MACOM Technology Solutions Holdings, Inc. (MTSI) Earnings Call Transcript & Summary

Good afternoon and welcome to MACOM's Third Fiscal Quarter 2020 Conference Call. This conference call is being recorded today, Wednesday, July 29, 2020. [Operator Instructions] I will now turn the call to Mr. Steve Ferranti, MACOM's Vice President of Investor Relations. Mr. Ferranti, please go ahead.

Thank you, operator. Good afternoon, and welcome to MACOM's Third Fiscal Quarter 2020 Earnings Conference Call. I would like to remind everyone that our discussion today will contain forward-looking statements, which are subject to certain risks and uncertainties as defined in the safe harbor for forward-looking statements contained in the Private Securities Litigation Reform Act of 1995. Actual results may differ materially from those discussed today. For more detailed discussions of the risks and uncertainties that could result in those differences, we refer you to MACOM's filings with the SEC. Management's statements during this call will also include discussion of certain adjusted non-GAAP financial information. A reconciliation of GAAP to adjusted non-GAAP results are provided within the company's press release and related Form 8-K, which was filed with the SEC today. With that, I will turn over the call to Steve Daly, President and CEO of MACOM.

Thank you, and good afternoon. I will begin today's call with a general company update. After that, Jack Kober, our Chief Financial Officer, will provide a more in-depth review of our third quarter financial results for fiscal year 2020. When Jack is finished, I will provide revenue and earnings guidance for Q4, and then we would be happy to take some questions. Revenue for our third fiscal quarter was $137.3 million and adjusted EPS was $0.33 per diluted share. We are pleased with these results, and we are pleased that demand for our products continues to increase, primarily from the Data Center and Telecom markets. Equally important, as Jack will discuss later, our Q3 gross margins have improved, and our operating expenses were well controlled, and the net result was continued improvement at profitability and cash generation. Notably, our operating margin exceeded 20% for the first time since 2017. Our strategy is to execute on product and technology developments so that we may take full advantage of the growth opportunities in front of us, while also improving profitability. Q3 revenue by end market was as follows: Data Center was $32.4 million; Telecom was $56.8 million; and Industrial & Defense was $48 million. Data Center and Telecom had sequential growth rates of 21% and 10%, respectively, while our Industrial & Defense business was essentially flat. On a geographic basis, approximately 40% of third quarter revenue was from domestic customers and 60% was from international customers. Our book-to-bill ratio was approximately 1.4:1. In our turns business, or business booked and shipped within the quarter, was approximately 25% of total revenue. Our book-to-bill ratio was exceptional, driven in part by the current 5G infrastructure and data center spending cycles. We also estimate that COVID-19 pandemic motivated some customers to order ahead of end demand due to concerns of future component shortages or potential supply chain disruptions. Additionally, we received some long lead time industrial and defense orders in Q3 that will be shipped beyond Q4. For all these reasons, we believe that in the coming quarters, our book-to-bill ratio will return to a more typical level. We remain in regular contact with our largest customers, and we are closely monitoring channel inventory, general order activity and long-term demand forecasts. For Q3, sequential growth in our data center end market revenue was driven by cloud data center demand, both from domestic and international deployments. Our 100G high-performance analog products and our emerging 200 and 400G analog product lines are supporting the growth in this market segment today. I'll note that our international data center growth is driven by Asia-based data center expansion, where we sell both 25G and 100G analog products. We view ongoing demand for bandwidth and associated infrastructure upgrades inside the data centers to be an opportunity for MACOM in the years ahead. And we see the expansion of 100G and the emergence of 200 and 400G to be opportunities to expand our position in the market. Sequential growth in our Telecom end market revenue was driven by demand for 5G wireless RF products, 5G front haul and mid-haul HPA products, improvements in the GPON market and market share gains in the Metro/Long-haul market from new coherent products. We view 5G infrastructure deployments as a key growth driver for MACOM revenue. In the coming quarters, we anticipate further expanding our current 5G portfolio by launching additional optical components, more discrete RF components and more high-performance analog and mixed-signal ICs. Our Industrial & Defense end market revenue consists of a variety of end applications, including long-term defense programs, satellite communication applications, MILCOM, and public safety handheld radio applications and test and measurement equipment. We recognize this end market has not been growing for MACOM over the past few years, and we are implementing new strategies to initiate growth, including improving our sales channels, refocusing on key accounts, increasing cross-selling of all technologies into the market and developing additional standard and custom products, which will appeal directly to these customers. This end market has tremendous growth potential for MACOM. However, we believe that it will take us time to grow our business in I&D given the long design in cycles. I'd next like to highlight a few corporate initiatives aimed at enhancing our quality standards across MACOM. We have kicked off an effort to certify all our major facilities to the ANSI/ESD S20.20 quality standard. And this past quarter, 4 of our main facilities were certified. This standard is a multi-industry standard, which defines control programs to protect ESD-sensitive components, assemblies and equipment. Our engineering, operations and quality staff are doing a great job updating our procedures in order to achieve these certifications, and we look forward to additional site certifications over the next 12 months. In June, we kicked off new efforts to certify MACOM on 2 additional quality standards. The first is AS9100D, which builds upon the ISO 9001 standards but modified to meet DOD, NASA, International Aviation and FAA quality standards. And the second is TS 16949, which is also built upon the ISO 9001 framework and focuses on defect prevention, waste reduction and supply chain management for the automotive industry. Expanding the capability of our quality systems supports our growth strategy to enter new markets and to find new customers. And these actions will open up new doors for us in the aerospace and automotive industries. Broadly speaking, MACOM has a wide range of differentiated products in production today. A number of these products have extraordinarily long life cycles and produce revenue years after they've been introduced. In total, we have dozens of different product lines, servicing thousands of customers. We view this diversity of technology, products and end market applications as an inherent strength of the company. MACOM, with its 65-year history is known for its RF diodes, gallium arsenide MMICs and silicon bipolar power transistors. We have also taken the lead position in the market with our high-performance analog drivers, clock and data recoveries, circuits or CDRs and transimpedance amplifiers or TIAs, which are amongst the best-in-class in the industry. We complement these products with high-speed coherent drivers and TIAs for next-generation Metro/Long-haul optical networks. And last, interest in our proprietary EFT laser technology is expanding because of our performance and because of our 4-inch indium phosphide wafers are giving us a tremendous manufacturing advantage. We see numerous opportunities to grow our business, and we believe that our current portfolio of products should provide a stable foundation for future profit and revenue growth. Our strategy is to build upon this foundation by developing technologies and new products, which will differentiate MACOM and help drive additional growth, including gallium nitride, or GaN, high-performance lasers, DSPs and silicon photonics. These technologies are compelling, and they have the potential to generate significant revenues and profits for the company in the years ahead. We continue to slowly move these technologies closer to productization. One of the highlights in the quarter was the completion of our first 100G PAM4 DSP program. I want to congratulate our engineering team for successfully finishing the design and our production teams for transitioning this product from engineering to production. While we do recognize we are entering an established market, the 100G PAM4 DSP market is large and growing, and we will aggressively pursue opportunities to win market share and maximize our return on investment. The completion of this project highlights our management team's ability to focus and execute. I'll also note that this project created a wide range of compelling intellectual property, including high-speed logic, data converters and high-speed SerDes. We will leverage this foundational IP into a variety of new product initiatives to maximize our future growth. I mentioned on last quarter's call that our 25G FP fronthaul lasers have been sampling to customers, and we have been receiving positive initial feedback. Our 25G FP laser lasers work in 300-meter and the more difficult 2-kilometer fronthaul applications. Today, this market is supported by our competitors' expensive 25G DFB lasers or in some applications by overdriven 10G DFB lasers. Now customers will have the option to switch to a MACOM 25G FP laser product, which was designed specifically for this application. And one that offers compelling performance, superior reliability and supply chain security due to our high-volume manufacturing capability. And our customers have quickly recognized one big advantage, that our lasers do not need additional support hardware, which can simplify the overall logical design and lower the bond cost. Our lightweight team has been achieving strong revenue growth in recent quarters. Primarily driven by expanding their portfolio with new laser and photodetector products. Our silicon photonics R&D work also continues. We are making slow but steady progress on 3 critical elements needed to launch an L-PIC product, namely: one, a robust continuous wave or CW laser design; two, a silicon photonics IC; and three, an active laser-aligned manufacturing process, which mounts from 1 to 4 lasers on a single silicon photonic IC. This is exciting technology, and there is still a lot of work to do before we launch our first product. As a merchant supplier of ICs and to maximize our opportunity, we have updated our go-to-market product strategy to include selling silicon photonic ICs without lasers and selling CW lasers to those that have their own silicon photonics. Our RF power team has been extremely busy over the past 12 months. Under our new leadership -- under our new technical leadership, we have learned a tremendous amount about the attributes of our existing GaN on Silicon process, and we have made significant improvements in both our driver and Doherty amplifier designs. We do recognize there are limitations of GaN on Silicon in certain applications. And over the past months, our RF power design team has made new efforts to incorporate GaN on Silicon Carbide into our portfolio as a priority. And I am pleased that in early August, time to be coincide with the virtual International Microwave Symposium, or IMS, we will be introducing our first wave of GaN on Silicon Carbide standard products. We will be branding this product line under the MACOM pure carbide trademark. I'll note the team has already been sampling our first pure carbide products to customers in areas where silicon carbide has a technical advantage and where it makes sense to do so. ST continues to work on the installation of capital equipment and their path to support the development of an improved and next-generation GaN on Silicon process. At this moment, it is too early in the development project to discuss schedules. I'll note that our RF power growth strategy includes winning market share in both the Telecom and the Industrial & Defense markets using our full portfolio of gallium arsenide, GaN, and silicon bipolar processes. We view these 2 markets as equally rich with opportunities. We had another strong quarter of new product introductions from all our engineering teams with over 30 products introduced. Engineering leadership is focused on executing product plans efficiently and we are challenging our designers and technologists to raise the level of innovation with more best-in-class products. And our semiconductor technologists are preparing to reinvigorate our low wafer fab by enhancing and adding additional process technologies to the fab. Our design and applications engineering staff are preparing for both the IMS and the China International Optoelectronic Exposition or CIOE Conference to be held in Shenzhen, China in August and early September, respectively. While IMS will be a virtual trade show, CIOE is expected to be held in person and our local China-based applications and sales teams will host customers and showcase new products across our data center, 5G and PON portfolio. In summary, we stand in front of multibillion-dollar markets with a unique technology portfolio. I expect we will experience periods of high-growth and periods of low growth and possibly even negative growth, which is normal for our cyclical industry. For these reasons, we maintain a long-term perspective on executing our strategy, and we will work to manage our business to be profitable throughout all business cycles. We are confident that we can continue to improve our financials and take market share in the months and years ahead. Jack will now provide a more detailed review of our Q3 financial results.

Thank you, Steve, and I hope everyone is having a good afternoon. Our fiscal Q3 results were another tangible step toward improving MACOM's overall profitability and cash flow. We posted sequential improvements in revenue, margins and adjusted earnings per share in fiscal Q3. We also recorded another quarter of strong cash flow and grew our cash balance. Revenue in the third fiscal quarter of 2020 was $137.3 million. On a year-over-year basis, revenue was up 27% from $108.3 million in the third fiscal quarter of 2019, which was our lowest revenue quarter over the past 4 years. Sequentially, revenue was up 9% from Q2. Sequential improvement in revenue was driven by continuing positive trends in our Telecom and Data Center end markets. Overall, Industrial & Defense demand continues to be healthy, despite revenue being relatively flat over the past few quarters. During the third fiscal quarter of 2020, we had 3 customers that exceeded 10% of total revenue. Two of them are located in Asia. These customers were all channel partners and service multiple end customers. Adjusted gross profit in fiscal Q3 was $76.2 million or 55.5% of revenue. Adjusted gross margin was up 100 basis points sequentially. As we've discussed in the past, gross margin improvement is a corporate priority for us with our sales and operational teams focused on continuous improvement opportunities. Over the past few quarters, we have made incremental progress with improving the efficiency of our manufacturing, supply chain and other operations. As you may know, we have a very diverse product portfolio with varying customer demands, and our products generally have long production cycle times. In an effort to help better optimize our structure we are expanding our sales, inventory and operations planning process known as SIOP. We believe this improved SIOP process and other initiatives will help us further improve our cycle times, customer responsiveness inventory metrics and overall profitability going forward. Another longer-term item to highlight is a multiyear project we recently kicked off to help reduce utility costs and our dependency on the local power grid at our Lowell, Massachusetts fabrication facility. This is expected to be a turnkey gas-fired cogeneration system that will produce uninterruptible power, heating and cooling for our Lowell fab operations. Once up and running in about 18 months, we expect the system to provide annual savings of approximately $1 million and improve our cash flow primarily through lower utility costs. Equally important, the system is expected to improve our fab resiliency and uptime by eliminating the impact of power grid surges and outages. And finally, we expect to improve our carbon footprint with estimated savings of carbon dioxide emissions of over 8 million pounds per year, the equivalent of removing approximately 800 cars from the road each year. Total adjusted operating expense was $46.9 million, consisting of R&D expense of $30.6 million and SG&A expense of $16.3 million. Operating expenses were down $2.4 million sequentially. Our corporate-wide focus on streamlining operating expenses continues to provide positive impacts, with further new opportunities for savings being identified and actioned almost daily. Our employees are focused on supporting our product development and growth opportunities, while also proactively looking for new and innovative ways to more efficiently run the business. The sequential decline in operating expenses was attributable to these continuing efficiency improvements as well as lower travel and promotional expenses in Q3 due to impacts from COVID-19. Looking ahead, we expect operating expenses to increase modestly from the Q3 levels. We will continue to balance investments in new product opportunities while managing our discretionary spending. Adjusted operating income in fiscal Q3 was $29.3 million, up from $19.6 million in fiscal Q2. Adjusted operating margin was 21.4%. As Steve mentioned, we view the 20% operating margin we recorded in Q3 as a significant milestone. We expect the combination of top line growth, improving gross margins and stable operating expenses to provide continued operating leverage through the remainder of the calendar year. Depreciation expense for fiscal Q3 was $7.1 million, and adjusted EBITDA was $36.4 million. I would like to note that our adjusted EBITDA was a $9.5 million sequential improvement over the $26.9 million we reported in fiscal Q2. Fiscal Q3 adjusted net interest expense was approximately $4.8 million, down approximately $2 million from fiscal Q2 2020. The decline was primarily driven by the reduction of LIBOR rates on our floating rate term loan. Looking ahead, we expect adjusted net interest expense to remain roughly at these levels. Our non-GAAP adjusted income tax rate in fiscal Q3 continued at 8% and resulted in an expense of approximately $2 million. We expect our non-GAAP adjusted income tax rate to remain at 8% for the remainder of the fiscal year. Fiscal Q3 adjusted net income was $22.7 million compared to $11.9 million in fiscal Q2. Adjusted earnings per fully diluted share was $0.33 in fiscal Q3, utilizing a share count of 68.6 million shares compared to $0.17 of adjusted earnings per share in fiscal Q2. Now moving on to cash flow and balance sheet items. Fiscal Q3 cash flow from operations was $34.1 million. Improvements in operating income and inventory management helped to enable strong cash generation for the quarter. Capital expenditures totaled $3.6 million for fiscal Q3. We remain focused on achieving appropriate returns on capital that we deploy. We expect overall capital expenditures in fiscal 2020 to come in at approximately half of our fiscal 2019 levels. Free cash flow was $30.4 million for the third fiscal quarter, and $20.5 million in Q2. These fiscal 2020 improvements in cash flow continue to be a result of improved operating income, continuing revenue linearity, reduced CapEx and other working capital improvements. We believe the numerous structural changes and ongoing operational and financial improvement initiatives we have made and continue to make throughout the organization will further help to drive positive cash flow going forward. Our Q3 accounts receivable balance was $60.5 million, up from $53 million in Q2. As a result, days sales outstanding were 40 days, slightly up from 38 days in Q2, driven primarily by increases in revenue during the quarter. Inventories were $95.6 million at quarter end, down another $4 million sequentially in spite of our higher Q3 revenue levels. Inventory turns improved to 2.6x during the third fiscal quarter, which is the highest inventory turns we've achieved since 2017. As I noted earlier, inventory management remains an area of emphasis, and we see opportunities to further improve our metrics going forward. Cash, cash equivalents and short-term investments for the third fiscal quarter were $265.1 million, up $43.5 million from Q2. In addition to the strong Q3 cash from operations, we recorded a cash inflow from investing activities of approximately $11 million associated with the payment we received from the sale of assets, which took place over a year ago. As a reminder, our short-term investments are comprised of corporate bonds and commercial paper and are classified as held for sale. Total debt was $691 million, inclusive of $31 million of finance leases. Our long-term debt of $668 million is covenant light, and has minimal annual principal repayments until its maturity in May 2024. It's worth noting that our trailing 12-month EBITDA increased significantly in fiscal Q3, more than doubling sequentially. We believe the combination of growing cash on the balance sheet coupled with improving trailing 12-month EBITDA will result in declines in net leverage over time. In summary, we feel Q3 was another period of solid financial performance, and we are pleased with the progress our team has been making. We also understand that there is still much more for us to do in order to achieve our longer-term objectives. I will now turn the discussion back over to Steve.

Thank you, Jack. MACOM expects revenue in Q4, ending October 2, 2020, to be in the range of $144 million to $148 million. Adjusted gross margin is expected to be in the range of 55% to 57%, and adjusted earnings per share is expected to be between $0.36 and $0.40 based on 69.5 million fully diluted shares. Our Q4 revenue projections include expectations that our 3 end markets will grow sequentially. Specifically, we believe our revenue growth will be driven by the increase in data center traffic, 5G network deployments and increased demand for our RF and microwave products and defense applications. We are excited about the multiple growth opportunities in front of us, and I would now like to ask the operator to take any questions.

Operator, we will take questions when you're ready.

[Operator Instructions] I show our first question comes from the line of Quinn Bolton from Needham.

It's Michelle on for Quinn. And congrats on the solid results and guidance. So for my first question, could you guys provide a little color on how you expect your end markets to perform in the fiscal fourth quarter, like which segments do you expect will be leading the growth? Any color you can give, that's great.

Sure. Thanks, Michelle. So looking into the fourth quarter, we are expecting the strongest growth to come from the Data Center end market, where we'll see strong double-digit growth. Telecom, we believe, will also grow close to 10% and I&D will probably be mid-single digits, maybe 5%.

Okay. Great. That's helpful. And then just as my follow-up, we were wondering if you guys give an update on your 25-gig laser opportunity in the 5G fronthaul space? Where are you in the qualification process? I know you guys mentioned it in your prepared remarks, but I'm just kind of curious when you think that opportunity will start getting into the model?

Right. So I think that we are -- as we said in the script, making good progress. We've been sampling. We're getting good traction. We do now need to intercept a qualification cycle, which our customers need to go through with the major OEMs. We expect that activity to kick off towards the end of this calendar year. And that should line us up for deployments next year, next calendar year when the new bids go out for the optical module. So we're hoping to position ourselves for revenue with this product line sometime early next calendar year. And by the way, I just want to come back to the first question you asked. I think I misspoke. Telecom for Q4, we're expecting sort of 3% to 4% to 5% in that range. I just want to correct that.

Our next question comes from Tom O'Malley from Barclays.

Congrats on the really nice results. My first question is about the Data Center. In your prepared remarks, you talked about, from the international side, most of the demand coming from Asia and 100G and I think some 200G applications. And you also mentioned 60% of the demand is international. Can you talk about what trends you're seeing from China as we move into the second half here? Obviously, you guys are aware of potentially some prebuilding, but what's the confidence that you have that, that portion of the business can keep up? Clearly, Data Center's guided up pretty strongly. Is that continued China strength? Or is that other strength kind of kicking in from elsewhere?

Sure. So there's a few item in there -- in your question that I'll try to address. The first is sort of the overall business in China. It's been strong over the past few quarters, and we expect that strength to continue as we enter into Q4 and possibly even Q1. A lot of that strength is being driven by the 5G infrastructure deployments that I talked about in the script. That we are able to support those customers primarily with 5G fronthaul products, for example, RF FEMs or front-end modules for the radio boards. And also we're supporting Metro/Long-haul equipment that we also include in this segment. When we think about the data center and the trends associated with that, we see -- we sort of look at things differently. Number one, we're actually picking up new data center customers in China, which is sort of an independent activity to what's going on in 5G and what's going on with our overall strategy in China. And so we see that as a very positive trend, and we expect that will provide strength for MACOM going into next year.

Great. And then a follow-up is really on the RF portfolio. Congrats on the pure carbide trademark and your progress there. I just -- I wanted to kind of understand timing. You said you're sampling to customers, but Asia is obviously ramping 5G now. You're expecting early next year, the North American and European customers to start ramping. Do you have a time line for where you're trying to intersect that product with the ramp? Obviously, you're hearing from some competitors such as NXP saying that LDMOS isn't really cutting it at the high end. When do you think that you'll be able to ship that for revenue?

Well, that's certainly a great question, and I'll just highlight that in our GaN business, we're really trying to force folks ask a broader question, which is, what's your RF power strategy? And where we look at 5G and the opportunities in 5G is just one element of a rather complex strategy. So when we think -- but to answer your question specifically, when we think about 5G, there's been a lot of effort over the past few years with GaN on Silicon. And as I made comments just a moment ago that we are doing more and more work with GaN on Silicon Carbide. Not only for 5G applications, but all applications, including I&D, test and measurement and other non-5G telecom type applications. So to look forward in terms of the growth associated with these activities, I think we're looking at the back half of '21 at the earliest where we begin to see revenue ramps coming from the new strategy, that would be at the earliest.

Our next question comes from Tore Svanberg from Stifel.

Congratulations on reaching that 20% operating margin milestone in such a short time. Quite impressive. My first question is on your PAM4. You mentioned the 100-gig product, the design is now finished. Could you elaborate a little bit on where you intend to sell that product? Either by speeds or by segments of the market?

Sure. So it's -- that product is targeting the data center first. So it's 25 -- it's a 4-lane 25G NRZ input and a PAM4 output. So that is the fundamental platform. We are targeting DR1-type applications. I can tell you that the team has done an absolutely phenomenal job finishing the design, going through the qualifications and now transitioning to production. We are actually -- have just started some very initial shipments of our DSP. So we're quite excited about that. As I mentioned, we do feel like we're late to market, and it's -- there are many existing solutions in the market today. But I would say that customers are looking for alternatives. And our part is compelling. It has integrated -- an integrated driver. It's competitive on power. And so we do believe that we can, over time, win market share. I'll also add that we're not standing still with using this platform. And we will go after other applications, including mid haul, which requires a DSP functionality. And then last, I'll add that the project was a multi-year project, and it created really a treasure trove of IP and we have mentioned publicly that we won't be doing new DSPs at smaller nodes. However, we will take full advantage of all the IP we have to go after a variety of markets with new products, so that we maximize the value of this IP.

Great. And as a follow-up, maybe a similar question on silicon photonics. Obviously, this is a bit more longer term, but again, what segments of the market do you intend to sample those products as they become available?

We'll probably start with 400G and work from there. So for example, a 400G DR4-type pick might be one of the first products. We would probably follow that up with an FR4-type application in product. So these are complex assemblies, as I've talked about, where we're mounting lasers up to 4 lasers on a single silicon photonic device. I can tell you that we've made tremendous progress over the past year. We've changed our strategy in terms of design approach. Not only on lasers, but also silicon photonics, and we've completely changed up our approach with putting together the L-PIC. So there's been a lot of change of strategy as it relates to this R&D project. And so we're feeling very confident that we have a viable plan, let's say. But I would just caution everybody, it is early. We still have a lot of work to do. We are working with some lead customers that have done some funding of some of the projects. So I think this year, maybe early next year, we'll have small amounts of R&D dollar or R&D revenue, let's say, going out the door to support some of these custom programs. And so we'll continue to work on this, but it is a long-term project. And once we feel we're getting close to product launches, and product introductions, then we'll talk about schedules and product revenue ramps.

Our next question comes from Tom Diffely from D.A. Davidson.

So the first question is on the really strong book-to-bill, I mean, 1.4:1. And then your comments that you expect that to come back down in the subsequent quarters. So I'm curious, does that mean that you expect a bit of a slug of revenue to happen in the fourth fiscal quarter as a result of this?