MKS Inc. (MKSI) Earnings Call Transcript & Summary

Good morning, everyone. Welcome to Day 2 of Citi Global Technology Conference. My name is Atif Malik, I cover U.S. semiconductors, semiconductor equipment and communication equipment stocks here at Citi. It's my pleasure to welcome John T.C. Lee, President and CEO of MKS Instruments as well as David Ryzhik, DIR. I'll kick it off with my questions first, and then we'll open the questions here for the audience. And if you have a question, please raise your hand, and we'll get the mic to you. John, welcome.

John, just to kind of start the discussion, I feel like we're coming up to the anniversary of your Investor Day from last year in November and the Atotech acquisition was a pretty big step for you guys to kind of diversify into more and recurring kind of end markets. And so we'd love to get your thoughts in terms of how that acquisition has gone. Also, if you can touch on the synergies. I kind of get a lot of questions from investors in terms of the dynamics of the business and how is it fitting with your semi business?

Yes, great question. Do you want to do a.

Yes, sure. Probably a little safe harbor first. Thank you. Just any forward-looking statements that we may make today are subject to risk factors in our SEC filings. And you can find the GAAP reconciliation to any non-GAAP numbers that we may talk about on our IR page of our website. And I'll pass to John.

Thanks. Great question, Atif. So the integration is going extremely well. I think we announced at the last earnings call that we're on our way to achieving the cost synergy numbers. But that's really not the reason, obviously, that we bought Atotech. The reason we bought Atotech is because we saw this trend happening about advanced packaging. And that advanced packaging was going to be incredibly critical to enabling advanced electronics. So not just the chip anymore. So in the old days, it was just a semiconductor. The semiconductor got better, you bought better advanced electronics. And remember, all of us, we don't buy our next iPhone or Samsung phone just because the chip is better. We buy because the phone is better. Before, it was just the chip that made it a lot better. Now it's the packaging that makes it better. And Atotech is a key supplier for enabling that advanced packaging. And so when you think of the latest incarnation of this great 60-year story of make better chips with new applications. First, it was the PC era, then it was the phone era, and then it's the cloud era, now it's the AI era, if you will. All of that is now enabled by not just semiconductor but putting all the various semiconductors together in a package substrate. And when you do that, some of the critical technologies there are about the equipment and the chemistry used to enable those interconnects in that package substrate. That is where Atotech is market leader and that's why we decided that having Atotech under the MKS umbrella, was going to help us enable the industry to move faster.

And AI has been a big theme with investors. And like we were discussing earlier, you are playing that theme through 2 areas first directly or indirectly through your OEMs like Applied Materials and Lam, who are participating in TSV and all those steps. And then secondly, through Atotech on the packaging side. So can you kind of elaborate on exactly where you're participating in the AI area?

Yes, that's a great question because there's a lot of confusion when people talk about packaging there's different parts to packaging, all are necessary. So there is the chip-to-chip or chip to laser packaging. And that is the kind of tools and equipment that Applied and Lam would be delivering, and we participate through that indirectly through the OEMs. There's also some chemistry there because you're putting bonding of interconnects together chip-to-chip, so there is chemistry there and Atotech participates there. But the chemistry there is relatively small. Once you've made the chip bonded to each other so you think about HBM, lots of stacks of DRAM together. That's been done now, but now you've got to put it on to something else. And that's the IC substrate and to make that IC substrate, that package substrate, to package the memory with the GPU, the CPU and everything else that goes with it. And you see these cards, and there it shows, there is 10, 50 chiplets on there. That all have to be interconnected through highways, if you will. And that is the package substrate. Package substrates used to be 4, 5 layers. Now they're pushing 20. It's the same story in semiconductor interconnects in the back-end mineralization, more layers and smaller features. And so things are getting harder there. And when it gets harder, we love that. If you have the R&D and the leadership to continue developing new processes to enable miniaturization and something that needs it, then I think you can maintain your market leadership. And that is the difference between MKS and many other companies. We're participating in the entire food chain for packaging, not just the chip-to-chip and chip to wafer, but also the package substrate part of it when you're putting many chips together and that's unique. And we saw this 2 years ago. That's when we announced the Atotech acquisition. I think we were early. I'd rather be early. I think it felt like a guy in the woods, but I didn't close saying packaging matters. And people like what is he talking about? What's this chemistry stuff? What is all this packaging. Now I think everybody kind of gets it. And we're a first mover. We already have Atotech under the MKS umbrella. We already have the semiconductor. We've already had the semiconductor for packaging as well. And so we bought ESI for lasers. Lasers is also about packaging as well. And so we have the broadest array of products, critical technology products to enable advanced electronics, both through the semiconductor, the chip packaging, chips to chips and chips to wafers as well as the chips to the substrate.

So another question I've been getting on your Atotech business is around competitive landscape. I guess the 2 areas, the equipment and then the electrolytic plating chemicals. And how does Atotech compare with competition. There's a threat of new entrants in Korea or China, is the competition increasing or decreasing there, I get asked on Uyemura and JCU, a bunch of the Japanese companies. So just help us understand the competitive landscape.

Yes. So the competitive landscape in advanced packaging and the chemistry delivery, the chemistry as well as equipment to deliver that chemistry. Atotech is obviously a leader in chemistry, so #1 market share in electronics chemistry delivery for packaging. But we also make it. Now there are many other companies who do 1 or the other but very few that do both. In fact, of the leaders, we're the only one that does both. Now why is that important? Well, if you have the equipment, then you have the chemistry, you have more knobs to optimize the interconnect. Now that was important in the past in certain parts of advanced packaging. We believe that, that will continue to be more important to broader parts of advanced packaging because things are getting smaller and more difficult. And you're going to run out of knobs, if you only have chemistry knobs. And you're going to run out of knobs, if you only have equipment knobs. And it's the same kind of thing that we're sunsetting. Early on, certain people needed equipment, some provided the chemistry. And now you see equipment companies developing not just the equipment, but the process, too, that goes with it. Now I think we're unique because we actually have the chemistry too rather than just the process. We're doing the chemistry for the process as well as the equipment. And so the competitive landscape is really placed to our strength, which is having a combination of both. Now with the acquisition of ESI and Atotech, we can actually add another piece of equipment that's critical to advanced packaging. That's the lasers. So lasers to drill holes then Atotech fills. So we're the only company in the world that has the laser equipment, the chemistry and the chemistry equipment. And beyond that, something that's maybe appreciated, but maybe not so much is we also have the Photonic Solutions division. We make lasers. We engineer new lasers that go into laser tools for advanced packaging. We engineer new motion, new optics that go into equipment for laser tools. So the laser tool is not just a laser, it's got motion, it's got optics. And so we're the only company that does all of that in 1 package.

Great. So let's move on to the semiconductor side of the business. And just curious, the backlogs have been kind of coming down, the orders coming down in the first half in WFE being talked about down 20% this year, memory being weak, mature logic demand. is quite stable, being logic is also coming down. Can you help us understand where we are in the correction of the cycle.

Yes. As we said in our earnings call, we think the second half is a little better than the first half in our semiconductor market as well as our other markets. But we're not saying there's an inflection for sure. We're just saying that we're kind of at the bottom and we're bouncing around the bottom, at least for the second half of 2023. And your guess is as good as mine as to when it comes back. And look, you guys have to predict that. I don't. I just have to react and be quick about it. But that's our view right now, Atif. I think it's well known that memory is kind of in a trough and China is buying a lot of legacy equipment and foundry remains relatively strong. And so -- and you have AI kind of kicking in for some parts of memory. But I would characterize it as second half slightly better than the first half, but kind of bounced around the bottom.

Okay. And then John, if you can remind us in terms of your exposure on memory versus logic and within logic, if you have overindexing to mature technologies more for partner supplies or more on the leading edge?

Yes. I think what I would say about memory is in some data in 2022 when the memory was decent year, we're about 55% memory and 45% logic foundry. So we are a little more indexed to memory because of our leadership in our power, enabling V-NAND. When you think about legacy tools and MKS' exposure there, the good thing is we've been in the industry for 60 years, and so we've been supplying a lot of those legacy tools. It's hard for us to tell where it goes because many of the critical subsystems that we ship to our OEM customers could go into both. And as they are updating their legacy tools, they might be updating something that we make with the newer version of what we make. So we're enjoying that, obviously. You can see that through our numbers, and you hear a lot of our customers saying that legacy tool sales are pretty good. I would also say that we're a little different now with just semiconductor equipment because we've been investing in what we call world-class projects to enable our ability to supply more share to lithography, metrology and inspection. And that's something that came with the Newport acquisition, but we're doubling down on that. And you saw some of our numbers that we talked about. The growth there of our revenue in lithography, metrology inspection is much higher than the vacuum group right now because the vacuum group is going through cycles and that's consistent with kind of what ASML and KLA will say about their business. So not all parts of WFE are created equal, even within our customer base. And we are exposed to 85% of all the equipment in WFE, no one else is exposed to 85%. And so that strength in lithography, metrology inspection is helping us this time. And certainly, when things turn around for DRAM and foundry and whatnot, we'll enjoy that with the likes of Applied and Lam and take a look on the vacuum guys. And so we've a much broader exposure to WFE than we have in the past.

Great. John, if you can just expand on that lithography exposure. Is it primarily through lasers? Or what are the components are you guys supplying into the big lithography equipment maker?

Yes. I would say we do supply lasers to the lithography metrology inspection market, but most of our growth is in what we would call really sophisticated optics and optical subsystems. So when you're building an EUV tool, there's a lot of sophisticated optics and optical subsystems there as well as DUV or inspection because tools that are inspecting EUV have to kind of use EUV to inspect it. And so it's really the optical subsystems that is where our customers are saying, if you can do more, and you can invest in more capability and technology, people and CapEx and processes, we'll give you more. And that's why you see some of the growth that we've had in our lithography, metrology inspection markets.

That's a great point because it does diversify you across multiple technologies. On the June quarter earnings call, you mentioned a revenue recovery and shipment catch-up in your September quarter outlook. Is there any lingering effect of the ransomware incident going into Q4 this year?

Yes. I think what we said is in Q3, we will be substantially caught up. There might be a few things that linger into Q4, but really will be done by this quarter. And the reason is because the things we do are difficult things. They are designed in multiple years working with our customers to get them designed in. We recovered pretty quickly from a ransomware event and that allowed our customers to make their quotas even in Q2. And these design wins are very difficult to replace. If we can recover fast enough, obviously, we're going to -- we have that ability to replace all of it. And so we'll be pretty good with respect to recovery by the end of this quarter.

And then one other question I get asked on your semiconductor market is your differentiation versus your peers like Advanced Energy. And obviously, you mentioned RF being an area of strength for you guys. Can you help us understand what causes the incumbency or the stickiness of the component makers into the big OEMs?

Yes. Well, what we do with the OEMs is very difficult. It's the history of MKS. We always look at the critical technologies that enable whatever the market is originally with semiconductor. Now it's semiconductor and advanced packaging. And when you do that, then you're doing -- you're basically going where the hardest problems are. You solve that for your customers. They've got to give you the next hardest problems. And when you solve them, it's difficult for other people to solve it. And that's really our strategy. I think what differentiates MKS is we saw more difficult problems and more categories than anybody else. We have over 20 categories of products where we're either the #1 or #2 just in semi. And then, of course, in electronics and packaging, we serve 70% of the package substrate process steps. So that broad portfolio allows us to see trends very quickly. That's important, but lots of people can see trends. But what's really important is we can do something about it. So if a trend shifts from 1 particular kind of critical subsystem to another like from valves, to our power, for instance. We actually go do something about it because we have both. And in the future, I don't think anybody can really predict what is going to change in terms of criticality because things always change in this industry. And I've been in 30 years like you and it's always surprising the kind of innovation that comes up. So I'd rather be very prepared with the broadest portfolio, #1 or #2 in the entire portfolio, so I can pivot very quickly to whatever it takes. And that history, we're just expanding now to electronics and packaging. So we're not just semi anymore. That was the strategy for semi still is. We're expanding that to electronics and packaging as well, that breadth of portfolio.

And John, you were in instruments in your past life and you've been a customer as well as a supplier now. And we went through a pretty big change in terms of supply chain over the last 3 years with COVID and there were instances where some of your OEMs had kind of difficulty in getting the components either from you or from your peers. So help us understand in terms of the supply chain disruption, where you guys are? And if there's any reason for the OEMs to be looking more in-house for some of these areas or it's not a great an effort to get there.

Well, I think our OEM customers as well as we are always looking at strengthening our supply chain, especially given the last 3 years of challenges. And so but the things we do with our OEMs are very critical, very difficult. So I think we have very strong relationships with them. I would say, though, that the supply chain constraints have eased. So but many of the supply chain constraints were not about our capacity it was about getting semiconductors from the semiconductor makers. I think what I've said in the past is, actually, it caused a lot more collaboration between our customers and us because they knew that it wasn't us, it was about getting allocation of certain types of chips. And we work together oftentimes even with their customers to look at where can we get these chips because it's a very circular industry, right, where the chips that we need to make equipment for Applied and Lam to make the equipment for TSMC, sometimes it's made by TSMC in their legacy fabs or Samsung in their legacy fabs. And so there was a lot more collaboration I think in our ecosystem during that time to try to solve these kinds of constraints.

And then just switching to the specialty industrial business. We do see it has added stability to your sales in the last few quarters since you've kind of closed the acquisition. Looking forward, how should we view your kind of revenue growth versus the WFE growth over time.

So especially in the industrial business, as you pointed out, it's about 1/3 of MKS right now. It's a little higher, not because it's growing very fast. It's just that WFE is a little lower. We kind of look at the specialty industrial as kind of a GDP plus segment. And we say that because it's diversified into many different kinds of markets. There's research, there's defense, there's health care, there's all kinds of industrial kind of applications. And as we've said in the past, we're really leveraging the R&D we're doing for semiconductors and electronics and packaging to specialty industrials. And so there's not a lot more R&D necessary. It's already been done. And so we kind of look at that as, wow, this is profitable. It helps to fill our factories. And it actually gives us optionality because there's a couple of markets there that are interesting. One is our general metal finishing business of Atotech, which is 1/3 of Atotech. And that is really levered to automotive. And if you think about automotive today, with all the EV talk, batteries, right, are a big part of that, and coating, metal coating of those batteries and corrosion resistance coatings, those are things that we already do as a participant in general metal finishing. But it certainly gives us potentially optionality to maybe invest more there, if that makes sense.

We pause here and see if there any questions in the audience.

Thank you very much. You said that you cover 85% of the WFE segments and you're in touch with more people in the industry than anybody else. So I was just wondering that are you spread out too much compared to some of the larger equipment manufacturing. They are large in terms of sales, market cap, employees, so are you spreading your R&D budgets too thin over too many areas and remain subscale in R&D?

No, that's a good question. I think the difference between us and our customers, if you will, is that they make bigger things, a bit higher ASP. And we make critical subsystems. So we've never skipped on R&D. We have been able to put sufficient R&D in all these categories. And remember, this is not something that was done overnight, right? This was done over 20 years of organic and inorganic growth. So those 20 product categories that make up that 85% of WFE exposure, each 1 was grown over time. And each one, as I said, is #1 or #2 in their market. So obviously, that tells you that we put enough R&D to take #1 or #2 or maintain number one. In some categories, we have very high market share. In some categories, we might only have 25% or 30%, which means room for growth but that still might be #1 or #2. So we're not really skimping on R&D. We feel very comfortable that we're able to manage that for growth going forward.

John, a couple of questions on kind of your model, target model. It's been about a year since the acquisition of Atotech. Could you update us with the debt pay down progress and any changes in the free cash flow allocation strategy in the near and long term?

Yes. Well, debt pay down is still our #1 priority. And I think you saw that we paid $100 million extra in Q4 of 2022. We said we were going to pay another $100 million or so in Q1 and then of course ransomware hit us and so I think Q1 and Q2 are a little odd, if you will, with working capital. But our intention is to continue generating free cash and the use of that free cash is really to lower the debt. Now long term, our model is 2x gross leverage. That's a long-term model for debt. And on Capital Markets Day, we said in that period, the planning period, we should get to that. And so that's still our goal and our intention.

And then how should we think about the gross margin progression for you guys?

Yes. I think the best way to think about it is we have 3 different business units and different products have different gross margins. But on average, our corporate margin has been about 45%, give and take and inching up actually. In the Capital Markets Day, we think that it can continue to increase. The way to think about it is kind of 50% variable gross margin for every incremental dollar of sales. That's true actually in all 3 divisions. So that's the way I would think about it. And over time, we can update that if that changes. But remember, Newport, we bought Newport, it had higher gross margins than legacy MKS. Atotech has yet higher gross margin than legacy MKS with Newport. And so that helps us kind of continue inching up towards that 50% variable gross margin. That's the way we think about it today and no update right now.

And then John, a question I get is that when I look at some of your peers, they're all taking a very different approach to diversification. I look at Advanced Energy, they're going more into data center, industrial applications. You guys kind of stuck more around semiconductor competency, advanced packaging still around there and others like Integra's are totally gone more of the chemicals and consumables business. So I think the question I get asked is, which one of these diversification strategy makes the most sense. And I think from your perspective, having more insights into the road maps of TSMC and advanced packaging. How is it helping the company to maybe 1 or 2 steps ahead of where your customers are going.

Yes. Well, so our diversification strategy in the beginning was a very big step was the acquisition of Newport, adding lasers and optics and motion to the portfolio. That helped diversify into some more special industrials, which are more stable, but also added to lithography, metrology inspection. So they actually increased our diversification in semi. So there's a little bit of diversification now in semi. But really, when we think about our diversification strategy, it's really not what drives us, it's really about what market do we want to be leaders in. And we've decided it's advanced electronics. Now under that, can you be more diversified to address advanced electronics and if you have a chemicals business utilization rate kind of business that helps smooth the bumps out, which Atotech brought. But that wasn't the reason. But the reason was Atotech is a market leader, enabling advanced packaging. That's the reason why the acquisition occurred. And now as you pointed out, Specialty Industrials is this great lever that -- the leverage that we use because the technology has already been developed for semiconductor and advanced packaging, and that's being used in all of the markets. And that really adds another 30% of kind of very stable revenue. So I would say, first and foremost, our strategy is about advanced electronics. Diversification, now that can make sense. And if it does, that might have a little bit of an edge if we were to look at M&A in the future.

We'll wrap it up here, John and David, thank you for coming to the Citi conference.

Thank you.

We do have a few minutes if you have any questions for John, you can come in and ask.

Thank you, everybody.

Thank you.