys kind of catch up to the normal times?

Yes, there's a lot in that question. So obviously, Keysight has been on a pretty aggressive ramp of expanding both gross and operating margins about -- adding about 1,000 basis points since our spin back in 2014. It's through a combination of increased software content moving from selling kind of tools to our customers to selling them complete solutions that address specific challenges that the industries that we serve are trying to solve. And through that increased value add, we've been able to increase the value delivery that we gave and monetize that value. I think during COVID and the subsequent supply chain disruption, there were an inflationary elements, right? I think there, we've seen input costs go up certainly. And in the case of the supply chain disruptions at points in time where we're having to reliant third-party brokers to get key components to continue delivering to customers, sometimes at pretty extraordinary markup. So I think the good news is that through that supply chain disruption, we were able to maintain gross margins at approximately 65%. I think we were able to do a very good job of getting product into the hands of our customers on a timeline that was acceptable. Did we see lead times extend? Absolutely, we did. But we saw our lead times extend weeks, not 6, 8 weeks, not the kinds of multiple month lead times that many in the industry saw. So when you're talking about a few weeks extension of lead times, that's something that your customers can plan for and respond to. And I think we saw that benefit in not only the margins that we were able to sustain but in the customer retention that we were able to drive through that period of time. I think now that we're coming out of that, our lead times have largely normalized. At this point, I view with a few corona case exceptions that are still out there. The supply chain disruptions are largely behind us at this point. But we do believe that there continue to be opportunities for Keysight to continue to expand gross and operating margins. I think we continue to grow software revenues at a rate that's above the company average. We continue to migrate more and more proportions of our portfolio to full solutions. I think where Keysight really differentiates ourselves are at the high end of technology when the problems are the hardest, and obviously, when you're solving those kinds of problems, you're bringing unique value to our customers and can monetize that value. And so we do believe that there are opportunities for us going forward, and we just need to continue to execute, continue to expand our first-to-market strategy and enabling our customers' time to market.

And what are the key drivers for the software revenue growth for you guys, the new business?

Yes, there's no one answer because we do a number of different things in software. I think if you think historically, if you go back far enough, there wasn't a lot of software attached to Keysight instrumentation. But as we've pivoted the question from kind of seeing ourselves as somebody who sold tools to trying to offer our customers more complete solutions that are addressing specific needs of the industries that we serve, much more of our software now goes out with attached software as part of the sale. So whether that's specific applications that run on the instrument or in the case of 5G in our ability to now provide our customers with a complete 5G protocol stack that if you're a device or a modem manufacturer will emulate the network. And if you're a network equipment manufacturer, will emulate data traffic. And so, is that portion of software is very much linked to our hardware and solution sales. I think through M&A, we've also entered into more pure software markets, the Eggplant acquisition of a couple of years back, which uses software to test software user interfaces. The recent ESI acquisition, again, doing simulations in the auto space are going to be, are going to have a different unique set of drivers because they're decoupled from Keysight hardware. We have a question over here.

So as Atif said, we have a very enviable track record both on execution and on margin improvement. So my question, as I look at your business, and funny, every time I go to your website, you have 1,000 businesses, like a lot of them have moved together, but there's a lot of different end markets, different drivers, both like managed herding cats, like you're managing around the business. When you think about Keysight over the last few years one of the hallmark is, most of those cats are going in the right direction. Just a lot of secular drivers and a lot of things. It seems like they are a little bit of a rough patch, something that is -- you came out a period of [ COVID ] that long backlog, normalizing quite -- so trying to understand the drivers at Keysight going into 2025, can you just help -- I'm trying to think the right way to ask it like if you were giving grade like what divisions are an A, a B or a C, what needs attention to the turn around versus what just kind of looked at the cyclical thing that it'll fix itself. So how do you fix the error?

Yes. So I think there's really 2 sides to that story. There's the immediate time frame and then there's the longer term. And I think the overarching message would -- there's some short term challenges in our markets, but the long-term secular drivers across a broad range of our industries remain intact, and we remain really very bullish around the long term. So if you think about the short term, I think our aerospace, defense and auto markets driven by AV and EV have continued to be strong, whereas semi commercial communications and general electronics right now are experiencing a period of weakness. I think but as you look forward, and particularly over the long term, what are the long-term secular drivers that are going to drive these industries. And as we've already talked about with regard to commercial comms, there's multiple new revs of the 5G standard that are just still going to come out there that are going to drive ways of R&D there's upgrades on the wireline side from 400 gigabit to 800 gigabit to 1.6 terabit, not only driven by the traffic that comes from 5G, but driven by AI/ML. Aerospace defense budgets continue to grow. So that should remain positive. On the industrial side, the semi programs are pushing out. They're not being canceled, and so the move to smaller process architectures, the need to secure semiconductor supply and reinsure semiconductor production is going to continue. In the automotive markets, the continued investment in electric vehicles with the support of government regulation driving the need to wean ourselves off of internal combustion vehicles will be a tailwind. And then in general electronics, I think there, it's probably a little bit more macro driven where you really are looking to a broad set of industries and you're looking for macro strength to really drive a broader recovery. But within that -- even within that general electronics business, there are submarkets that continue to be very strong. IoT, advanced research in the education markets, medtech. These are all areas that where we continue to look to drive growth, albeit small within that broader general electronics space.

I'll walk back to some [indiscernible] costing a larger acquisition, which didn't happen. Do you now look at this opportunity, particularly in some of these more cyclical areas where I don't know if valuations are depressed, but looks like they've come down. Do you -- I think maybe this is the time that Keysight should make a move or evaluations still continue to [indiscernible]?

Yes. I mean I do think that over the last, I don't know, 6 to 9 months, we've seen an increased, we've always had a large funnel of ideas, and I say it's a increasing number of those feel like they're becoming more actionable in the short to intermediate term. And I think we're going to continue to evaluate those opportunities, right? But I think we're going to stay disciplined with regard to our strategic and financial hurdles, make sure that we're not chasing people that have unrealistic value expectations and ensure that we can get a return on any investments that we make.

I just hope you go can back to the question on margins. Could you update us on what we're seeing [indiscernible]?

Yes. So I think the good news is the need to use third-party brokers is rapidly coming to an end, and so that has been a bit of a tailwind to margins here over the course of the last several quarters. I think the OEM suppliers of the components that go under [indiscernible] are continuing to raise prices. And so we want to make sure that we continue to keep pace and work to maintain margins, but we're confident in our ability to do so. We're confident in the differentiation of our portfolio. There's a question over here. Yes?

Can you talk a little bit about the capital structure? You've got 3x gross levers target out there, which feels a little stable gross leverage onetime in that cash-neutral position. Maybe just how are you going to [indiscernible] ESI? And how we should think about that kind of pushing on the leverage part going forward, maybe in context of larger M&A deals that are looking to focusing up commercial?

Yes. So we'll obviously fund ESI of cash on the balance sheet. We have the cash to do that. The 2 to 2.25x gross leverage target is still the target, but we do think of that over time, right? And there's going to be periods of time when you're operating like we are now at a place where we're operating significantly below the leverage target. But we want to make sure that we have the strategic flexibility and dry powder to make the investments that we see fit when the opportunities present themselves. I think ESI is a great example of that. And as we have done in the past, there have been points in time where you overlap the leverage target, right? When we did the ESI acquisition, we levered up to 3.5x and quickly brought leverage back down to the 2.25x target. So it's not the intent to always maintain leverage at 2.25x, but that is what we think is the right operating level over time. And I think right now, particularly in this down environment, we're enjoying having a little bit of a defensive balance sheet and dry powder to make whatever strategic decisions we deem appropriate.

And then just a follow-on on shareholder returns. And post are kind of ramp here over the past couple of years, how should we think about that going forward?

Yes. I mean, again, we have a commitment out there to at least be anti-dilutive with our buyback program, but you have seen us in the past be more aggressive with our opportunistic purchases, either as a function of dislocation in our own share price or the fact that M&A valuation expectations are out of reach, and it doesn't seem like things are actionable. I think in this current environment, we clearly have ample room in our authorization. I think from a capital allocation standpoint, though, first and foremost, we want to make sure we're making the organic investments that are necessary for us to fully participate in the upturn when it comes. And so you can expect us to keep our core R&D programs on track. We do have a robust funnel of opportunities via M&A, and we'll evaluate them appropriately. And again, if there are things that align with our strategic direction and allow us to get the -- meet our return hurdles, I don't think you'll see us hesitate to pull the trigger. But at the same time, I think there's been a dislocation in the stock price. We remain very bullish on Keysight's story over the long term. Admittedly, there's some short term challenges. And we'll assess that appropriately when assessing our return of capital approach here over the coming quarters.

Neil, one final one for me. I believe when you guys talked about your orders, you're expecting a rebound in fourth quarter. Is it that driven by seasonality?

Yes.

And then I think first half comments for next year were more muted. So help us understand how you're thinking about the orders?

Yes. So we did say that we do expect a sequential uptick from Q3 to Q4, although a smaller sequential uptick than we would typically see as driven by the current demand environment. So we do -- we are expecting things to be up sequentially, and then I think as you move into the first half of next year, I think at least we run a 6-month final process. So I think at least through Q1, the environment is likely to be challenging. We have put a stake in the ground to ground our expectation that by the second half of next year, we think there are numerous things that are lining up that would suggest that a return to growth in that period of time. I think there are scenarios where that pulls forward. I think there are scenarios where that pulls out -- pushes out. But I think the main point that I'd like to leave you with is that the long-term secular drivers across our industries remain strong. And while the specific timing of a return to growth may be challenging to call, we're fully confident in Keysight's ability to fully participate in that upswing when it comes, and then we've clearly exhibited our ability to turn growth into strong profit and cash flow generation. So we feel good about the position. Some short-term challenges admittedly, but over the medium to long term, I think the company is very well positioned.

Great. With that, we can wrap it up. We still have a few minutes if you want to come up and talk to Neil on any specific questions, you can do that. But Neil, thank you for coming to the Citi Conference.

Thank you.