MKS Inc. (MKSI) Earnings Call Transcript & Summary

Good morning, everyone. Thank you for attending Day 3 of the Stifel Cross Sector Insight Conference. Up next on our agenda is a company I really enjoy covering, MKS Instruments. They are a leader in the semiconductor subsystem space with expanding market opportunities in other advanced markets. Before we start with the fireside chat, David Ryzhik, if you want to start it off?

Yes, hi, everyone. Any forward-looking statements that we may make today are subject to our risk factors in our SEC filings. You can find the GAAP reconciliation to any non-GAAP numbers we may talk about on the IR page of our website.

Great. Thank you, David. And with us today for our fireside chat session is CEO, John Lee. One, John, thank you very much for taking the time out today and looking forward to going over the story with you. Before we go to the long-term opportunities related to MKS, I did want to kind of get a near-term update from you from the standpoint of over the past month, there's been a lot of changes in the macro environment. There's heightened investor concern. You were pretty positive on the outlook for 2022 in your last earnings call. Has there been any major changes that would make you a little bit nervous in terms of the demand outlook given some of the recent volatility?

Yes. Thanks, Patrick. Again, thanks for the invitation to join here. The short answer is no. I think we remain very optimistic and bullish on the demand side of semiconductor demand for 2022. I think our peers, our customers, the industry has been pretty consistent with that message. I think it's really a story of constraints, the ability of our industry to deliver that -- to that demand. And there's some end markets that are up and down, but in general, that demand environment still is very strong.

Great. The other near-term question I wanted to address with you guys that I've addressed with other companies is the supply chain, the lockdowns that we've seen in China, higher input in freight and logistics costs. Over the past year, I think you guys have actually managed through that situation relatively well. Your margin profile has held up well. And look, everyone is struggling to get products to their customers. With that being said, what have you done to mitigate some of those issues on your end? And secondly, what's the biggest concern out of those multiple variables on a going-forward basis?

Yes. Maybe I'll answer that second part first. And nothing has changed. It's still supply chain constraints, mostly with legacy semiconductors. So we can't get the chips to make the equipment so our customers can make the equipment to make the chips. It's very circular, but it's really what's happening right now. So that hasn't really changed. And then the other kinds of constraints are, for instance, in certain specialty resins that might go into cables and things like that or specialty metals that might go into certain parts of our instruments. So those continue. I think I would say, characterize it as the same as we said at the earnings call, it's whack-a-mole. Things keep popping up. We keep dealing with it. I would also say that the collaboration with our customers continues in terms of working together to figure out exactly how to get more allocation for our industry. And so that is really a pretty positive that's come out of it. What MKS is doing for sure is we've added people. We've added resources. We've added inventory just to be ready. So when that critical supply constrained part comes in, we can ship quickly. And I think that's not any different than most of the people in the supply chain. And you're right, we've been doing pretty good, I think. But it's been a lot of diving catches and hard work and adding resources, working much more closely with our suppliers and their suppliers going much deeper into the supply chain. I think that's true of almost everybody in the industry. In terms of the reasons for that, I think we are constrained. The industry is constrained in making those legacy chips. All those fab guys are full. And COVID shutdowns, wherever they happen, whenever they happen, don't help. But I think the industry has been pretty good at navigating those kinds of changes.

Great. Let's go to the MKS story, which I find, one, very exciting and a multipronged approach. But let's start first on the semiconductor side of things. You and I have talked, I do believe we're in a secular growth phase, especially for the equipment industry, given the capacity expansion plans and the need for more semiconductors in the overall marketplace. Something that I believe investors want either don't appreciate or don't recognize fully is your leadership position in the overall semiconductor subsystem market. I know it's probably taking you back to the core of what MKS was before what you are today, but if you can remind investors of the value that you provide a lot of your equipment companies, to the point where I remember your predecessor used to tell me, hey, that etch system wouldn't work without one of our Baratron products. If you can just highlight the strong position you have in the overall subsystem market and how you support many of the key process segments today?

Sure. Yes. So semiconductor, the market is a great neighborhood getting better. I think people have said that. So we love it. And MKS is a franchise in semiconductor equipment. So if you think about the critical subsystems that go on to -- originally, it was vacuum-based equipment. So think of Lam and Tokyo Electron and Applied. Those are our biggest customers. But over the last 5 years with the acquisition of Newport, we expanded those top customers to include companies like ASML and KLA. So if you think of those top 5 equipment customers, that's 85% of WFE, and we're supplying all of them. And so in the critical subsystem arena, we have the highest market share for a semiconductor critical subsystem. And when you think about the fact that we've been in this industry for 60 years, only the strong are left, people who have been able to survive cycles and manage through cycles. And scale does matter because in down cycles, our ability to continue investing for the long term is really important for our customers because they are doing the same thing, and they want suppliers that can invest with them. And taking share is not easy. In some of our product categories, we have very high share. In some, we don't. And some, like RF power, we've taken share from kind of the 19% to 21% share 3 years ago to 30% to 31% share just 3 years later. But that was an investment we made 6 years ago. So we started that a long time ago. And that's the kind of investment that only companies that have the fortitude and the scale can do. And so we believe that MKS's franchise in semiconductors will continue, and we'll continue to grow actually.

Great. I do want to follow up on the RF Power share gains you've talked about because, again, you and I have been in this industry, I think, too long. But it's really hard to have vendors make switches, but you were able to do it. One, if you can characterize what were some of the key differentiators that allowed you to get these share wins. And secondly, the collaborative efforts that you mentioned in terms of your scale size, how that has helped in terms of enhancing the relationships with some of your largest customers.

Yes. No, that's perfect. I mean as I said, 6 years ago in the category of RF generators, we were a distant #2, kind of that 19% to 20% market share. The pie has gotten a lot bigger, almost doubled, I think. And at the same time, we took 12 points of market share. And all of that was done through strong collaboration with key OEM. Also driven by an inflection in the industry, and this inflection was the change from 2-dimensional NAND memory to 3-dimensional NAND memory. And that's the reason why all of us have phones where we can take pictures without worrying about it. We can actually take videos without worrying about it. In fact, when it's blurry, we don't even delete it, right? Some of your -- I'm old enough to remember, you had to delete stuff because you didn't have enough memory. That's all enabled by vertical 3D NAND. So it was an inflection. And then we had to develop our power supplies to allow the OEMs to etch these really high aspect ratio features. When D NAND first started, 3D NAND first started, it was 32 layers of memory stacked on top of each other. And then it went to 64, and then 96 and 128. And now you're taking 2 of those and putting it on top of each other. And people are talking about putting 3 of those on top of each other. We're in kind of generation 7 of the road map for A vertical NAND. And every time there's a generation change, the RF power supply is -- there's 3 of them per chamber, have to increase by order 20% more power. Every generation, 7 times. And that requires a lot of, number one, development innovation on both sides, the OEM, us, because interactions occur. We've solved those problems 7 times now for 7 generations. And that's really how we took the market share. So the market grew, but we had the wherewithal to invest in engineering and R&D through down cycles. So 6 years ago, there was a down cycle in the middle, but we never stopped. And because of that investment and the OEM also made a big investment, they made it. They were going to try to take that share. And we both are mutually succeeding from that. That's the kind of mentality we have in MKS. We have to take share. You have to take advantage when the inflections occur. You have to be bold enough to make that investment. And then you have to be strong enough financially to continue in that investment during downturns.

Great. I did want to go back to something you've briefly touched in terms of the opportunities that expanded within your optical-based solutions with customers like KLA, like ASML these optical-based solutions. Over the last few years, post the Newport acquisition, that's an area of growth that I've seen, again, with the customers. And I'm sure your collaboration and your understanding of semiconductors has helped. But what -- what were some of the biggest changes you made after you acquired Newport. Because I'll be honest, I remember the Newport days, it was a sleepy business. It never gained share you never lost share. But now you're increasing your content with the process control and lithography companies.

Yes. Well, so when we bought Newport, it was a $600 million revenue company. It had been like that for many years. It was a 10% operating income company and been like that for many years. This year, you can look at it in our first couple of quarters and our guidance, and it's pushing $1 billion, all organically. So we bought Newport 6 years ago, $600 million. This year, we're pushing $1 billion all organically. More importantly, the 10% operating income is now 25%. So within that, though, there are many areas of levers of growth, the one is called -- what we call world-class optics. And this is what you're asking about with respect to what do we do to change our presence in the supply chain for customers like lithography customers or metrology and inspection customers. Well, the first thing I'm going to change is mentality. I think the Newport approach was these customers are one of many good customers. The MKS approach is these are key OEMs who are market leaders, who have a lot more business to give us if we earn it and we have the capability. And so -- and they're going to be around a long time, a very long time. So it's kind of like you got an oil field that's giving you oil, well, dig more holes. That's really the strategy. And so we started investing more specifically in our capabilities to do coatings and to do polishing of optics to make them bigger, more precise. All those kinds of investments require CapEx and they require hiring of process engineers, and we did a lot of that. We continue to do that because we think that this is also a multiyear growth opportunity so that you're designed into EUV. That's a good thing to be designed in, so is Deep UV and all that lithography tools as well as all the inspection tools that KLA among them are working on. So that's another large growth area that we think will help drive the Newport business, what we call Photonics Solutions division today going forward. And all of that growth has been done organically over the last 6 years.

Great. Let's start the big picture on the advanced market side, so "the non-semis end". And I want to focus a little bit on the strategic vision and capitalizing on market opportunities. I know at the beginning, when you bought Newport, you talked about surrounding the workpiece similar to surrounding the chamber on the semiconductor side of things. But one thing that has caught my attention is the focus MKS has on industry trends. So for advanced markets, you talked about miniaturization, technical complexity. Can you detail from the advanced markets and how you're trying to capitalize on those market trends, just like you did with semiconductors and their inflection points?

Yes, sure. So when we think about where MKS wants to be in 5 years, we think about the markets that we want to be in. And when we think about that, advanced electronics is really where we want to be a strong supplier in that supply chain. And when we say advanced electronics, we're talking about your phones that everyone has in the room and your laptops and things like that. And the future of those devices, if they're going to get better, they're going to be required 2 things. One, the semiconductor itself has to get better. That's not news. But you need the advanced packaging, that has to get better. And actually having one or the other by itself is no longer going to be sufficient. So if we're all going to buy the next smartphone in 2 years from now, 4 years from now, 6 years from now, we want it to be better. That's the only reason we're going to pay for it. In order for it to be better, the chip will be better. So that's the semiconductor story, get all that. But in order to have that -- those semiconductors talk to each other faster and connect to the 3 cameras now, you're going to assume to have 5, you have a fingerprint sensor, you're going to have other sensors. You need to have all those things interconnect with each other. And you have to have interconnections with higher bandwidth and smaller. And so that's advanced packaging. Now you see a lot of companies talking about advanced packaging. The chip companies are talking about it. Our OEM customers are talking about it. We're talking about that, for sure. The tiling chips, making sure that they can talk to each other. But also beyond that, putting those chips on the rigid PCBA so they can integrate into all the other sensors on that smartphone, if you will. That's why Atotech makes sense. That's why laser drilling makes sense because those features of those kinds of interconnects are so small, you can no longer make them without lasers and without advanced materials processing. That's full stop. In the old days, you could drill those holes with literally drill bits. That was the old PCBAs. No one made money, by the way, right? So now -- we see the same story happening with advanced packaging, the same story that SEMES saw for the last 60 years. Things are going to get smaller because there's a need for it. They're going to get more complex. They're going to be more layers. There's going to be the need for customers and suppliers to continue pushing that road map really fast. Otherwise, Advanced Electronics will not progress the way we all want it to progress.

Great. Let's go into some of the market opportunities within that kind of advanced markets and kind of your equipment solutions business. I know I'm still characterizing it in the old business segments you have. But from a pulse laser market opportunity, the more I've looked at the company and you talked about the organic growth within Newport, the pulse laser market is one where you guys have gained share. You're a leader in the nanosecond pulse laser market. You had a relatively new product on the picosecond. One, what are some of the emerging market opportunities that have helped you grow that overall advanced market revenues that you've talked about since you acquired Newport?

Yes, great question. So I should probably explain first, the difference between pulse lasers and fiber laser. So fiber lasers are high-power, continuous wave lasers and they're for welding, welding car parts together and things like that. Pulse lasers are lasers that go on and off really fast. And that's so that you can do high-precision machining, basically, with very small features. And then they have categories, nanosecond pulse, picosecond and femtosecond. So for those engineers in the room, nano means 1 billionth. So the duration of the pulse is 1 billionth of a second. So think about that. You can put 1 billion of those pulses in 1 second. Pico is the another 1 million more, and femto is another 1 million more. And so why is that important? Well, if you could pulse really quickly with really short pulses, you can make finer features. So that's how PCBAs are actually made. Your phone now has flexible circuits in it. Those holes are drilled with pulse lasers. And so we -- the Newport side, for sure, built up a capability in nanosecond lasers. So about 6 years ago, they had a new design that would allow us to get the nanosecond pulses at much lower cost for the same power and they took market share. They went from a very distant #1, actually not even in the market to #1. We're doing that now for picosecond. There's another one, femtosecond, that's for the future, even more precise manufacturing. So think about the OLED screen on your phone, you think about cutting it. How hard is that, right? Well, it turns out, if you don't cut it very precisely, you get defects, those defects propagate and you have cracks. So more and more of those cutting, even just simple cutting are using pulse lasers that have shorter and shorter pulses. And so that's really the opportunity. Now our plan A is always organic, can we invest organically to take that market share. Now as you know, we were after Coherent for a while. That would have been inorganic. So we didn't win because it was a little too expensive for us. So we went back to Plan A, which is to continue now really accelerating the investment in pulse lasers. And so that's where we're pushing on now to move into picosecond pulse lasers. Femtosecond we already have, and that's the future.

8 And the other thing I would just add just for the audience here is pulse lasers are much, much more challenging to manufacture. And that's why you haven't seen any commoditization or even the Chinese -- I think the Chinese do try and get into it, but they realize that this is not an easy type of product to make.

Right. Unlike fiber lasers, there has been a rapid copying, if you will, commoditization, if you will, of fiber lasers. Pulse lasers, our competitors are people who've been doing pulse laser manufacturing and design for decades because you need that much expertise. There's a lot of in-house capability that's trade secrets in terms of how you manufacture those kinds of pulse lasers. And so to your point, people can make easy pulse lasers, low power, not so precise. But what we're talking about is really high precision manufacturing.

Let's go to the ESI business, especially on the PCB laser opportunity, which I think are twofold. One, you've already kind of briefly detailed your leadership in the flex PCB laser market. One, if you can give us an update there, both on the near-term outlook, where we're seeing some, I think, capacity digestion as well as the longer-term opportunity. And probably, secondly, more importantly, you've entered the HDI PCB laser market, which is a larger market opportunity and one where you've had a differentiated product that you're starting to get traction in the marketplace, if you can give us an update on that.

Yes. So flex and HDI is -- just think about it as flexible and rigid PCBAs. So both very advanced PCBs, so printed circuit board-type things with really small features in it that can only be made by lasers. So in the flex world, the capital equipment for flex manufacturing, that's where we have market share leadership with the ESI group. That uses pulse laser from our PSD group, actually. And you're right, this year, there's a digestion period in the CapEx build-out for it. When we bought ESI, the year after, there was a digestion period, but what happened 2 years after that is 40% growth. So CapEx, unfortunately, is cyclical. But when you have market share leadership, it's just about just making sure you wait. And if this is a down year, the chances of the next year being an up year are higher. Because frankly, that's the way it works. Now that's the flexible circuit, printed circuit board industry. The rigid where we are -- we're just entering -- we already have dozens of tools with a new rigid drilling tool that we have in manufacturing, making money for those customers. We've had second orders from one of the -- repeat orders from one of those customers in volume. And then we have design wins on multiple -- with multiple other customers. So we're waiting for them to continue to ramp. I wish it was faster, I do. But I do know that I have a tool that works because it's working in manufacturing, in volume, making money for those customers. And so we're patient. We're going to continue investing. We're going to continue innovating that laser and that laser tool. Because that market is 3 or 4x bigger than the flexible capital equipment laser market. And that is levered a lot to the advanced packaging that we just talked about, advanced packaging for putting chips together. That's the kind of laser that's used for the printed circuit board. And so we see that as a great opportunity that ties into the Atotech acquisition as well.

Maybe as a quick follow-up before we get to the Atotech deal itself and the rationale. The one thing I've noticed with the HDI PCB market is, there are multiple markets that are using these rigid boards, whether it's the automotive industry, as you put more and more silicon content, you talked about consumer electronics. How many of those different markets do you believe will influence the continued growth in the HDI market?

Yes. Well, I think all of them are moving towards HDI, if not already there. And fundamentally, because even if you're in automotive and I've got a relatively more space than smartphone, I still -- I'm trying to put it in a dashboard in some kind of small region. And so there's always a reason to shrink the overall package, but the biggest reason is speed. So I want multiple devices chips to talk to each other quickly. Well, I want them to be close, right? Because if I make the chips further part, it just takes too long. That's the whole reason why high-density interconnect exists, is I want to put multiple chips together as close as possible so they can talk to each other as fast as possible. And you think about the concept, I think Intel talks about it, tiling. Tiling chips on top with each other, next to each other, that's all enabled by the advanced packaging because we can't yield if we're going to make a memory chip with a logic chip with a GPU chip altogether. We can't yield those chips enough -- so we make GPU chips, we make microprocessor chips. We make memory chips and we try to tile them sort of close enough so they can actually operate almost like if they were on the same piece of silicon.

Great. Let's -- let's talk about the Atotech deal from the rationale point. I'm not going to ask you about an update on timing and it's stuff that neither of us can control. But the rationale for this deal in my opinion makes a lot of sense. It fits into your overall strategy of stuff where you're trying to capitalize on miniaturization, technical complexity and it supplements your current product portfolio by bringing on a new marketplace in terms of materials and chemicals that you don't currently participate in. Can you remind the investors here the rationale behind this deal? And I know you don't want to get specific on the financials. But again, just my quick analysis, this is going to be a long-term, very accretive type of acquisition for MKS.

Yes. No, the rationale is, again, towards our vision of being a transformative supplier in advanced electronics. And as I said before, it's not just semi, that's going to be necessary. It's going to be advanced packaging. Sorry. And advanced packaging, there are a couple of steps there that do require -- process steps that are really difficult. So how do we measure that? We measured by gross margin. So if you look at Atotech's gross margin, it's on the order of 50%. So this is a chemistry company and PCB. So your initial take was PCBs, that's not that hard. It shouldn't -- why would anybody pay 50% gross margin? Well, it turns out it is getting a lot harder. And that's why a chemistry provider, a materials provider like Atotech has that ability to get to garner 50% gross margin. And so we see the interplay of making that interconnect, drilling the hole by us and plating it with Atotech. It's literally steps next to each other. So in a joint customer factory, our tool will be next to theirs literally. So if we can work together under 1 roof and accelerate that much faster, that road map much faster, we think the industry will need to do that for sure. And we know that some customers will want us to partner with them. So that they can get to their end result much faster.

Great. John, I wish we could continue this conversation, but we are out of time. Thank you again. I think you know I'm a big fan of what you guys are doing. So continue to do good work and best of luck.