MKS Inc. (MKSI) Earnings Call Transcript & Summary

Great. We'll go ahead and get started with the next session. Thanks, everybody, for joining us at the DB Tech Conference here at Dana Point. I'm Melissa Weathers. I'm the lead analyst covering semi cap equipment and memory here at Deutsche Bank. And for our next session this morning, we are pleased to be joined by John Lee, President and CEO; and Ram Mayampurath, CFO of MKS. And I had to remind myself to call it MKS and not MKS Instruments this time. Before we get started, if anyone has any questions from the audience, feel free to raise your hand, and we can get a mic over to you.

So I guess to kick us off, I'm going to keep it a bit more near-term focus, just to kick us off. You reported earnings a couple weeks ago. A pretty strong quarter, in my view, which is very impressive given some of the other trends that we're seeing in WFE and in the semi cap equipment space right now. So could you just recap us on what are the main takeaways from the quarter you just printed? And what are the main takeaways you want investors to have walked away with after that print roll?

Ram, why don't you take that?

Sure. So it's interesting to see what top line can bring to the overall P&L and cash flow, right? We had 473 -- sorry, $743 million as top line, and it's been a while since we saw that kind of a top line. It's been 8 quarters actually. Semiconductor did very well. Electronics and packaging, which is a very profitable part of our business did very well. And that speaks for the breadth of the portfolio and the reason why we did that acquisition to take us away from the cycles of semiconductor. The flow-through in gross margin was very strong, 46.6% with the 115 basis points impact of the tariffs. This is the first quarter we saw the tariff impact. Without that, we would have been close to 48% gross margin. Cash flow was 14% of revenue. And OpEx scalability, we saw. OpEx was in the low end of what we guided. So the takeaways are the steady improvements we have made over the last several quarters to the cost structure. And what that has -- we've been running 47-plus percent gross margin for 7, 8 quarters now. Last quarter was the one where we dropped again, mostly because of the tariffs. And what the current cost structure will help do when that top line comes back to more normal levels and the flow-through that we saw is, I would say, the key takeaway.

I would add, the other takeaway, obviously, is our progress on deleveraging. And so the last 2 months, we prepaid another $200 million. The free cash flow is allowing us to do that. And this is, as Ram said, in a very relatively muted market for us. So those of you who follow MKS know how much it flows through on the top line growth. So we're pretty happy with where we are today in controlling the costs and making a progress towards deleveraging and then spending ourselves up for lots of engagements with customers for design wins as well.

Great. Maybe let's dig into that top line performance. The WFE environment has been relatively mixed. I think we've seen some mixed prints from some of your customers in the last couple of weeks. Can you just remind us where are we in terms of inventories at your semi cap customers? And then how do we think about MKS' performance relative to the broader WFE market, especially in a world where we don't have as much of an inventory overhang as we have?

Yes. So inventory has burned off. So that's good. You saw our first half performance versus our first half last year was 18% higher year-over-year, first half to first half. That's comparing ourselves to ourselves. So there was still some inventory burn occurring last year. NAND upgrades happened, whereas last year didn't. And that was a part of it as well. So growing 18% year-over-year is excellent compared to WFE, which is kind of 5%, give or take. You're right. Going out, it's hard to predict. Some of our customers are saying, good. Some are saying, not so good. But we always look at it long term because quarter-to-quarter, even half-to-half, it can vary for sure. But when I look at the macro trends for semiconductor equipment, it is more tailwinds for us now. And a couple of them are NAND upgrades continuing to happen. They can be lumpy, but they are going to continue to happen, and we have really strong market share there. So remember, when you're upgrading, you have to upgrade from something that's already there and it's kind of been well known that we're the only ones there, right? I think also our broad portfolio strategy is to allow us to take advantage of wherever inflections are occurring and how that impacts particular subsegments of critical subsystems. That strategy has allowed us to outgrow WFE by 200 basis points a year for 10 years. And if you think about what's going to happen in the next 5 years at least, chips are becoming more vertical. Last 5 years is about litho. EUV came in and we were print better. Five years before that, it was double patterning because litho wasn't ready, right? So these things always happen. In the next 5 years, it's going to be probably more etch-dep centric. Now we want to be a foundational supplier to litho, metrology, inspection as well as dep, etch, and we've made some progress there. But we are still stronger in dep, etch. And so I think that's going to be a relative tailwind for us going forward in the next 5 years because of an inflection in chip structure.

I want to dig into more of that because I don't think you get quite as much attention on the leading-edge node side. Everyone pays attention to NAND and the memory piece. But gate-all-around, I think, is a -- like you said, it's much more dep-etch intensive and you guys have decent share there. So any more color technologically on some of the ways that you're able to enable some of those critical dep and etch technologies.

Yes. So gate-all-around is another example of chips going vertical, right? Before it was just planar lay down a layer, print it, lay down another layer. Now you're making gate-all-around means a tube. And you're going to surround that tube, and you got to make a tube, and then you got to get rid of stuff around it and then you go and then put the materials you want around it. That's crazy, right? A lot of that requires atomic layer deposition processes, putting things down one atom at a time in all directions simultaneously. And a lot of the subsystems that we make enable that. So we've been in ALD a long time with ozone systems. And now it's just a lot more ALD-type applications. You can see some of the customers who are -- have traditionally been strong in ALD have really grown, ASMI, for instance, as well as Lam and Applied. And those critical subsystems, we're seeing that pull as well. And the other thing that maybe gets lost is a lot of cleaning. Cleaning of surfaces after you remove some material. Now you're not cleaning just a surface, a flat surface. You're cleaning, again, 3 dimensionally. And that, again, requires dissolved gas kind of cleaning. And that's what we talked about in our earnings call, a big pull in dissolved gas for 2-nanometer applications. And that's where it's getting harder. We have had competitors in the past. But over time, as things have gotten harder, we've been able to invest in making the next-generation dissolved gas systems. And I would say now, our market share has continued to increase there. A small subsegment of our business. But when you add a lot of these things up, that's how we are able to outgrow WFE by 200 basis points a year.

You talked about lithography. I want to touch on your world-class optics business and specifically the semiconductor side. I think you had talked about a big design win or some increased momentum at some lithography and maybe some metrology and inspection. And so can you talk about the progress you're making there and what the market outlook you're seeing is?

Yes. So it's something that we started 5 years ago. We said litho, metrology, inspection is a great market. We have some capability that limits us in terms of what other things we could do for these companies. They told us that. And so if you invest in other capabilities, we'll give you more to do. And so we did. More CapEx, more process engineers. So we're developing new processes to make advanced optics. And then we're putting together optical subsystems. And so 5 years ago, we were about $150 million, that subsegment, litho, metrology, inspection, now $300 million. And by the way, the first 3 years is just about investing design wins until you see that volume. And in that space, it's much stickier, right? Those critical subsystems stay for a very long time, decades, even longer than vacuum-based equipment. It's a little less lumpy as well. And so we can see ourselves continuing to do this. I think it's still mid innings, if you will, in terms of our ability to continue gaining share through investments.

Maybe let's go back to the NAND topic. I think when you first spoke, you said that the NAND upgrades happened, past tense. But then you said that NAND upgrades are happening. Can you help us understand, at least from your perspective, what kind of buying trends are you seeing? What kind of upgrade trends are you seeing? What are the key drivers of that NAND upgrade cycle?

Yes. So if you step way back up to the highest level, what's the fundamental need for NAND memory, right, nonvolatile memory. And if you go back in the 2010s, the reason NAND really rocketed up was because it was replacing hard disks for smartphones and for PCs. That's kind of done now. So the question is what's the next big application for NAND? And you're starting to see some of it in AI data centers, right? It's not as much as DRAM, HBM, but people are starting to talk about high bandwidth flash. Pretty exciting, kind of taking NAND chips and stacking on top of each other. So fundamentally, it's going to be the market driver that requires us to -- as an industry to put CapEx into NAND manufacturing. If I look at today, it's still most efficient for our customers' customers to upgrade. But at some point, they're going to need capacity. And even today, some customers are saying, I just don't have a fab to upgrade, so I got to build greenfield. But there are not a lot of players in NAND. So that's why it can be lumpy. Lam has talked about a certain number in terms of the opportunity. Their SAM is some subsegment of that, sorry. And ours is a subsegment of that because we're really talking about [ biometric ] etch. But you can see that when it happens, that was the upside surprise in our Q2, and it was significant. And to Ram's point, it flows through very quickly.

And as we think about those semi cap customers resuming now that inventories have burned down. I think we talked about this on the last earnings call, but their order patterns, do you expect kind of a rush back to refill their inventory? Or what kind of rebound do you expect from the purchasing side from your...

Yes. Well, I think we're shipping to end demand. I think that's the bottom line. And just to give you a little more detail, we have inventory at our customers. We own it, right? It's consigned. So they always have some inventory to pull very quickly. And as they pull, then we refill. So there's a buffer, built-in buffer by design, right? Our lead times now are pretty short, back to kind of normal. Now our power decks are pretty complex units. So those lead times are a little longer than our Baratron or flow meters, but they're back to normal. So our customers can plan. They know that if they order X, they're going to get it in that same time period. So they're able to plan and not need to over order or order for inventory. And so I think we're in a good spot as an industry and certainly for MKS's inventory, we're shipping to end demand.

Great. And is that the case across DRAM and foundry logic as well?

It's a case across all of our critical subsystems.

Is there any tightness in particular areas? I know HBM, we can get into the advanced packaging side later on in the discussion, but...

Yes, it's advanced packaging that's got the tightness in, then the equipment orders, but not in the semiconductor chip manufacture part for us.

Got it. Well, with that, let's transition over to the E&P side. This has been a nice profit driver for you guys in recent quarters and a nice revenue stabilizer, I think. So I guess at your 2022 Analyst Day, you outlined the revenue growth target, I think, for this business of GDP plus 300 basis points. There are a couple of different segments within this business that you've talked about growing at different growth rates. So can you just remind us what are the moving pieces within this E&P segment? And maybe we can dive a little deeper into each of those.

Yes. So how we characterize the electronics and packaging market is PCBs, printed circuit boards, right? That industry can be segmented into 3/3. The bottom 1/3, we call multilayer board PCBs. Those are lower technology, if you will, fewer layers, bigger features, think washing machines and dishwashers. Big industry, though, and we have market share leadership there. The middle 1/3 is HDI, high-density interconnect PCBs, think smartphones, more layers, smaller features, more complex, higher ASPs. And then the top 1/3 is what we call package substrate PCBs. They're all PCBs and even smaller features, and that is what you need to connect large chips to a large chips. So GPUs together or CPUs together, or GPUs with CPUs and HPM. And that's really what's enabling data centers in AI today. And the top 1/3, we think grows at high single digits; middle 1/3, mid-single digit; and lower 1/3, GDP. And we [ mush ] it all together, and that's where we came up with GDP plus 300 basis points for the entire slug because we participate in all 3. Now we're not changing our model right now today, but I would say some things for us to consider is we have been getting a lot of orders for equipment for HDI and MLB. Those 2 lower technology levels. And we asked why. We're not making more washing machines or smartphones than normal, and it's all driven by AI. So AI boards, the chips go on that higher level package substrate, but then it's got to go on to something else, HDI, and then something else MLB before it can talk to the outside world. And those HDI boards are many more layers than what you need for smartphone. So more complexity. And the MLB boards are many, many more layers than you would need for dishwasher. So AI is actually driving the entire industry from the most advanced to the middle to lower edge. And what we're seeing in terms of constraints is a lot of our customers are ordering equipment for HDI and MLB processes. So they don't have the capacity. And we've had 4 quarters now of very strong equipment bookings. And historically, it's been a very lumpy kind of business, chemistry equipment, but it's been 4 quarters of strong equipment bookings, and you can start seeing in our numbers as well.

And I guess two questions on that. The sustainability of that spending, are you worried that it could fall off? And then second question, how would you characterize utilization levels of the current capacity that's in place today?

Well, the current capacity is very high. Otherwise, they wouldn't be ordering equipment. Equipment is lumpy. So we come from a semi CapEx world. We just deal with the cycles. So at some point, the equipment orders should slow down. But we haven't seen that yet. In fact, after the first quarter of higher bookings and equipment, I thought maybe it's over, right? And here we are on the fifth quarter, and it's still looking pretty good. But the most important point is that equipment that we're selling comes with our chemistry, almost 100% market share. And that chemistry is, of course, much higher gross margin and consumables and is always going to be used for the future. Even after 5 years of -- after 5 years of running that piece of equipment, we still have 85% market share of our chemistry on our equipment. So the installed base of equipment that we're putting in now and for the next few quarters, that's going to pertain to great market share gains in chemistry.

Maybe let's just zoom out a little bit on that topic. Atotech, I think it's now been 3 years since the acquisition closed. And sorry, Ram, know some of this predates you, but can you give us a high-level review of like how have those 3 years been? And how has the acquisition played out versus what you were hoping for?

Yes. I'll start, maybe Ram can add. But I think in terms of cost synergies, we got that, that was pretty fast and easy to do. I think in terms of the strategy, like the reason why we bought Atotech, we thought packaging was going to be more important. We thought packaging was going to be harder to do. And we thought it was going to be the same movie as semi. That all not just been reaffirmed, but even more because when we decided to make the offer to Atotech, AI wasn't in anybody's consciousness. AI just put an exclamation point on that strategy. The other part of the strategy was that having equipment and chemistry knobs was going to be an advantage to gaining market share. We just talked about ordering equipment with all our chemistry, that's another exclamation point on that strategy. So I think when we closed Atotech, the industry went a downturn. So it didn't look good. Like, well, and of course, interest rates are much higher. So all these assumptions were kind of against us. But now you start seeing the strategy play out and you start seeing what we believed was the reason of putting Atotech together with the rest of MKS. Ram, if you have anything else to add to that?

No.

As we talk about -- or as we think about some of those new packaging technologies, that's -- I agree with you, it's some of the most interesting growth drivers in the space right now. As we think about CoWoP, CoPoS, some of those new acronyms that we all have to learn what they mean, which one of those makes you the most excited? What should we get excited about for MKS on that packaging piece?

Yes. I think there are incremental tailwinds. So CoWoS, we all know, is TSMC's chip on wafer on substrate, that substrate is the PCB, the highest level is PCB. So that's good for us. The wafer, the chip on wafer, that's redistribution layer of silicon. So we're not as strong there. So okay, but it's 1 layer. CoPoS, chip on panel on substrate. Substate stays the same, chip stays the same. The panel is replacing the silicon RDL with the PCB. For us, that's great. So an incremental tailwind but it's 1 layer versus 10 more layers in HDI or 15 more layers in MLB. And then CoWoP, chip on wafer on PCB. So the Ps are different. The idea there is to get rid of the S, which is also a different type of substrate. It's the most advanced PCB substrate. Let's skip that step. Let's go right to HDI. If we can do that, it's cheaper and faster for the integrated server board. But that requires more layers of HDI, smaller features than we've ever made. And I think they're going to come to technology providers with more knobs in order to do that because if we could have done that, we would have done that. We couldn't do it, and that's why we went to substrates, different layer, different type of PCB. So now the idea is if we can make HDI even better, could we remove that need for a substrate. That's going to require a lot more development. And we're, of course, intimately involved with our customers.

Maybe if I could squeeze one more in. Glass substrates. Can you remind us how you play in on the glass side?

Yes. So people have talked about a glass substrate. There's 2 -- when we talk about it, there's 2 different applications, a glass substrate core of which PCBs are put on both sides that allows that package of PCB layers to be more rigid, okay? That's a great idea. It's one layer. We've been working on glass for 15 years. We hope it happens, actually, and because we've been working on it for 15 years. But it doesn't happen, it's okay, too, because that core layer just stays a PCB in which we play as well. The other glass layer potentially is at the chip level. Chips going right on to glass, and that's probably a little further out, I would say, a lot more technical problems to solve. So glass is something we've worked on it happens, great. It doesn't happen, okay, by us.

Okay. I'll just pause here to see if anyone has any questions. No. We can keep going. On the specialty industrial side of your business. This, I think, is a less appreciated part of your business. There are a bunch of different moving pieces. It's difficult to model. If -- I guess for my first question, what's the most misunderstood part of your specialty industrial business that you wish investors could appreciate more?

Well, I think we've talked about it, but it's leveraging the R&D. We're spending in semi and E&P. It's not like we don't spend any R&D in specialty industrial, certain areas where we do for sure, but much lower relative R&D percentage for the same revenue and the same profitability. So it's stable -- more stable business, many markets. So you're right, it's hard to model, but when you mush it all again, it kind of is flattish, right? Recently, I think we've had some automotive headwinds and industrial-industrial headwinds, like everybody else, has come down a little bit. But it's a nice stabilizing part of our revenue stream. Now it's not that -- it's not part of our strategy is to buy companies to grow specialty industrials. Our strategy is to grow semi and to grow E&P. And it comes with a specialty industrial component that leverages that technology, it fits the model and it's good for the P&L.

Does it even make sense to -- a lot of people ask, why not divest the business?

Well, I think part of our strategy is always -- our responsibility is always to 2 things. When we buy a company, make everything better, whether it's in semi, E&P or specialty industrials. It's also our responsibility to look at each one of our businesses and say, is there a better home for it? And we always do that. We've set out a couple of things over the last 10 years, not many. Because when you make things better, say, "Well, why don't I want to get rid of this," right? But we always look at that as an option for sure. And some of the things we've spun off have gone to other companies, they've grown it. The employees we spun off, there's 3x more. The revenue is better because they're in that market, and those companies care about that market more than we would have. So we'll always be looking at that portfolio management.

Well, let's get Ram involved in the conversation. Ram, I think you're coming up on your 1-year mark at MKS. Can you give us a scorecard? How have things gone versus your expectations? What has positively surprised you? What has negatively surprised you? This 1-year anniversary.

That's a great question. Yes. So I was -- I am very impressed with the execution the company has done in -- if you look at just '23 to '24, the top line was slightly down, actually, flat almost. But the gross margin grew 190 basis points. Operating income grew 180 basis points. OpEx was flat, maintained all inflation made up for all inflation with efficiency. So the financial acumen of the leadership team and how quickly they get to execution has been very impressive. That probably goes back to the semiconductor industry background and the riding the cycles and knowing how quickly to adjust. That's been very impressive. Agility, the tariff is a good example, how quickly the teams came together to quantify, forecast, identify mitigation actions and implement those actions was very impressive. And it's a whole company got together, a core team from various parts of the business because as you know, this has been changing too. It's a very fluid environment, right? So you come up with strategy and next Monday morning, it's old, and then there's a new problem. That's what happened to us in Q2 where China was the biggest impact item identified when we did the earnings call. And soon after that, it became metals. And that changed the guidance we had given. So being agile to adjust with the changes in the market, the tariff being one example, I find it very impressive based on what I have -- where I have worked before. So the challenges mostly are adapting to a market that's so rapidly changing and the geopolitics of it. And I'm sure at our cost structure, like we said before, when that top line comes back to more normal levels, you'll see much more flow through both to the bottom line and cash flow.

Let's dig a little deeper onto the tariff side. You talked about some -- can you just remind us what are the mitigation measures that you guys are taking? I was very impressed with your ability to continue to optimize gross margins in such a difficult environment. I think a lot of companies have struggled with that. So what are the actions that you're taking to mitigate those risks?

So there are a broad area of actions we are considering. The good news is that we are having very productive discussions both with our customers and our suppliers. And people are transparent. There's nobody who's trying to make money off of this thing. It's out in the open. And those include those mitigation actions include supply chain activities, using bonded warehouses where possible, routing production. The multi-site manufacturing capability we have helps us source products from different parts of the world as necessary and some commercial actions and pass through where necessary, right? So it's a broad range of actions, and it's being addressed very openly with our key customers.

On the gross margin piece, you guys have seen a little bit of a boon from the E&P side and that chemistry piece carries a pretty accretive gross margin to your business. It's gotten me questioning really what is the long-term gross margin potential of MKS? Could it have a 5 handle? Could it be a healthy 5 handle? So I guess as we think about the moving pieces on gross margins going forward, what are the levers that we should be thinking about in terms of what could drive gross margin upside?

So the gross margin has been -- it's something the company has worked on for a while. And like you mentioned, Melissa, it's been over 47% for several quarters, last quarter, like we said, without the tariff, it have been high 47%, close to 48%. The fundamentals of the gross margin and the P&L structure and cost structure is very strong. It's these things that happen that we need to mitigate and there are actions in place to do that. The product cost structure work we are doing in terms of identifying manufacturing excellence programs, procurement savings and design improvements will continue to improve the margins. But the step change is going to really come from volume as that top line comes back. And I always say that the road to 50 goes through 48 and 49. So hopefully, you'll get a chance to ask the question again.

I'm getting greedy. On the OpEx piece, can you talk about where is -- where are your incremental OpEx dollars flowing through? You've kept it pretty tight in the most recent quarters, but there also are a lot of organic growth opportunities for you. So where is the OpEx priority at this point? And how are you thinking about the trajectory?

So when the revenue was not growing in '23, '24, we held OpEx flat. It's something where we -- which we focus very carefully. And as you saw in our Q2 numbers and Q3 guidance, we are at the bottom end of that range, the $250 million to $260 million. The investments we are making are in people, mostly and some infrastructure, but mostly to retain talent and help with long-term growth. And going back to the discussions we have had on profitability and cash flow, the improvements we have made is not by starving the business. We have invested in business in the P&L and in CapEx. Our CapEx is 4% to 5% this year. The debt repayment we have done is after making the necessary investments. So the careful investment that you initially look for always reallocating resources before we look for new dollars, but the investments we are making in OpEx is tied to retaining talent and driving growth.

Maybe as a final wrap-up question for both of you. On the capital allocation piece, you are highly levered, and I know that's a priority to bring down that leverage. First, can you remind us where you are in that journey? What are your expectations or goals in the next 18 months on the leverage side? And then second, I'll be greedy again, but you have a very strong history of M&A and inorganic growth at the company. And so how are you thinking about further inorganic growth opportunities and maybe some of the holes in the portfolio?

Well, you start first, Ram, and I'll follow up with the strategy going forward.

Sounds good. So you're right. So the capital allocation priorities are, first, invest in the business to support growth and business continuity and then focus on strengthening the balance sheet, which is lowering our debt. Now we are at net 4x leverage now. Our goal is to get to 2 to 2.5 over the last in a period where demand has been pretty flat in the last 7 quarters, including the one we are in now, we paid down $800 million towards our term loan. So that remains our continued focus. And with our cost structure today, as that top line, again, comes back to more normal levels, we can accelerate that payment quite a bit.

Yes. And I think once we get to that 2 and 2.5 net leverage ratio, M&A will always be part of our strategy. I don't think big M&A makes a lot of sense anymore. We just did one. So we have the foundations for our strategy, which is advanced electronics, semi, advanced packaging to make advanced electronics and be foundational to that. But there are a lot of tuck-ins that make a lot of sense. Fewer in the vacuum equipment side because legacy MKS did a lot of that consolidation, probably more in optics and lasers because it's still a disaggregated market. Some in chemistry, but not much because Atotech is already a market share leader. So -- but our standard for acquisition is higher now, the bar, just because we have made some big bets in the last 10 years that have paid off. And the reason you do M&A is to get there faster. And some of these big bets, though, are certainly a lot cheaper than buying somebody, but we're getting there almost as fast. And so I think a bar is going to be a lot higher. Why should we buy this company? If it's such a good idea, why don't we invest? Why don't we do it ourselves, especially if we're already halfway there. So -- but I think tuck-ins might make sense to me, as we're waiting for Atotech to close, we did felt on control. We didn't do it. It's perfect. It's around the chamber, same sales channel, great technology, differentiated, same sets of customers. So those things we'll do all day.

Great. I think that's a great place to end it. Thank you guys so much for joining us. And enjoy the rest of the conference.

Thanks, Melissa.