MKS Inc. (MKSI) Earnings Call Transcript & Summary

Good morning. Next session before we break -- have a short break for lunch. At the 26th Annual Needham Growth Conference, we're going to be having a discussion with the CEO of MKS Instruments, John Lee. We also have with us today David Ryzhik, Vice President, Investor Relations. My name is Jim Ricchiuti, senior analyst in the Equity Research Department at Needham covering companies in the advanced industrial technologies area. MKS, I think most people know, is a leading subsystem supplier to the semi-cap industry for decades, been a longtime player. But in recent years, has diversified and broadened its reach into the laser and photonics markets, some real interesting markets, we think, as well as increasingly so in the electronics and electronics packaging market through a series of acquisitions, the most recent being Atotech in August 2022. So we're going to get into a bit of a fireside chat. Before we do that, David is going to do some of the disclosure.

Thanks, Jim. So because we're in our quiet period, our comments will solely focus on the long-term growth and opportunities for MKS, and we'll not address results for Q4 of 2023. In addition, 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 that we may talk about on the IR page of our website.

Okay. Great. John, thanks for joining us...

Thank you. Thanks for having us.

Sure. So I touched on it a little bit, what the company has been doing. But why don't you give us a brief snapshot from where you sit on MKS data...

Yes, sure. Thanks, Jim. Well, in MKS, we like to think of ourselves as foundational to a connected world. And that connected world is, of course, advanced electronics. And as Jim said, we started in this market 60 years ago in the semiconductor chip making market. And that's really the legacy MKS. Over time, we've expanded our breadth there through acquisitions as well as organic growth. And so we've assembled the broadest portfolio of critical subsystems addressing the semiconductor manufacturing market. And we started with Deposition and etch and then we expand to lithography, metrology and inspection. And so now if you look at a fab, 85% of every piece of equipment in that fab has multiple MKS subsystems in it. There's no other company with that breadth just in the semiconductor manufacturing. And as Jim said, over time, we realize that manufacturing using lasers was going to become more important because things are getting smaller, the [indiscernible] precision. And that informed us through the acquisition of Newport as well as Electro Scientific Industries. And it's a bigger picture because when you think about advanced electronics, that trend is something where I think everybody would agree, Advanced Electronics is a good place to be. No one's ever disagrees with me on that. And in the past, what made Advanced Electronics better was just the chip. So [indiscernible] are old enough to remember buying a new PC every time Intel came out with a new processor, right? 286, bought a new computer, 386, 486 Pentium. Because in the past, it was just the semiconductor that made that advance electronics better. But really, when you think about it, we didn't buy the chip, we bought the advanced electronics. That was the PC. Now then you move forward and that advanced electronics took on a new phone factor, phones, smartphones. And now you require not just the chip to be better, but you require the packaging to shrink everything, to be better. And when you think about that road map, Advanced Electronics is no longer going to advance just because the chip is better. You have to have the packaging be better. And that informed us is the reason why we bought Atotech. Atotech is the market leader in providing chemistry and chemistry equipments to enable the most advanced package substrates. What are package substrates? Package substrates are things that allow chips to talk to each other. And this has been going on for many years, but it's really accelerating now because when you think about the power of the chips that we have and the number of chips stacked on top of each other, that's packaging too, chip-on-chip, HBM or memory on top of logic. But once you've done that, you've got to get all these things to talk to each other, and that's done through this package substrate. This package substrate, by the way, is getting bigger. The lines are -- and spaces are getting smaller. The VAs, the holes are getting smaller, and the number of layers is increasing because you have to have more highways for these chips to talk to each other. And so that's a great place to be for MKS. We are really the only company that addresses all these major critical areas to making advanced electronics.

Let's talk a little bit about Atotech, because for some people, it was a little bit of a surprise. But when you talk about the opportunity in electronic packaging, I think it has begun to resonate a little bit more with investors. So going back to the acquisition of what, 16 months or so since you...

Yes. That's right.

What's worked well with the acquisition? What maybe has surprised you things that you maybe had to do some course adjustments, maybe it's been the macro?

Yes. Well, certainly, during our diligence, we knew that Atotech had probably the strongest R&D organization in chemistry. They also had the largest market share in equipment for plating. And what I was surprised at was it's even stronger than we actually thought. They have the deepest bench of R&D folks. What's also a little surprising is we knew that they were already addressing the top 30 substrate makers. But as I've gone on road trips with the Atotech team to visit customers, it was really a bit surprising how critical Atotech is to the success of these customers with Atotech as well as our laser tool, we're addressing 70% of all the steps needed by those customers to make an advanced package substrate. So you can imagine that when we install a 100-meter long Atotech tool with all the chemistry in it and then put in laser tools in there [indiscernible] and critical to those companies. So that relationship with customers is really deep, really broad and across the world. So that was a great surprise. I think we certainly were not expecting a macro did in electronics and packaging in the order of 15%. That's the market decline, 15 over the last year. It's also the highest -- the largest decrease ever in Atotech's history. So they've never seen this. Now it was driven by a couple of things. Of course, PCs in the first half of '23 were down 30%, servers were down. Smartphones were down. Everything was kind of down. But that's the market right now. So that was a bit of a surprise for us but I'm really happy with the synergies and the design wins and the conversations we're having with customers going forward. And I think that's really going to be portend really great upturn when the markets recover.

And we'll come back and revisit that. But obviously, there's still a lot of interest in the legacy semiconductor portion of the business and what's happening there. We've been hearing for some time now about the opportunities that present itself in the semiconductor market from AIML. Over the years, you've seen more than your fair share of catalyst, right, for the semiconductor and electronics demand. Talk to us about what you see as the driver for MKS, maybe for the industry when we get to that next cyclical upturn -- and maybe...

Yes. So certainly, there's a lot of buzz today about artificial intelligence. And that is a big driver. It drives more GPUs, more powerful GPUs and the CPUs I go with it and the high-bandwidth memory that goes with it. But when you step back over at least my 30 years in semi, it's just really the next thing of many things that have driven the need for more semiconductor chips. First was PCs. Remember P stands for personal. Some of us are old enough to know that before that, you didn't have a personal computer. You had to go to the university center and use a big supercomputer. The P became personal. Everybody can own one. And then you go to laptops, mobile. You can carry on. And then suddenly, you can carry your phone. And then by the way, the phone is talking to something. It's a cloud, latest servers now, right? And now I have generating all this data and AI is kind of the next application of how do I make information out of data. And so I look at it as just another stepping stone to a long history where if we can make chips cheaper and more powerful, people are going to find ways to utilize it. So I think that's really why we're long-term bullish, obviously, on semiconductors. You have market analysts predicting $1 trillion semiconductor chip market by 2030. We don't necessarily disagree with that. And then when you look at CapEx intensity, it's hovered around that 12% to 14%. So 12% of $1 trillion is $120 billion WFE. We're at 85% this year, right? And that's a down year. So at $120 million or $140 billion WFE in the next couple of years, this is really great tailwinds for the industry.

For MKS, you've talked about being able to grow in excess WFE. And some -- over certain intervals, that's played out other times. It hasn't talked to us about your confidence in that.

So at Analyst Day, we talked about the last 10 years' history, you're right. On the upturn, we outgrew the market in the downturn, we underperformed the market. It's just the nature of inventory corrections during a cyclical industry. So that's why we look at the long term. In the long term, when you look at WFE CAGR, in our CAGR, we've demonstrated that we can outgrow WFE CAGR by 200 basis points. That's just data. And we expect that to go into the future and then you can ask, well, why do you -- why should we expect that to occur? There are some product categories in semiconductor equipment, where we are high market share. So it's tough to grow -- outgrow the market there when you maybe are defining the market. But the many other categories where we might have been 15% market share going to 30 our power being the most recent example. There are also other areas we've talked about world-class optics, right? This is an area where we have underserved the metrology lithography inspection markets. And so investments there that we made a few years ago are starting to pay off now. You're starting to see the revenue from our lithography metrology inspection market increase over time. And that's actually good in a couple of ways. Number one, more market share to outgrow WFE. But also, it's a little more stable critical subsystem than the vacuum part. Because our customers there, I think the lithography companies and inspection companies, they have very long lead times. They have a huge backlog that lasts a long time. The supply chain is similar. So we're trying to take some cyclicality of our company as well through exposing ourselves to parts of WFE that are less cyclical as well as exposing ourselves to other areas of advanced electronics, where it's a little less cyclical and utilization dependent. So Atotech chemistry, of course, is utilization dependent, not CapEx-dependent. And so that also takes out some of that cyclicality. That's important because as the problems get harder, you need to have scale to be able to continue to invest in R&D during downturns. And as the problems get harder, these problems take multiple years to solve. And the best example is ASML EUV, 2 decades. That's a lot of persistence and a lot of R&D, but they got it done, right? And that's an extreme example, but that's really what's happening throughout the semiconductor industry. That's also what's happening throughout the advanced packaging industry.

Okay. And Curious, you've seen some of the commentary from some of your customers. And since Q3, are you seeing anything that has changed the way you're viewing that part of the business over the next couple of quarters? Or is it pretty much as expected?

Yes, the semiconductor business.

And by the way, tell us John, just heard for folks, what does the semi represent right now?

Yes. The semiconductor revenue is about 40%.

Versus what a few years?

It could be as high as 70%. 60% to 70%. Yes. And it's almost able now, too, because you've got the lithography, metrology inspection. And electronics and packages is 25% and Specialty Industrial is a very stable part of our business is [indiscernible] of the company. But in Q3, we talked about the industry kind of bounce along the bottom if you -- semi CapEx. And we'll have more discussion on our Q4 earnings call. But I think if you read the industry consensus, if you will, I think folks are seeing the first half of '24 kind of similar. And I think the big debate is the second half of '24 and how much it picks up or doesn't. But some good signs. Memory prices are improving. Utilization rates are improving. So those are all great signs that eventually a recovery will occur. And I'll be the last person trying to predict when that is, of course, we've been in this too long. We would always look at -- we're always looking at triangulating, having our customers are saying, everything their customers are saying, we have more exposure now to packaging, even and so we can kind of agglomerate a lot of different data points. And -- but that doesn't take away from the need to be fast and pretty reactive from a manufacturing standpoint. And that's been our DNA honed over 60 years operating in a wildly cyclical business. It's always one foot on the brake and one foot on the pedal. Because when things turn up, they really turn up when things turn down, they turned down. So I think being able to react quickly is also part of our operational efficiency, is also part of the DNA and the value that MKS brings to the industry.

Yes. In addition to the way you discuss the business in specialty, industrial and semi, in the packaging, you provide some data as well on the legacy vacuum business, the Photonics business. And one of the questions I've gotten is to see the margins get back to where they need to -- where they've been historically, what kind of level of quarterly revenues do you need to be in the semi business? What's a good way to think about that?

Yes. Well, I think Q3, we're at 47% gross margin. That was good, good mix. And that was on a kind of a muted market right? Semiconductor was muted, electronics and packaging was muted. I think the legacy MKS business, the vacuum base, that used to be in the low 40s and kind of pushed up to the mid-40s. Newport that company came in, in the mid-40s to a little higher and Atotech gross margins are even better. And so when you combine the 3 of them, we're kind of in a downturn kind of in the 45% gross margin level. We did guide at Analyst Day that we expect that to kind of tick up to that 47% range. And we're still -- we're not guiding quarter-to-quarter on annual -- that long-term model, but we're very comfortable with it. It's been well thought out those gross margins. We did have some headwinds, certainly, in the last year or so, there were supply chain constraints. And certainly, the cost of components rose quite significantly. We implemented price increases as well, but they take a little time to catch up. But I'd say we're probably done there. You can always do a little bit better, but I think that PPV headwind is pretty much under control now, I think, for us, for sure.

But probably fair to say as we get into more of a recovery, there should be some nice leverage in those areas of the business.

That's right. I mean in terms of drop-through margin, we've publicly said it's 50% drop through gross margin. Incremental increases in dollars. And about 40% on OI, right? And so we're in that 45% range now. At kind of a run rate of $3.7 billion, $3.8 billion, $3.6 billion, give or take. Remember, in 2022 pro forma, it was $4.5 billion in revenue.

And what I've been struck by is the materials solutions division, the MSD. And when you announced the Atotech acquisition, you're making a case for the margin profile of that business? I mean I think Q3, and Dave, correct me if I'm wrong, Yes, I think you showed pretty almost 400 basis points of improvement in Q3, 54% or so. And I guess what I'm asking is, first of all, can you talk about that what's been driving that and that profile of that business? Is it sustainable?