MKS Inc. (MKSI) Earnings Call Transcript & Summary

Good morning, everyone. This is Krish Sankar, the senior equipment analyst at Cowen. Nice to virtually meet all of you. The company we are presenting right now is MKS Instruments, one of the leaders in components, lasers and also PCB and MLCC testers. Diversified business over the last few years. We're very fortunate enough to have Seth Bagshaw, the CFO, here. Seth, how are you doing?

Good, Krish. How are you? Thank you.

Good. Nice to virtually see you, Seth.

So I have a list of questions. I'm just going to go over it one by one. So first and foremost, thanks for your time. So let me start with something more topical, Seth, the commerce department (sic) [ Department of Commerce ] ruling. While I understand there are a lot of unknowns and political outcomes are difficult to handicap, it seems like there are 2 rulings: one is the civil-military fusion one, which is going to go into effect end of June; the other is the direct product rule that came out 2 weeks ago, targeting Huawei shipments through TSMC. So from your vantage point, how do you see this impact the industry in general and MKS Instruments in particular?

Yes. Great question. So it's quite topical. So it's really hard to handicap exactly what's going to happen with these rulings. Obviously, there have been fairly recent rulings. The impact can be kind of widespread. I would say the -- there's a bit of lack of details behind these rulings. So again, it's kind of hard to handicap these. What we found is we do ship some products that are core dual use. So we do go through Western process today. We're pretty used to doing that, which is kind of our core competency. So we think we navigate that, I think, pretty easily going forward as well. That's really, again, hard to say. Obviously, the Huawei ban, for us, affected us last year. The direct sales for us were relatively minor. The indirect sales could be larger. We navigate that pretty well. What we're really excited about is if you look at the semi industry in general, you need MKS products and technology to manufacture any chip around the world. So our view in the long term, for sure, is no matter what happens with these rulings, the MKS is in a good position to support the industry across any geography, U.S., China, Europe, obviously. So we're still pretty positive about the long-term impact on the semi -- long-term growth on the semi industry. We're trying to figure out the short-term impact on this has been quite challenging. So just hard to figure that out.

Got it. So do you still say it's kind of like a work in progress kind of fit?

Yes, exactly. Work in progress. We have internal meetings trying to go through the rules, and we're kind of in that early stages, quite honestly.

Got it. All right. And then when you look at your blended gross margin, it does look a little down versus prior cycles. Now I understand your much more diversified business today versus even 3, 4 years ago. You have ESIO in the mix and also Newport. What are the puts and takes that can help gross margin get back to prior cycle levels?

Yes, exactly. So the thing that drives for us is really volume. So as we said in the past, our operating model is a fair amount of leverage as you grow volumes and revenue. The 50% variable gross margin is still applicable. That's intact. It's been a long-term model as well. And so if you look at kind of our Q1 results, $536 million of revenue, maybe take ESIO out of that mix and compare the Light and Motion deck analysis revenue component. You go back to the peak period of early 2018, $573 million revenue. There's a big delta in the volume. That's really a big driver for us on the gross margin. We feel we can back up to those volumes, we'll be back to those similar margins we had back at the peak semi cycle. We're really happy on ESI. In the first quarter, the mix of product for ESI was more toward the flex market. And the margins on ESI in Q1 were actually above the corporate average. So we think that model is pretty well intact. We'll always strive to -- our DNA is to do profit improvement activities, leverage low-cost countries. We've always have that part of our DNA on a regular basis, and that's been going on for many, many years. And again, that's still intact going forward as well. But the real driver for us will be volumes, quite honestly, Krish. And again, getting back to those historical volumes, I think that margin would back up to those levels as well.

Got it. And then like on the topic of margins, how should we think about OpEx? Clearly, pre-COVID, OpEx will increase this year because you're kind of heading into a cyclical recovery. Now everything is up in the air at this point. So how should we think about OpEx? How much room do you have to model it that if downstream demand does slow down, down the road?

Yes. Great. So we guided the second quarter. We were kind of careful in talking about the operating expense in Q2. We won't make any major changes in operating structure. And the business is very robust in Q1 and coming into the second quarter as well. So our view right now is the midpoint on the margins in Q2 was very similar to Q1. Maybe a little favorable because people are traveling less, less discretionary spending, but generally in the same relatively quantum of OpEx. That's kind of my view certainly for Q2. Again, our DNA has been to react very quickly. So if we, for a downturn, had to make changes in our operating structure, we have a lot of levers to pull, variable compensation and resize. That's probably $5 million or $6 million per quarter. We hope that doesn't happen, but that is an opportunity for us going forward. We do a lot of temporary labor, overtime, direct labor resizing, discretionary spending. Those things are kind of all in the mix that we had to pull levers, if we had to. Our view right now, though, is Q2 feels very strong for us, strong operating business levels. So not making any major change in the operating structure for sure right now. But we can go back to 10 years ago in the '09 downturn, when the whole world really seized up and we weren't as diversified back then. We mostly get inside semi market. We did make a lot of changes and really were approaching breakeven that year as well. So we can really resize things pretty aggressively. What's different today is we're much more balanced portfolio. Half of our market is in semi, half our revenues outside the semi market. We react in kind of different trends and all operate in sync. And then the service business has grown for us as well. So the operating model today is much more robust than back 10 years ago. We actually can make those changes if we had to. And right now, that's not in our uptaking.

Got it. So Seth, along the point, when you look at just the COVID-specific issue, so you have the headwind of higher freight costs and also had the COVID tailwind of lesser travel expenses. So if you look at all the COVID specifically, is it net-net awash that the upside basically offset the downside?

Yes. It's a great question. So for us, the COVID expenses on the freight side, I know some of our major customers have probably had a little more headwind on freight than we've had. We're not shipping some of the heavy tools and equipment that other OEMs are certainly shipping outside the U.S. So the freight costs for us have been manageable. We've actually been driving down the freight cost on a separate workstream to be more efficient. So I think kind of a net-net neutral. We had incurred some cost in Q2, more on the incremental onetime costs and managed through the second quarter, and we did non-GAAP those costs out as well as we'll get a credit from the federal government to keep paying employees. We have a non-GAAP debt creditor as well. So I would say that in Q2, the net exposure has been actually, in Q1, relatively minor for us on a non-GAAP basis. On a GAAP basis, it was probably $500,000 to $800,000 for the quarter. So it's been quite manageable going forward. We think some of those costs I mentioned that are kind of short-term in nature will not occur in Q3, unless something changes [ back ] in some of the states we operate in. So it's actually quite manageable going forward. I do give a lot of credit to the operations team as well, where when we gave our Q1 guidance, we guided $520 million on the midpoint. That was before COVID-19 became really a factor in anybody's thinking. And then we came through at $536 million in Q1 as well. So we had some higher costs, I mentioned, but the operations team has done a fantastic job. We [ won ] support from the corporate team to really make that revenue well above the midpoint of the guidance range, and again, a midpoint that we gave without any COVID headwind in our thought process. So again, it's kind of our DNA to be able to react pretty aggressively and quickly to anything that kind of comes our way.

Got it. That's helpful, Seth. And then I think over the last -- I think it's been a little over a year. I think you guys have been speaking about gaining market share, especially on the etch power supply side. So can you elaborate a little more on the market share dynamics because you're seeing a gain in share, so is your competitor on the power supply side. So from your vantage point, are these share gains -- are they coming from U.S. semicap OEMs or Japanese customers, Korean customers? Any kind of color would be helpful.

Yes. So if you go back probably 4 years ago, one of the things we did as a company, and this is [ came ] into Jerry Colella's leadership and John Lee's on the product development side, is we looked at looking at putting R&D dollars to work in a pretty efficient fashion. And one of the areas we looked at on the semi side was the power segment. We felt that opportunity there for growing share was compelling for us. We felt there was some unmet needs by major customers. So probably back 3, 4 years ago, we put additional R&D spending into that vertical. And that spending is, obviously, headcount, it's material spending for R&D, it's kind of channel interaction, road mapping with the major customers. So now you kind of fast-forward today, we are seeing some opportunity. We've gained some share in the power segment of our business. And that's a direct result of the decisions and the investment we made a number of years ago. Don't really want to comment, quite honestly, on a customer-level basis on where those shares came from. But if you look at 3D NAND, some of the power requirements there do the high-aspect ratio etch, we have virtually 100% share on that power segment as well. So -- and we had obviously no share years ago, and that's a vertical we saw had a lot of opportunity. We worked very closely with some major customers to kind of get that type of opportunity. So -- and then we're looking forward, I'll say, pedal to the metal, we think that's a good opportunity for us going forward as well in the power segment. So we're very happy with where we are right now. We think that will continue going forward in the future.

Got it. All right. And then switching a little bit away from semicap to, I think, the legacy new [ quarter ] what is called as the Light and Motion business. It seems like the end market there are mainly industrial customers. So is that still the case? And then when you see this market recover? And the reason I'm asking that is because IPG Photonics, on their earnings call a couple of weeks ago, mentioned that they are seeing a V-shaped recovery in China, but were unsure of the sustainability on the recovery on the laser side. So I'm kind of curious. What has MKSI seen on Light and Motion business?

Yes. So Light and Motion, you're right. We acquired a company -- it's actually 4 years ago last month. It's been a great acquisition for us. Gave us exposure to the laser market. And in the event -- within the Light and Motion Division, we have a number of markets and we're kind of breaking a couple of major categories or broad strokes, if you will. So we have the traditional industrial, which is the cutting, welding, process industries, and then we call more of the advanced electronics manufacturing piece, which is microprocessing. We have pulse lasers, more high precision, whereas IPG is more of a continuous wave laser where you're welding and cutting. We do have products that support that ecosystem, beam profilers, power meters, optics, vibration controls. We are exposed to that segment. But our laser portfolio is more in the microprocessing. We have high pulse, high precision. We're doing applications today that can't be done in the other way. And ESI acquisition is a good example of that. You can't do 35-micron via whole processing with a drill or a saw bit obviously. So that microprocessing a little bit different than IPG, which we think is kind of compelling for us. And those markets are exposed a lot to the mobile device industry. Now with 5G and the growth there as well, we think that will be a growth driver down the road for us. So right now, we're seeing good opportunity there. We don't have the pricing pressure with -- that some of our competitors are seeing in the classic macro processing segment. Trying to pivot and predict what will happen, is it a V or a W, it's really hard for us to say. It's the same question. It's a great question. It's just hard to answer right now because we have to see what happens. We are well positioned in those markets. Our direct sales in China runs about probably $50 million a quarter. It's about 10% of our business. The indirect is probably a larger proportion, obviously. We're trying to predict whether V or W, is hard to say. What is encouraging is we do a fair amount of manufacturing in China, and those facilities were hit pretty hard, obviously, in early February of a Lunar Chinese New Year, Lunar New Year, the extended holiday season there that the local governments gave to get people back up and running. Those factories came back actually quite quickly for us. And so I think that's encouraging. But trying to predict what's going to happen in that China market is a little bit challenging, frankly. But we're very optimistic. We're well positioned. We have put more investments in the sales functions the last several years as well in China. So we think that will be an opportunity to invest in that business going forward.

Got it. And then just the way we spoke about the competitive situation on the semicap side. We talked a little bit about it on the laser or the Light and Motion side. I mean, I look at it as 2 segments. One is the western competitors like the Coherent, the TRUMPF lasers. And then the Chinese competitors who typically have been like [ breakers ], et cetera. So how do you see the competition on the laser side? And how would you evaluate them versus your strengths?

Yes. Yes, great question. I would think for us, we've got a slide in the investor deck that kind of lays out our market position across the different segments and you look on the left-hand side of that page, you'll see kind of [ dots ] we dissect on the competitive side. And Coherent for us is probably the best as comp on the research side, for sure, and so the microprocessing segment. IPG, we don't really -- the macro processing segment. I wouldn't say there's not much overlap between IPG and MKS. I think Coherent is one of the U.S. competitors are probably the ones I count to. Interesting, in some of the cases, the Chinese laser companies, we actually have are customers of ours as well. So we can kind of provide components. And again, with the thing, I think, a little bit different than us is in the microprocessing segment, it's very hard to replicate that type of solution in the marketplace. So we're not seeing -- we have a lot of qualified competitors around the world. We're not seeing the pricing pressure in the China market, the lasers that -- that I know other people have seen as well. So I think that's a testament to either the technology we have, our customer relationships, that's again the focus we have going forward. That has not been something we experienced to a large degree that some other people experienced as well.

Is it really because the pulse laser is really difficult to do or?

Yes. It's the optics are hard to replicate. The power generation is hard to replicate. These lasers pulse 1 billion times a second. Obviously, they're very precise. They're relatively low [ waters ] compared to a continuous macro processing laser. But the peak pulses create huge spikes in power. To control that is not easy to do. And in Newport, in the Light and Motion Division, for us has really decades of experience on the optical side to make that work. Spectra-Physics, which is part of our portfolio, is one of the oldest laser companies in the United States. So they've got a long history of really doing that type of technology very effectively. So it's very hard to replicate. A lot of IP wrapped around it.

Got it. All right. And then recently, you guys did introduce the ultrafast lasers, especially the femto and picosecond. I remember seeing it at the Photonics West conference in San Francisco in February, although it seems like it was an era ago, given what happened after that. So on that ultrafast laser side, is the goal there to gain share at the expense of, I believe, the incumbent is Coherent? Or is it more an increasing [indiscernible] opportunity for you?

Yes. It's actually both. Again, I don't want to get too detailed on the competitive landscape. But those, the nano, pico and femto are probably a $600 million market growing pretty -- a nice clip. Nano and pico are probably similar size. Femto is relatively small. We think about $75 million market there. And that's the market. We had -- in femto, we had a product portfolio already exposed to that market. The new product release kind of upped that game, if you will. In nano is where we had a lot of gains in share the last couple of years with new product releases. So with these pico and femto lasers, the general -- the way I look at it is if you can pulse more quickly, obviously, throughput gets affected negatively because your -- the slower processing time. You can speed that up and be more high precision. Two things can happen. One is if you have a better product, you can gain share. That's obviously our goal and desire. But also when you have these applications that you get to more precision, faster throughput, more pulses, our experience intended to create application opportunities in the same expansion organically that you never see without these type of tools. Again, my analogy is to look at drilling and saw blades, those welding that can be done in a big stainless steel slab. And now you're pulsing lasers by a billion times a second. If you can make that quicker and more precise, applications open up that a high-precision can't do any other way. So it's really twofold, Krish. It's one, to gain share. I think that market will expand naturally with more applications as you develop a lower cost, higher throughput opportunity. And that's been our goal with Light and Motion since the day we acquired that company back in August of 2016, and that was their goal, obviously, prior to the acquisition. We just sort of gave them a little more accelerator and more additional funding and executive sponsorship to kind of drive that going forward. So we're very optimistic about the laser portfolio.

All right. That's helpful, Seth. And then moving to the other part of the business, which is your last big acquisition, which is ESIO. It's been a little over a year, I believe. Can you just share your progress so far? And what makes you most excited about the deal or the product on the ESIO's front?

Yes. So ESIO was interesting from -- if you look back, I mentioned before is a great example where without lasers, you can't do this type of processing. When you're drilling 5,000 [indiscernible] a second, very high precision. 35 microns, you're very precise. In the flex PCB market, you now have smaller form factors, more connectivity, think of like a mobile device, an iPhone and so forth, and 5G as a driver as well down the road. So we like that opportunity, and that market was very compelling for us. We had a view on smaller form factors, more connectivity. That's the flex PCB market. When you look at -- when you pivot to the HDI market, which is a much larger market, there's no share to ESI or we have right now in that market. Our goal is to gain share over a number of years. And that's a product portfolio that ESI was developing before we acquired that company. And that's a $500 million a year market. There are 2 major incumbents. Again, we have no share. We have compelling product opportunity, is higher throughput, lower cost of ownership. They're actually a smaller and lighter tool versus the competition in the marketplace. So the thesis was if you believe flex will grow with 5G and mobile device, which we believe that's the case, then HDI is a whole new kind of greenfield opportunity for us with the right product portfolio, and unlike semi with [indiscernible], where we try to dislodge a competitor in the short term, in the HDI market, if you really have a better product and you have a better compelling reputation and service opportunities, you can actually gain share in that marketplace. So that's the whole ESI thesis. We fast-forward now a year into it, that's still intact. We had a good quarter in Q1. The flex market had a lot of capacity put in the marketplace, and we knew that back in calendar year '17 and '18. And we're now digesting that kind of capacity in the marketplace, we're seeing an uptick in the flex market, which is great. And then the integration was probably one of the quickest integrations I've seen in my experience. The culture of ESI is very similar to MKS, very much focused on the customer, growing the business, working on things that are really important, not a political environment, very much focused on just getting the job done. And then when you look at the cost synergies, we announced $15 million over 18 to 36 months. We announced last quarter, we had the $15 million complete, obviously, well ahead of schedule. And none of those costs savings affected the long-term growth of the business. They're very thoughtful. And the team at ESI was very supportive and helped drive that. So the markets are intact. We think flex is coming back. It will take a little while to digest, I think for the capacity marketplace. HDI is in early innings, but we're very optimistic there as well. The management team has integrated and they're fully engaged, helping drive that business. And we're providing some executive level of support, but frankly, they're a very confident team and know what they're doing. And then on the cost side, we're ahead of schedule. We'll probably beat that $15 million over time. So right now, we're feeling very good about that acquisition in the marketplace that we've entered. And then the last point in ESI, which is kind of qualitative, and it's actually very important. We looked at Light and Motion, provides lasers to ESI as a component. And ESI does, obviously, material processing and we build systems for end users. Having that -- the expertise on how material processing interacts at a usual level, which is ESI or E&S division, and how you develop lasers support that, having those type of R&D development activities under one roof is very important. Before, you're doing a road map with an end user, now you've kind of got those 2 individuals or 2 groups under 1 roof. We had, last summer, a number of R&D meetings, actually in the room we're in right now with the Light and Motion laser development team as well as the E&S system development team, having the interaction in that room and comparing notes. You can't put a number on that, but qualitatively, that's very effective and also part of the reason of why we acquired ESI.

Got it. So Seth, on that point, if you look at ESI, yes, the flex PCB opportunity in HDI, PCB, MLCC testing. So is it fair to assume the majority of the ESI business is going to be driven by smartphone? And if I -- if I'm a generalist, should I look at smartphone trends as a leading indicator? Are there any, besides the HDI set, are there any other product specifics I would look at?

Yes. I think it's fair. I think the mobile device, again, I mentioned before, if you look at -- an iPhone is a good example. You pull an iPhone apart and you see all the flex, where you have ear buds as well, there's flex in those. Anytime you have smaller form factors, you're trying to get more connectivity in those smaller form factors, think of flex as an opportunity. So there's a fair amount of leverage to that market, for sure, the mobile device for ESI and Light and Motion, to some extent, as well. The big -- so there is a driver there as well. What's interesting, too, when you get to the 5G rollout, we believe the flex component in a 5G phone may be 30% higher than existing phone today. So again, that's going to be a growth driver on 5G across our whole portfolio. But at the flex level, it requires much more flex PCB in a mobile device, and they'll drive more to the end for capacity adds as well. But again to your point, it's heavily leveraged the mobile device market for sure.

Got it. And then my last 2 questions was, one is, clearly, it looks like you're like doing some delevering right now. And if I look at the history of MKS, pre-Newport, pre-ESIO, that is largely bolt-on M&A. Maybe you go back 15 years ago, something to say, Helix was a one-off, but it's been largely bolt-on, but the last 2 M&A has been more transformational. So once you're done integrating ESIO, how should we think about an M&A strategy? Will there be an appetite again? Would it be bolt-on, et cetera?

Yes, it's a great question. You're right. If you went back -- we went public in 1999 and we acquired Newport in 2016. So we've made probably 15-plus acquisitions in that time frame. They're mostly on the semi side, for sure. And if you look at our IR presentation, we have a surround the chamber diagram, and we've added a lot of content in that, add more content in the semi market as well. That's still a goal going forward, although there's fewer opportunities out there, for sure. And we did, back in 2016, as you looked at Newport acquisition as an ability to kind of take our expertise in integrating companies and we go out send the expertise and Newport had a large semi component in their revenue. And so we acquired that company to give us more semi content. We now have KLA and ASML as 1 of the top 5 customers. We gave us obviously extension to go into laser processing and that ecosystem and ESI's extension on that as well. So now we've got half our portfolio in semi and half in these advanced markets, heavy leveraged towards ESI, E&S division as well as Light and Motion. So our goal going forward is exactly as you described, to continue to act, thoughtful acquisitions, disciplined in our thought process. The -- again, the semi market is pretty well consolidated. You might run into normal competitive issues there. But we would like to continue to ideally acquire assets there as well. But the bigger opportunity for us will be, I think, in these advanced markets. We have the laser ecosystem, which is still quite fractured. There are some larger players, very good companies. But I think that's -- I believe that space should consolidate, like it did in semi, the next 10 or 15 years. So that's where our focus is probably going to be realistically as they can look at those markets. And the acquisition is absolutely front and center for us. We've done, I think, a pretty good job delevering the balance sheet and repricing of debt. COVID-19, right now, we're kind of in this conservative cash mode at least in this quarter. But our balance sheet is pretty rock solid, and our debt structure is pretty modest. So the acquisition front, it's still part of our thought process today. This seems to take a little while to execute and do it correctly. It was absolutely -- that is our core desire to grow not only organically but inorganically as well. We think there's opportunity there definitely to do that going forward.

Got it. And then in the interest of time, my last question for you, Seth, is now I found it interesting in your last earnings report, there was no buyback all of 2019, and then you did about a $20 million buyback in Q1. So is the buyback thought process more opportunistic? Or was it a one-off that -- how should we think about your rationale for buybacks?

Yes. So we've done buybacks, historically speaking. I think we had $20 million, time flies, but maybe a year or 2 ago, yes. And it's kind of funny that the stock did dip in Q1 and tempting time to look at that, obviously. But with COVID-19, it was appropriate to kind of conserve cash, given the outlook we have. So share buybacks, you're right, are optimistic. If you went back, historically speaking, I think our average buyback is probably $25 a share or $30 a share. So back in the day, obviously, heavy weighted and it's always part of our discussion and mix. I think the dividend we have out there, we just announced that -- well, we started back in 2011, raised, I think, 6 times since then. So not a big cash use for dividends. I think it's a good proof statement on kind of the cash flow in the business. And I'd look at the buybacks as kind of opportunistic, to your point.

All right. Thank you very much. I really appreciate the time. That was very informative, and hope you have a great rest of the day today.

Okay. Thank you.

Thank you, sir.

Okay.