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

Okay. Great. Thank you, everybody, for joining us. My name is Mark Delaney, and I cover Keysight for Goldman Sachs. And very pleased to have with us Satish Dhanasekaran, Keysight's President and CEO; and Neil Dougherty, the CFO. Thank you both for coming.

Pleasure to be here.

Thank you, Mark.

Satish, maybe to start a question for you. The company is a test and instrumentation provider of hardware and software with over half of its revenue tied to R&D processes at your customers. What has allowed Keysight to be such a key part of customer workflows in end markets like aerospace and defense, communications, auto and industrial?

Yes. Thanks, Mark, for that question. I think if you go back in history, I always refer to this business as an enduring business, it's been around for 80 years since its inception in HP as one of the founding businesses there. And one of the reasons it stayed as enduring is because technology keeps changing and evolving. And our customers need new tools. And we've always adapted to provide them the tools and adapted to the environment, which continues to give us opportunities to expand and grow. And as we were part of different corporations and we had limited ability to invest in our future, that changed as we spun off as Keysight and really focused on transforming the company from a hardware-centric products company for decades with great reputation and technological skills to becoming a software-centric solutions provider. And that unlock of value has been huge to date, and we continue to see even more opportunities to contribute to our customers because of technology transitions that are happening. I believe the rate of transitions are going to only accelerate I think of government investments in technology for owning organic IP in today's geopolitical landscape. I think that's another tailwind for the business. And I also think of different end markets and industries that we can apply our IP to and continue to grow and transform. So feel good about the strategy we have to be a bigger player in the R&D labs of our customers because that intrinsically makes us more resilient by giving us more software and recurring contributions to make to our customer base.

A cyclical question. After 6 consecutive quarters of year-on-year order declines, which is about the duration of historical downturns. This last quarter, orders were relatively flattish year-on-year. They were up 2% sequentially, as the second consecutive quarter where the book-to-bill was above 1. So what should investors take away from the orders that you reported last quarter and the history of this industry and what do they infer about the go-forward nature of the business?

We're quite encouraged by the strength in demand that we saw. But as I mentioned on the call, it's too early to call this a recovery at this point. And based on the dynamics that we see, progression in the funnel that we watch near term, we continue to believe that in the slow gradual recovery getting into 2025 because different end markets are in different places. So as an integrated view, we think the market returns to growth in '25, but it's probably a slow, gradual recovery.

Can you talk more around what you're hearing from customers and in terms of any differences by end market and region?

Yes. I think one of the things that as we peel through the first major downturn in the company's history and look at the business model, right? I think what we see is the diversification into aerospace defense has definitely been a stabilizer for the business because I think that has proven to be resilient -- more resilient to even CapEx cycles, clearly. Our ability to tap into data center capital is enabling us to recover now with AI. We hear from customers tremendous pull for enabling technologies in AI. We see this in our wireline business. But across our customer base in R&D, I think there is a higher level of curiosity on what AI can bring to our customer base. But more tactically, just probably where your questions were going we're starting to see some favorable funnel dynamics after a prolonged period where our customers were constrained and cautious. I think we're starting to see the interest level and engagement levels pick up and that conversion in quarter that we referenced starting to do it. Now, one quarter doesn't make a trend, but we'll look to see how this evolves over the next couple of quarters.

That's helpful. You mentioned, as you look out to fiscal '25 at this point, I realize it's still a bit early that you're expecting more of a gradual recovery. Company does have a 5% to 7% revenue CAGR target. So what do you think might have to happen for revenue to get back to that kind of 5% to 7% level?

Yes. We just look at our integrated view of our multiple end markets, and we say, look, our base case is for -- that we put out in our model at Investor Day is for our markets to grow 4% to 6%. And when our markets grow 4% to 6%, we remain confident in our ability to outperform the markets. And so that's sort of the coupling. And I continue to think that even in this slow gradual recovery scenario that we talk about, we'll be more than prepared to capitalize should the markets have a broader recovery quicker. And at this point, we're seeing strength in wireline. We talked about stability in our aerospace defense business, stability in wireless, and also some strength in semiconductor as the CapEx environment there looks better and some incremental weakness in auto. So you put it all in a blender and you say, that's how we came up with this slow gradual recovery thesis for '25. But the portfolio is in a very strong shape. Our customer collaborations have never been stronger. And when I think about the acquisitions that we have made with ESI and other areas, the expansion moves are well on its way.

Recurring software and services now make up about 30% of revenue, up from 21% at the 2023 Investor Day. With the company's exposure to R&D budgets and recurring software and services rising, what does that suggest about how cyclical your business will be going forward?

This has been the strategy all along, Mark, as we started to think about moving from this hardware company, products company for decades to transforming the business to software and solutions. And that's been a big shift and a big pivot. It's impacted our investment strategy, but also our organizational design. We're organized around our customers. That allows us to see where the puck is moving, anticipate and align with their needs. And it's not about one customer. We serve 30,000 customers. So we're able to really figure out the monetization strategy associated with our investments a lot better as we move forward. But the big part of this is how do we get into more secular spaces of our markets. And one of the big trends I see, and it's true is our customers' time to market imperative has never been higher. And I think this is something, I think, if I'm sitting here year after year, we're going to keep seeing that because even in the downturn, have not met customers in R&D lab saying, well, it's okay, let's take a little bit more time. While they've pulled back on their investment appetite in the near term, there are engagements around next-generation technologies and wanting to be first to market or wanting to have a differentiated position is higher. And Keysight's ability to service them with the breadth of portfolio we have, we are the best in our industry, and we'll continue to be the best in our industry. So as we add a higher R&D mix grow our gross margins by adding more software and recurring content, our goal is to make the company less cyclical. And if you think about '08, '09 as the big example when maybe we were down 30-some percent on the top line, at the recent Investor Day, based on the composition of the business today, Neil outlined a negative 10% revenue scenario as part of the modeling we've done and the business is currently performing to that.

Longer-dated orders are now a high single-digit percent of the total. Why is this occurring? And do you think this is the level that longer-dated orders mix will normalize at?

Yes. I think we're seeing our customers look to sustain some of their longer-dated programs even as they're getting a little bit more cautious with more immediate-term things they want to keep those longer-dated programs on track. So I think it's shifted as a percentage of the mix over the course of the last 1.5 years or so. I think as we look forward, there'll probably be some normalization or mean reversion as the core parts of our business start to recover. But it's -- I think it's positive that we see these customers continue to keep those long-dated programs on track because I think it gets the confidence in the longer-term secular trends that are driving our end markets.

Emulation and simulation are areas that Keysight is looking to expand into. And you've already made some efforts in that end market. Can you speak more on how big that market might be? And as you shift more of your business into that type of application, what would that mean for how much of your revenue is coming from R&D and recurring products?

Yes. I think it's a great question, Mark. If you think of the portfolio mix when we spun out of Agilent, we were largely a tools company, 100% of our business was in the physical layer tools category. And most of our expansion efforts since then have been in the emulation space and more recently into the simulation arena with the application layer pivot that we have. So I think of the comprehensive portfolio where our ability to service customers design, emulation and test needs as a very unique positioner for the company, a bigger strategic position that allows -- gives us greater confidence in the growth, but also the margin targets we laid out at our Investor Day. And so as we think about why this is more important, I think of like, let's say, we started a quantum program in the company, a small application 5 years ago. Now that was primarily to service the test needs of Quantum. Today, because we have enough of IP aggregated, we're able to now turn that into a simulation library and we've just announced a simulation library that for the Quantum engineers around the world, so they are able to bring out their designs quicker. So there is an intrinsic, I would say, leverage between test and design and connecting that workflow unlocks more opportunities for us. And what that will enable us to do is become a bigger player in R&D labs of our customers and tap into that, where we think we're today even with the best -- the highest or the biggest customer, a smaller fraction of the overall R&D budget. But we can also do so by making more recurring contributions and growing our ARR at which time. We're only 30% right now, and I see more upside there.

When you think about the companies you're competing with in simulation or emulation, maybe help us better understand what that set of companies looks like?

Yes, there are obviously very large companies who are focused on EDA. And we're not necessarily competing with them. I think what we are focused on is being the best design emulation test company. And I'll give you an example of what that really means. Like you could say, well, if we're a pure test company right now, most of the action in AI, we would see with speeds where people are trying to test 800 gig or terabyte, yes, we're participating in that. We're capturing our share but we're not stopping there. We're enabling our customers trying to emulate it AI workloads in the lab because trying to emulate it on expensive GPUs is astronomically expensive and takes a long time. So our ability to provide emulation platforms that gives them an off-ramp so they're testing and training their algorithms in an offline system is an opportunity, and it's created incremental value for us. And that's the sort of intrinsic linkage I think about between design emulation and test, the positions Keysight uniquely for the future.

China was 18% of revenue last year. How is the geopolitical backdrop been affecting your China business?

Yes. I mean the -- and I think the good news is here, we've seen numerous waves of trade regulation over the course of the last several years that has materially derisked our position, right? It started with military and it's more recently moved to semi. And so we've taken some of the communications sits with Huawei and others along that kind of continuum of time. And so I think we continue to succeed in the markets. We saw broad range of tools but those big technological levels have -- we've crossed those. So I think as we look forward, obviously, there's still risk of things escalating, but it's more in line with what others across the broader industry scope are facing.

Okay. Maybe we could dig more specifically into the commercial communications business that accounts for about 45% of Keysight's total revenue. Can you give us a sense of how the commercial communications business further splits out between wireless and wireline, especially given some of the strength in the wireline part of that business of late?

Yes. So commercial communications end market, very innovation-rich and the biggest driver is technological change. We serve regulated standards-driven applications. So they move on a certain cadence, and we're able to participate in the standard setting process and enabling an entire ecosystem to succeed. So we have a large base of customers in the business. Wireless is roughly 55% of the business and the remaining 45% is wireline technologies.

And within that wireline piece of the business, maybe give us a sense of how important AI has been for growth and the overall business?

Yes, all the way from silicon to the cloud market, I think we are seeing lots of innovation happening, right? Concurrently, whether it is new silicon chips, subsystems, AI clusters, emulation opportunities as we integrate those and look at how workloads move through an AI network, all of that has given us a rich set of opportunities to participate in. Right now, we're also benefiting from the data center capital that's being deployed and the flow-through that's happening is manufacturing is being put in place or capacity is being put in place to manufacture all the way from interconnects to subsystems on the AI hardware side. But we're very encouraged by the pipeline of opportunities we have with the hyperscalers and their ecosystem around software and emulation as well.

You do have some test capability for Ethernet, including 400, 800 gig and terabyte? Where do customers stand in making some of those transitions?

Yes. We've seen a pretty significant acceleration and interest in 800 gig and transition to 1.6 terabytes. I'd say that if we were looking at it, we launched solutions in '21, '22 for 800 gig, followed up with 1.6 terabyte capabilities. But now we're seeing a broader adoption of capabilities because people recognize that there is economic value from having the network interconnects move faster through an AI workload because it's all about user experience. It's about cost and moving to higher speeds actually saves you cost in that process. And so getting those technologies ramped up is an advantage, and we're benefiting from the portfolio we have. Again, as I mentioned, all the way from silicon to the cloud in enabling this AI revolution. We're still on very early innings of the revolution that's taking place and it's starting with the data center investments that are happening right now.

Maybe we can shift gears slightly to the wireless side. You said on the last earnings call that you've seen some stability on a year-over-year basis, albeit at a lower level. What do you think it may take for wireless to get back to growth?

Yes. I think what we've seen is pretty accelerated levels of spending as 5G was being invested and matured, right? I think as scale deployments happen in China first and then in the United States, that drove a lot of the big investment waves that we saw in '21 and '22. And from those levels, the industry continues to normalize but we're starting to see stability and bottoming of the business. And what we're seeing is no surprise, the R&D is obviously more resilient than manufacturing. But there's also been a pullback in the production levels of spend with smartphone-related applications. And as we look forward, we still think that 5G advanced non-celestial networks, open RAN types of applications continue to give us some strength. And then as we get into 6G or talking about 6G, there are some application areas such as energy efficiency, sustainability engineering that start to form the basis for what 6G might be in the future, but there will be a lot more experimentation of that in 5G that gives me a confidence that this business stabilizes at these levels. And there's some early investments in 6G already being discussed around research agencies around the world, there will be additional opportunities for us to pursue.

You said energy efficiency is one thing for 6G. As consumers, we all have cell phones. I see some out in the audience in front of us. Anything that we can look forward to as consumers with 6G in terms of better speeds or longer battery life?

Yes. I think the vision for 6G is forming, and it is about making networks more reliable, more robust, with lower latency, higher bandwidth, all the stuff that we have started to see from 4G to 5G as consumers' experience for consuming data is insatiable. And so I think 6G will push those traditional boundaries, but the difference is going to be to focus on energy and sustainability because it is becoming a bigger imperative. If you add the data center expansions and if you add all of the cell tower deployments around the world, I think you can start to see a sizable chunk of energy consumption locked in there. And I think getting more greener is the only way for these technologies to scale, and I think we'll remain key areas of innovation for our customers. And so we're working with them on these teams. I mean you can start to think of applications where cell stations are more smarter as we move forward. And they recognize when the -- when there is a payload to be delivered and they also recognize when there isn't like at midnight, do you really want to be transmitting energy or can you be smarter about the way you transmit energy. So those types of applications to make the cell phone infrastructure or the wireless infrastructure smarter is getting a lot of attention in the research area right now.

Okay. Very interesting. When do you think 6G will become more meaningful?

Yes. I think when you think about the time line associated with any of these generational technologies thereof, roughly, we've set a decade long in -- as a cycle like it plays out. On the front end, you have more research, then there's a design activity, then you have manufacturing at scale and then you have more optimization. And so you might say we're transitioning to more of the optimization phase in 5G right now. So when we start to think about mile markers for 6G, you'd say 2028 is when released, '21 of the standards are projected to be ready. We'll see there's still a long time line for that. And typically, customers start to get invested in and engage early, at least a few years prior to that. So -- and then we've started to have discussions and in '22, '23 that have now translated to collaborations and some revenue for the company already. And I only expect that to continue as we move forward.

Okay. Very helpful. 5G is a really important cycle for Keysight and the company took a lot of market share as you're observing some of the early start of 6G, how confident are you that you'll sustain or maybe even grow your share with 6G?

It's a really important point, right? I think one of the reasons it goes back to the philosophy of how we've navigated this downturn, Mark. And I think it is quite possible for companies to cut back significantly in downturns and then find themselves not having the investment power to capitalize on the up cycle. And we've actually done quite the opposite. Yes, we've trimmed OpEx. I think Neil will talk about that 3 to 4 points. But if you look at our R&D line, we've kept our R&D line flat over $800 million. And a big part of that is also pivoting to what comes next because we have to stay ahead of our customers by 2 to 3 years because it takes us 2 to 3 years to build our technology stack up. And that's -- all of the investments we're making will enable us to capitalize. Some of the collaborations that we're having that are in public domain as well, again, speak to this continued collaboration we're doing with customers that, again, give you another external marker around Keysight's readiness to capitalize on the next-generation technology wave.

Maybe we can talk about the aerospace and defense end market. I think you mentioned earlier in our discussion, it's been one of the things that's helped to reduce a little bit of the cyclicality of your business, and it's been a growth area. But the last 3 quarters, revenue in the A&D business has been down. Company said in the last earnings call, there's been some prolonged, continued approval process that's behind that. Can you help us better understand as to when you think A&D may return to growth?

Yes. We're actually quite pleased. If you look at -- this is a business where if we play out the long-term growth rates, it's actually very easy to forecast this business. It's hard to forecast on a quarterly basis, but the long-term trajectory we've said is 2% to 3% of market growth and our Keysight has been able to do 3% to 4%. And so that's sort of the growth rate expectation for the business, and we still feel good about that. I would say a couple of things specific to this year. Last year, 2023 was a record year for the aerospace defense business, driven by a number of factors, but a number of program wins, many of those we were -- are for this long-dated category of systems and solutions that we're launching, which will ship in '25. So that's 1 data point that I think it's important to note. We also have seen in this fiscal year, delays in budget appropriations process that has pushed out some of the new programs, which we expect at some point will kick in. It's hard to really know what's going to happen in October with the budgets being discussed right now, whether the continuing resolution is going to be pushed out through the election cycle or beyond, and that's just a budgetary phenomenon. But despite that, I think this geopolitical landscape that we're in today, I think security is top of mind investments in research is being prioritized, and I look at the backlog for a number of the U.S. aerospace defense prime contractors, they'll remain robust. So all of that gives us confidence in the medium-term outlook as we look forward. And yes, we're having a down year, but that's down from record levels of the business last year.

But half of the revenue in aerospace and defense was historically tied to the U.S. defense budget. With the rise of the commercial space and satellite industry, maybe help us better understand how the revenue exposure of that business is evolving?

Yes. I think we're still in the -- over 50% of the business is tied to U.S. markets. But I think space and satellite, the renewed interest in space, the continued collaboration or cooperation between prime contractors, government entities and commercial space has been reason for unlocking a lot of the innovation that we're seeing, right, faster turnaround times, more reusable technologies and such. And so I continue to believe that space will be an important driver for growth for us as we look over the horizon.

Final segment I wanted to touch on was EISG. It's about 30% of Keysight's revenue. you sell into things like general electronics, semiconductors and automotive? Maybe help us dimensionalize those different buckets in terms of how important they may be for Keysight?

Neil, do you want to take that.

Yes. So I mean, if you thought about those 3 markets size-wise, they're -- if you started that 30% is kind of 1/3, 1/3, 1/3 with semi being a little bit bigger and automotive being -- or excuse me, general electronics being a little bit more than 1/3 of it and auto being a little less than 1/3. I think the secular drivers in those industries, starting with semi, it's about kind of an insatiable demand for chips. It's about assurance of supply in regions around the world and move to smaller process architectures. 3- and 2-nanometer are the things that are driving demand. We've seen a little bit of a disruption in that business here more recently with some of these big fab programs, Arizona, Texas, Ohio being pushed out. But I think there's indications now that those things are picking back up. And as Satish mentioned earlier, there's a broader belief in the semi industry that calendar '25 is going to be materially better than calendar '24. So we ourselves saw a nice sequential uptick in the business in the incoming order rate in Q3. Again, we'll see if we can back that up here with a couple of additional quarters of strength that would give us confidence in the upward trend there in semi. I think in general electronics, that business is stable at a lower level. We've talked about that. I think business has a little bit of a higher focus on manufacturing than some of our other businesses within Keysight. And obviously, we saw a lot of capacity that went into place in '22 during the supply chain disruptions. We need to see some of that capacity get absorbed. PMI sustained above 50, so you can absorb that capacity, and we can start to see some of those manufacturing investments begin again. And then on automotive, I think that's the one area across the portfolio where we may continue to see some incremental weakness driven by the EV portion of that portfolio. The adoption rates for EVs have slowed. There's some interesting paid dynamics with China and the low-cost Chinese vehicles and response and tariffs and other things around the world that I think is causing a little bit of a pause in the EV investment. And so kind of taking a wait-and-see approach there. But again, the long-term secular drivers, the government support for green initiatives, the move towards electric vehicles, all that remains intact. We're just in a bit of a tumultuous period at this point in time.

You also have some exposure to ADAS as I think about radar and all the software and simulation that needs to get done to develop these cars in the future. Have you seen weakness in that part of your auto business as well? Or is it really even more confined to the electrification part?

That portion of the business has been the strongest. And it's ADAS, but it's also the electronic content that goes into these vehicles, whether it's infotainment systems or various sensors, technologies that are in the vehicles. And so that business has been far more resilient than either the EV pure portion or the pure manufacturing portion, which is tied to volumes.

A couple of financial ones for you, Neil, if I could. At the '23 Investor Day, the company laid out a target of 31% to 32% operating margins by fiscal '26. With revenue weakness, the whole industry has seen, how should investors think about margin progression at this point?

Yes. I think it's a fair question. Obviously, we didn't -- understand on that stage at the New York Stock Exchange in March of 2023, we didn't quite anticipate with the next 18 months were going to look like and the pullback that we were going to see in our business. I think from our perspective, we're not backing away from the 31% to 32% operating margin target. I do think it's going to slip out in time. And we have not updated the time line at this point because I think we need to get ourselves better visibility as to what the timing and shape of recovery is going to be. That's what's going to ultimately drive our progression towards those towards that 31%, 32% operating margin. In the meantime, I'd point you back to the broader operating model that we've talked about when this business grows in mid-single digits, we can drive 40% operating leverage, which in itself will start to get operating margins moving north.

Very helpful. And then anything in terms of investments you may want to make in terms of R&D or cutbacks with lower revenue, even if it's more SG&A and discretionary measure, just how to think around spending levels?

Again, I think as Satish has already alluded to, one of the things that I think we're both proudest of is our ability to sustain the R&D investment during this portion of the down cycle, maintain our R&D investments north of $800 million and position us to really fully participate in the upside. I think outside of R&D, we've tried to stay as disciplined as possible. We've taken down headcount across the company by about 4% over the course of the last 3 quarters. Our SG&A spending is down on a pre-acquisition basis. And so enabling us to drive strong loss of profitability on the downside of the cycle. So we'll continue to make those dynamic trade-offs, but with a high priority on maintaining R&D investments going forward.

Just make sure I had the right, 4%, excluding engineers?

Excluding acquisitions.

Okay, excluding acquisition. Yes. Given the cyclical environment that the company is in and the industry is in, have you seen any change in the pricing environment, perhaps more competitive pricing out there?

Yes. I think 1 of the things we tend to see, Mark, is we have high-end solutions. And now obviously, there's a demand profile associated with that, higher ASPs associated with that. In tougher economic times, our customers tend to buy more lower-end solutions and with lower ASPs, right? So we offer the whole catalog. So we see that mix be a bigger driver. We've had to -- during the up cycle years, we kept our pricing strategy in line with inflation. So we've been able to mitigate some of the inflation effects from our P&L during the downturn, some of those, we're always looking at it and balancing what the customers need is and where we place our bets from a pricing perspective. But overall, I feel good about our ability to monetize our differentiated value. And as we launch the next generation -- every year, we launch a new cohort of new products across our portfolio, and we feel good about our ability to continue to grow the margin profile of the business as we launch the next-generation products that replaced the previous generation.

A couple on capital allocation. With the recent ESI deal and also the proposed transaction at Spirent, how should investors think about capital allocation over the next 12 to 24 months?

Yes. I don't think our capital allocation priorities have changed. Again, as I've just stated, #1 priority continues to be for us to support the organic growth of our business through the R&D line, through the CapEx line, through the sales force line. I think beyond that, we look to strike a balance between continuing to expand our markets, round out our portfolio via M&A and returning capital to shareholders. I think with this pullback in our end markets, we have been through a period of time here recently where things have been actionable at more reasonable prices than we'd seen during the post-COVID recovery and the supply chain disruptions. And I think we've -- fortunately, we've had the financial performance and the cash flow to be able to capitalize on some of those investment -- inorganic investment opportunities. And so I think we'll continue to take a similar approach as we look forward, capitalizing on the opportunities that are in front of us, while at the same time, returning capital to shareholders.

One other on capital allocation is on the proposed Spirent transaction. And I was hoping the company could provide an update on how that is progressing in the regulatory approval process.

Yes. Mark, on that front, given the U.K. process and regulations, there's not much more I can say other than we've seen this as a SAM expansion opportunity for us. And so at this point, based on everything we know, as we've stated in the 2.7 document, we remain confident in our ability to close the transaction in the second -- in the first half of 2025 calendar year.

Fiscal year.

We have time for 1 question from the audience, if anyone has one. I had one then on EISG, and we talked about the software intensity of your business. And I was curious if you could talk about how the software intensity is in the EISG part of the business?

Yes. Historically, EISG has been more of a manufacturing PMI-led business, right? And we've seen that and with lower software mix. And I think the transformation of Keysight, CSG has been where we had invested for that software transformation. I think there's an opportunity to do that in EISG. As we looked at the big trends playing out, virtual engineering was a big trend. One of the reasons we acquired ESI was to really add more software content and ability to engage with leading innovators with system-level tools. And this is where ESI, if you look at their historic strength, is in auto markets where they provide simulation tools for crash test applications. We're now starting to take that and apply it to a whole range of applications outside across the whole company. But clearly, there is plenty of room to drive transformation, the EISG business by applying a similar methodology.

Great. Well, unfortunately, we're out of time. Satish, thank you, and Neil.

Thank you, Mark.