MKS Inc. (MKSI) Earnings Call Transcript & Summary

Thank you, everyone, and good morning. This is Patrick Ho from Stifel. I cover the semiconductor capital equipment and other applied technologies sectors in the technology space. Up next on our agenda is MKS Instruments [indiscernible]. They are one of my preferred names. This is a company that participates in the semiconductor side of things on the subsystems and optics ends, but has also evolved over the last several years to go into new markets like lasers and other photonic solutions in many different other marketplaces. We have the executive management team here from MKS Instruments here today, including CEO and President, John Lee. I'll let John first give a couple-of-minute introduction on MKS Instruments as a company. And then we'll start our Q&A for the fireside chat session. So John, with that, I'll toss it over to you.

Well, thanks, Patrick, and I hope everybody is safe. MKS has gone through a large transformation over the last 6-plus years. We were originally a 1-market company, semiconductors. And then about 4 years ago, we transformed that by the acquisition of Newport, expanding our markets into lasers, photonics and optics. And then a year ago, we continued that transformation through the acquisition of Electro Scientific Industries. And so MKS in the last 6 years has gone from kind of a $700 million, 1,800 employee single market company to a multi-market company, $2 billion, with over 5,500 employees. And this transformation has occurred in actually very rapid fashion in the last 4 years. So one of the areas that I'm focused on right now is to make sure that we're $5 billion ready, is kind of the tag where -- we like to use inside, meaning, making sure that our functional organizations and our leadership scale to that next phase of growth for MKS. And if you just do the math and the way we've grown and our cash generation and what we prefer to do, which is acquisitions, since there's still many good targets, $5 billion is not that far off in the future. So as many of you know, MKS' technology has been world leading. We have the broadest portfolio of all the vacuum components that surround a vacuum chamber in semi. We've expanded that to encompass lithography, metrology and inspection. And then we've moved into advanced markets. And the part of the advanced markets that we focus on is industrial microprocessing, making things smaller and more precisely using lasers and the Surround the Workpiece portfolio. So we've taken that Surround the Chamber concept and moved that to Surround the Workpiece with our portfolio in lasers, photonics and optics. So with that, I'll stop and go on to other questions from you, Patrick.

Great, John, and that's -- that was really a great introduction, and you're right about the evolution of the company over the last 6 years. Maybe start off a little high-level question for you since you've been at MKS for some time, but you're relatively still new as a CEO, what are your -- some of your priorities as CEO, particularly as you look at MKS Instruments over the long term?

Yes, you're right. I've only been CEO for 5 months, but feel like 5 years though, Patrick, because we had this thing called pandemic, we had a recession, and now we have some social issues, too. But the team I inherited is very solid. It's pretty much a similar team with some new people added as well. So the area I'm focused on is to ensure that we can put the people, the talent and the infrastructure to be ready to take on the accelerated growth to $5 billion over the next 3 to 5 years, I'd say. And so that's really an area that I really focused on. We've hired some key functional leaders from larger companies to help us tell us what a $5 billion company might look like. And also, the other area that I focused on is driving growth in our 2 market segments, the first one being semi, the second one being advanced markets. I think there's still a lot of opportunities there to grow organically and inorganically. And then finally, I focus a lot on driving the collaboration between the various groups. So for instance, Light & Motion and their laser portfolio and motion portfolio and optics portfolio is really key to the Electro Scientific Industries, ESI Group, in order to allow them to make the next solutions -- next-generation solutions for their customers. So those are 3 areas I am focused on.

Great, John. Let's get to some of the topics at hand. And we'll primarily focus on at least 2 of the near-term topics that investors have had questions on. First, we'll start off on the COVID-19 impact, both internally and operationally and on the demand front. First, can you discuss how MKS responded as the crisis evolved? What steps did you take in order to ensure you could procure the necessary supply and parts for your products? And what efforts did you take to ensure that you protected your own manufacturing sites, while at the same time, being able to deliver to your customers?

Yes. Thanks, Patrick. As you know, we've had a long history of operational excellence, having been in a cyclical industry like the semiconductor, where you can ramp very quickly. We've had to basically develop those skills that allow us to do these ramps, which can be as high as 30% in a quarter, followed by another 30% in the next quarter. And so some of those skills served us well, actually, when we started seeing these challenges brought on by COVID-19. So when you have supply disruptions in your supply chain or even if your own factories have some disruptions, we have a playbook of things that we normally do to counter that. I'll give you some examples. First of all, we certainly procure long lead items ahead of time. And then we -- because of COVID-19, we had to start segregating shifts, so that shifts don't talk to each other, so that if we do have a positive case, it only affects 1 shift. We started doing that early on. And then also reaching down and helping our suppliers get the necessary government exemptions as an essential business. That's another area that we didn't usually have to do. So those are kind of new things versus what we normally do. And then, of course, ensuring the safety of our employees is and has been, continues to be the first mission. Without a factory of working people, we certainly can't meet our demand. And so we continue to evolve our factory processes and to keep the employees safe. As we learn more, as the new guidelines come out, we continue to implement those to keep our employees safe.

That's great. Maybe as a follow-up question to COVID-19, can you describe the overall demand environment and how MKS is positioned to meet this demand outlook in the near term? Are lead times still extended? Or are you seeing any signs that condition of returning to "some level of normalcy"?

Yes. As you know, Patrick, in -- for Q2, we guided down about $50 million from -- at the midpoint from what we did in Q1. And we did that as an event of caution because there's still a lot of unknowns to the supply chain constraints and the shelter in place directions around the world, specifically in Malaysia and Mexico, where we have some large footprint and/or our suppliers do. We did note though in our earnings call that order rates had remained healthy in Q1. And that if the constraints didn't exist, our Q2 revenue would be in line and possibly better than our Q1 levels. And so I would say today, many of those countries and suppliers have kind of gone back to a new normal, and they're operating well. And so really, the task now is to try to recover some of that backlog that obviously was hindered during the quarter. So -- and we're off doing that. And certainly, we can't guide this quarter yet anything new from that, but I'd say things have returned to new normal and on recovery now.

Great. That's helpful on that front. So let's move to the second issue that's out there for investors. The U.S.-China trade war and commerce tensions that we see today. What is MKS's take on the recent escalation and the new commerce department reservations regarding licensing of sales into China? What potential impact will it have on your business opportunity to sell directly there to any other potential Chinese equipment companies?

Yes, it's a great question. So we continue to review it internally. It's still too early for us to measure and quantify that. We have ranges, for sure. And the reason we can't really quantify it is because we're not sure how these directives will be implemented because they haven't really taken effect, and they will be taking effect shortly. But I'd point out that MKS has always had dual-use products. So it's not something new to us. We already have processes in place, including customer certifications to seeking export for it. So it's not something new to us. It's maybe more paperwork and more products and more customers. But the process is pretty robust within MKS. I think more broadly, if you look at the kind of products that we sell and the kind of products that we like to sell in the markets we like to be in, our solutions always have a high barrier to entry and are differentiated. And this has led to our leading position in so many categories of subsystems. And so I think that is the best inoculation towards any kind of tariff or commerce tensions in the short term, for sure.

Great. That's helpful on that front as well. Let's go to your different business segments. And let's start with your core semiconductor subsystems business which has been, like I said, the core of your company over the last few decades. From a big picture perspective, can you provide your thoughts on the increasing capital intensity trends in materials, both engineering and manufacturing, which I believe is driving increased capital intensity for processes like etch and deposition. Can you provide how MKS sees this trend and -- if my thoughts are valid? And how you're well positioned to capitalize upon them?

Yes. I would say we certainly would be in favor of capital intensity rising, we certainly are not counting on it. It's always been in the 10% to 12% range, 10% to 12% of semi revenue. But we hope it does increase. I think capital intensity increases may be driven more than by just materials, Patrick. I think it's not just materials driven, but process -- production process driven and chip structure driven. And so for instance, our RF power is really addressing structure change, vertical NAND, for instance, and FinFET. EUV, for instance, is about a process change in semiconductor manufacturing. ALD, of course, is about materials. So I think it's a little broader, in our view, Patrick, in just materials. I think there are opportunities as processes change, production processes as well as chip structure changes.

Great. And you are the expert on that, on the engineering side, not me. So it's good to hear. Secondly, can you discuss how you've taken your previously stated Surround the Chamber strategy and position MKS to continue to benefit from these different areas, as you mentioned, very process-driven? Surround the Chamber has been something your predecessors have talked about. How do you continue to evolve that?

Yes. One of the most valuable parts of having a broad portfolio and a Surround the Chamber strategy is that when you have this broad portfolio, it gives you insights into key technology inflections very quickly because you're participating in many of these different process steps. It also gives you expertise across products and applications. So you're good at many things. And then, of course, most importantly, if you have a broad portfolio, you have the ability to address any shifts in those market demands. So for instance, in the '80s measuring pressure was key, still is. Then things started inflecting as chip structures changed to verticality, and then RF power became more important. And now as we get into the age of atomic layer kind of processes, ALD has become more important. So the strategy about Surround the Chamber is not just more is better, it's more is better because. And we're taking that same thing, the same idea towards our Surround the Workpiece strategy as well. I think when you have a broad portfolio, you're also becoming a more strategic and intimate partner to your customers. They know you have a lot of products in the portfolio. They may only need half of it today. But in the future, they might need different things. And they know you're there for them, and they know that you have that toolbox of solutions -- potential solutions for them. So I think that's how we look at our Surround the Chamber strategy and how we would extend that to Surround the Workpiece.

Great. Maybe as a follow-up to that. Are there market segments within your subsystems business such as RF power would you believe MKS can gain additional share? And what's been the driver in terms of winning in these segments?

Yes. We'll talk of RF power a little bit, one of my favorite topics. The vertical scaling of VNAND certainly has driven an absolutely unprecedented change in the road map of RF power. For the first 40 or 50 years in the semi industry, RF power has increased a little bit, new frequency has been used. But in the last 4 years or 5 years because of VNAND, RF power has increased orders of magnitude and complexity. And so our RF power solutions enable that VNAND hole etch, for instance. This will continue. I think even if everybody who's making VNAND starts stacking them, I think if you can increase your ability to process higher aspect ratio features, it actually makes the ability to not just stack higher layers, but to actually make them smaller, so you actually increase density for the same number of layers. And so I think RF power for dielectric etching will continue to be a growth driver for us. We've talked about some of our design wins in conductor etch. We've talked this year about some initial revenue from some of those design wins that we've had in the past. And just as a reference, even though the numbers are small and -- but growing, our conductor etch revenue last year was kind of single digits. And this year, it's doubled. And so it's still small, but we like the trend. And we like the fact that we've had design wins in the past and now it's turning into revenue. So I would say there's still a lot of areas of potential market share gains. ALD is the other one, atomic layer deposition. So I think, again, it goes back to our broad portfolio strategy, which is that RF power the last 5 years has been key; ALD, the last couple of years and going forward will be key as well.

Great. And maybe as a final question on the semiconductor side of things. In your acquisition of Newport several years ago, part of it entailed an optics business that serves different marketplaces within the semiconductor manufacturing process, including lithography and process control. Can you discuss your strategy and efforts to grow that business, which you've actually shown over the last few years? But what are some of the opportunities there to continue to expand on that segment?

Yes. I think -- we call that internally world-class optics. I think when we bought Newport, they had already established a decent semi business with market leaders in lithography, metrology and inspection. But the customer has always told, if you could do more, if you have more capabilities, if you invested more in CapEx and capabilities, the process capabilities, we can give you more opportunities. And so that's what we're doing now, investing in new tools, new expertise and then moving our capabilities up the food chain so that we can address more of the kind of SAM that's needed by the lithography and metrology and inspection companies. So that's our strategy for growing in that segment. Just stepping back a little bit. If you look at the 5 key customers that we have in semi, that's the Applied Materials and Lam and Tokyo Electron, the vacuum companies, but it's also ASML and KLA-Tencor. Those 5 represent 85% of all WFE and they're industry or segment leading customers. And so we really like our exposure to all these leaders in the semiconductor industry and, more broadly, our exposure to all of WFE or 85% of WFE rather than betting on one or the other.

Great, John. Let's move to one of your growth segments on the Newport Lasers and Photonics business and some of the market opportunity there. First off, on the laser business, perhaps you can refresh investors and reiterate that MKS does not participate in the fiber laser market, which tends to be more commoditized, but rather supplies pulse lasers that serve different markets and customer bases. Can you provide the value proposition of pulse lasers? And which key markets MKS is particularly focused on given the share gains you've garnered since the acquisition? Are there additional markets or products that can further expand your presence?

Sure. Yes. So we primarily serve what we call the microprocessing market, which represents manufacturing of small things more precisely, as I said earlier. And this requires pulse lasers. One of the most exciting applications today for microprocessing is what we call advanced electronics manufacturing. So this is a key strategic focus for us and addresses applications such as PCB manufacturing, advanced packaging, solar, display, manufacturing. But our strategy is not just confined to lasers. We're unique in that we have a Surround the Workpiece solution, many different solutions that can serve these customers. In fact, we extended our Surround the Workpiece capability even further to include systems via the acquisition of ESI. So from a market share perspective though, we are pleased with our success in securing leading market share in nanosecond pulse lasers. We're entering the picosecond market of which we have almost no share. And we're already in the femtosecond laser market. So these pulse lasers are really difficult to make. They really enable the ability to make things smaller and more precisely. And so the fiber lasers that you're referring to primarily serve the macro processing market. We don't sell any fiber lasers, but we do still provide certain critical components and diagnostics to fiber laser manufacturers, such as beam profilers and parameters.

Great. That's helpful. You briefly touched upon it in your Surround the Chamber answer for the semiconductor side. But one thing I wanted to get a little more color is you've taken that strategy, and you mentioned again Surround the Workpiece on the lasers front? Can you detail how this strategy is applicable or similar on the laser front, given your success on the semiconductor side base? Why do you believe it's applicable and you can grow in that -- on the laser side in a similar fashion?

Yes. I think it's the same reason as with our Surround the Chamber strategy. The broad portfolio provides us the insights into key technology inflections because we're participating in many of those product categories. It gives us further expertise across products and applications, not just being experts in one category. And that allows you to address shifting market demands, just like we've done in semi for the last 50 years. In fact, the acquisition of ESI, when we added laser systems, it's just a natural extension of our Surround the Workpiece strategy.

Great. Let's move to the ESI business and some of the market opportunities there. In 2019, you made another transformative acquisition and acquired Electro Scientific Industries which further broadened your laser product portfolio as well as expanded your presence into other markets like [Audio Gap] First, if you can refresh the audience, the key drivers for this acquisition, why did you do it, how does it expand your presence? And how does it contribute to the overall operating model?

Sure. As I said, the natural extension of a Surround the Workpiece strategy is a systems solutions company. And the real motivation for it is that we thought that we could leverage some of the expertise in our various product categories of Surround the Workpiece to enhance the systems group, so that we can provide better solutions, better cost of ownership to our systems customers. And those road map meetings have started and continued for a year now. So road map meetings on lasers, road map meetings on motion control, road map meetings on optical subsystems. And we believe that collaboration can allow us to provide some industry-leading solutions for the ESI group. ESI already is the industry leader in flexible PCB via drilling. They've taken a lot of that capability, and now we're attacking what we call the HDI market, the high-density interconnect via drilling market. And there, we have no market share, and it's a bigger market than the flex PCB. So we think that the rationale of ESI is just a natural extension of Surround the Workpiece. If you have all these components, you should be able to develop next-generation solutions of systems better than anybody else.

Great. Let's go to some of the specific businesses in ESI. It's a company I covered, so I kind of know some of the businesses there. One of them, as you mentioned, was the flex PCB laser business. The company was in the midst of a cyclical downturn in this area at the time of the acquisition. How do you see that marketplace today? Especially with the disruptions and issues going on in the world today, do you see a potential recovery occurring in that marketplace as we get to some level of normalcy?

Yes. I think certainly, there's been a lot of economic disruptions globally. And you hear reports that the smartphone build being lower in 2020 than 2019. Now that's created some near term uncertainty. But really, our flex PCB business is not just driven by volume, it's also driven by technology transitions. By that, I mean, as you go to newer materials or flexible circuits, when you go to smaller features or just that a customer has to build out a factory to take on the next iPhone business, these are all drivers for our flex business tools as well. And then in fact, when you look at 5G, it's a catalyst for this too because the content of flex in a 5G phone is 30% higher than the flex content in the previous generation. And so even if the units are flat, the flex content is growing 30%. So those are tailwinds. And we really like the long-term pieces of growing flex content and these technology transitions and are positioned in there with the ESI Group.

Great. And maybe as you briefly touched upon in your intro on the ESI business about the HDI laser market where you're entering it with new product and trying to expand your share there, can you discuss the potential market opportunities in that business segment? It's a larger market than flex PCB lasers? What are some of the opportunities there? And why do you believe you can gain share in that segment?

Yes. The HDI market is around a $500 million a year market today for equipment, growing at high single-digit CAGR. The flex market is kind of the $150 million to $200 million market, growing at high single-digit CAGR as well. So we love markets that are growing in those kinds of CAGR numbers. As we talk about flex, we have a high market share. In HDI, it was 0. So we've launched new tools. We've talked about multiple data customers testing those tools in various regions. And we believe that we have introduced a tool that has a very attractive cost of ownership, footprint, weight and process flexibility. And so those are the kind of feedbacks that we're getting from our customers. So we will continue to test and develop new processes with our customers with these new tools. And I think 2020 is a develop applications, get designed in; and then 2021 as they ramp, then these tools will be PTOR for some of those processes.

Great. That's helpful, John. Let's move on to the operating model. And one of the things that I think had differentiated MKS from a few others, particularly over the last 6 years, is following the Newport deal, you were able to quickly recognize and exceed your cost synergy targets and drive significant accretion into your model. Market conditions and the acquisition of ESI have slowed it somewhat over the last year or so. But how comfortable are you with your long-term target model assumptions? And what are some key drivers that will continue to drive increased earnings and operating margins over time?

Yes. When we had our Analyst Day in 2018, that was prior to ESI, obviously, and so we had a long-term model that was kind of the $2.5 billion market range -- revenue range. And that was predicated on kind of the 50% drop-through for gross margin and kind of 40% to 45% drop-through in operating margins as we scale. And that was just the Light and Motion and Vacuum and Analysis divisions. And that model is still very much intact. ESI has similar gross margins on average, it's a little more lumpy. But we believe also that it has similar types of drop-through in terms of gross margin and operating margin as their revenue increases. And as we talked about, ESI did go through a digestion period in 2019 in their markets. We believe that going forward, on a long-term basis, ESI will also contribute similarly to the other divisions at MKS.

Great. Let's go to the balance sheet, your cash flow and capital allocation. Can you give the audience your thoughts on the uses of cash ranging from repayment of debt, which you've been very aggressive in the past in deleveraging yourself and other capital allocation strategies like your dividend? You guys have been obviously focused on M&A. We've seen 2 transformative deals in the last 6 years. How do you continue to evaluate future M&A opportunities?

Yes. So with respect to delevering, like you said, we are very aggressive on that. In the near term, as we've talked about, given the uncertainty in the global economy, we'll likely take a pause on voluntary debt prepayments, build our cash balance instead. And of course, when things stabilize, then we would probably return back to more of an aggressive delevering strategy. With respect to the dividend, we are committed to our dividend strategy, and we'll continue to also explore acquisition opportunities. There are still many targets and good targets in not just semi market, but also the advanced markets, arguably more targets in the advanced markets because there's just been less consolidation there. And I believe the acquisition is still a great way to improve shareholder value for MKS.

Maybe as a quick follow-up to that in terms of M&A. Obviously, you've got a really good track record, particularly with Newport. How do you look at both the types of metrics that would help MKS grow and expand from an M&A perspective and as you mentioned with ESI, that expanded your presence from the laser footprint that you established with Newport? How do you look at both, I guess, the fundamentals as well as key operating metrics that fit into your M&A profile?

Yes. I think the most important metric we will look at is the gross margin, Patrick. MKS is about technology, it's about differentiation. And as we talked about, that inoculates you much better when localized trade wars occur and things like that. We look at is 45% gross margin, that range, plus or minus 5% tells you that, that company has products that people are willing to pay for, it's differentiated. And that's what we really look for. There may be situations where it's lower than that. But it's for some specific reason that we think we could change very quickly. And so that is the #1 area that we look at. Now we look also fit with the current markets that we're in. Semiconductor, where we have half our revenues, continues to be a strength for MKS. And so if acquisition targets become available, that's certainly something we're always interested in. But as I said, advanced markets, there are just many more companies there, that's just because there has been less consolidation in advanced markets. So we like both of those. And we will continue to look at those very actively in our pipeline.

John, with that, I think we're out of time, but I want to thank you and the team again. It has been a great ride to date for MKS Instruments. You now, I believe, are over a $6 billion market cap company. And I know you've been a big contributor to it. So again, thank you for the time this morning. And keep up the good work.

Thank you, Patrick. Thanks for your support.

And with that, we'll end our MKS Instruments fireside chat. Thank you.