Onto Innovation Inc. (ONTO) Earnings Call Transcript & Summary

Mike, thank you so much for participating in our conference and great seeing you over Zoom. Before we get ready, I just need to read a quick disclosure. For important disclosures, please see the Morgan Stanley research disclosure website at www.morganstanley.com/researchdisclosures. If you have any questions, please reach out to your Morgan Stanley sales representative. So Mike, we can now start. Again, thank you, and I know that the loss has been happening in the semis industry, in the semi equipment and this has been a very atypical year, but it will be great for you to introduced this conversation by giving us a bit highlight for Onto Innovation in this very unique year.

Certainly, I think the first highlight is probably the creation of Onto Innovation. So Onto Innovation as a result of a merger with Nanometrics and Rudolph Technologies that finished right at the end of 2019. So 2020 was our first full year. Only a few months into that, and we had COVID hit and impact the organization, but the team really came together very well. The integration planning, we did ahead of time was really, in fact, helped us quite a bit. So we were able to manage through all that, deliver -- exceed our targets on synergies, deliver a number of new products, which expanded our TAM and SAM by about 20%. Those products were already being adopted by multiple organizations, which we expect to add to growth in 2021. And yes, so it's been eventful, but very, very exciting and positive year for Onto Innovation in our first year.

Well, Mike, congrats on that critical achievements. On this conference, there's been a lot of talk about supply chain demand. I think it's been probably one of the most recurring topics as we go through many of these sessions with companies. How is that impacting Onto? And how are you seeing your growth prospects going in 2021 and even beyond?

So there's a lot of press right now on the tip shortage. So clearly, there's some impact to the automotive industry, a significant impact. As far as chip shortages impacting our supply chain, that's not happening. If anything, it's a positive. Obviously, companies are going to be expanding to meet the growing demand and so they're going to need more equipment, particularly to the automotive market, that's an area of strength from historical Rudolph Technologies. Not just from the inspection point of view but inspection and software and some of the metrology in the MetaPULSE that actually play key roles in automotive process quality and 0 defect initiatives. So for us, that's quite exciting. And we can talk about the Inspectrology also, which further enhances our ability to address the compound semi power and automotive markets. There was 1 more point I want to make. What was the full question?

It's really related to the supply chain demand and how we're impacting and when are you thinking about the growth prospects?

Yes. The other point I want to make is COVID. So I think we're seeing more impact from COVID, particularly overseas in Malaysia that we've had some issues with some of our suppliers. They're mitigated, and we're able to manage all of our customer shipments, of course, just as we've done throughout 2020. But in 2021, we're a little surprised to still see some of these impacts occurring. So that's the last point I want to make on supply chain.

Let's hope those COVID aspects disappear over the course of this year. Another big macro topic and even before we go into more specifics on Onto Innovation's performance relates to U.S.-China relationship. And obviously, we have a very important political year here in the United States, but China and Asia are, obviously, important markets as well. I just wanted to get your perspective on how that has impacted your business and what expectations are you formulating going forward?

Yes, that's a good question. It's certainly top of mind for us as a U.S. supplier. Just to set the table a little bit. China represents about 20% to 25% of our revenue. Within that, there's a split roughly half which is multinationals that set up factories in China, whether it's Hynix or Intel or whoever. So that part of the business is not generally affected by what's happening. The bigger impact is the other half, 10% to 15%, which are from domestic Chinese manufacturers. And there, we have got a mix. I mean we're certainly impacted by the trade situation with tariffs and entities lift and military end users and things like this. But I would say that customers, their primary focus is on building up the infrastructure to build the chips, and that means they want the best equipment in order to do that. So we're still seeing good demand from those customers for our top end equipment, the metrology, especially on the front end, where we're seeing a little bit of an issue is on the lower end, some of the low-end inspection for advanced packaging in some of those areas where they're preferring some non-U.S. suppliers. So it's a something we'll continue to work through, and we've got various strategies to do so. I think another impact with this China-U.S. relationship has been the unpredictability of regulations and strategy from -- primarily from the U.S. and that made some of our Chinese customers more concerned, when they can't predict, they can't understand. "Hey, maybe next month, I'm on the entities list for no apparent reason." That's then the -- that was causing some undue stress and holding back. With the new administration, I think there's an expectation of much more -- may not be easier, but much more predictable policymaking so that the customers can understand and manage their risks moving forward. And I think that's a positive. And we're certainly seeing that already with the customers asking about our licenses and policies, wanting to place some additional orders, updating letters of credit and things like this. So certainly, the engagements are there. And it makes sense. We've got 15 to 20 years of infrastructure built into China. We've got even some R&D there. Globalization means some partnerships there.

Absolutely. And I know that every major market, every major region is making statements about reducing dependency from international sources. Are you seeing that across other markets? Like is that impacting your competitive dynamics. Or in fact, Onto, given your ability to perform at the higher end of the spectrum of things that you do, enables you to just continue to differentiation and actually take advantage to position yourselves?

Yes. I think overall, you see semiconductors getting recognized as an arrow in the National Security -- arrow in the quiver for National Security. So certainly, more countries are concerned about that. Europe announced a $145 billion, focused the EU around bringing manufacturing back. The U.S. is certainly incenting Samsung, TSMC, et cetera, to come back. I would say the benefit to us is, hey, it's more factories. It's -- in the case of the U.S., it's in our "home court". So just like any sport events where the fans add some add some capability. So too, we think the home court advantage with our engineers so close to customers, being able to -- the relationships we've developed over decades is certainly going to be an advantage. And Europe has always been a relatively strong area for -- especially for the Rudolph -- former Rudolph Technologies. We had a high percentage of business coming from Europe, helping those companies, especially the automotive develop new technologies for the last several decades. So I think that's also very positive for us. At the end of the day, customers are going to buy the most competitive tools. I think we have the most competitive tools. We're certainly positioned very well. We're in leadership positions within OCD and inspection, macro defect inspection. So that's, obviously, a strong foundation to build from. The concern that 1 might have is, okay, all this build-out, it's being driven less by demand and more by nationalism or concerns around that. And so how much is overbuilt before supply demand picks up that extra supply and that's relatively minor. And certainly, with what we're seeing as far as chip shortages and DRAM prices rising, the industry is hot, the demand for electronics continues to expand. So I don't think that's a huge issue, but that's the 1 thing I'd be more worried about.

Understood. So Michael, we discussed some of the macro trends that are impacting the semi industry, in particular, your business. We talked about supply shortages, obviously, the regional aspects. I know that 5G has become also important in the way you're seeing opportunities in your business. Are there any other macro trends that we should be commenting to frame your performance? And after this question, we'll go more into the specifics of your current business situation.

Sure. I think 1 of the exciting parts about Onto Innovation is that we're tied to multiple macro trends, multiple growth, secular growth trends in the broader markets. One of them, as you mentioned, is 5G, and that's -- there's a whole infrastructure around 5G that we're a part of, both on the front-end leading-edge devices, 5-nanometer devices coming out of TSMC. But then the advanced packaging, the heterogeneous packaging for front-end modules that's being used. So the panel packaging that's being used for 5G. So that's, obviously, an exciting one, we've talked about that. In addition, high-performance compute is another secular trend. You've got all these devices out there that continue to grow exponentially almost, generating tremendous amounts of data that goes up into the cloud. How you start to see more investment from cloud, cloud services. But also, start-ups in AI to monetize that, all that data. And the ability to do that depends on compute power. So you're seeing a lot more investment in high-performance compute engines, specific for AI applications, which drives, again, the advanced nodes, 5-nanometer, 3-nanometer. But now we go into another level of packaging, which is the heterogeneous of chiplets. And there, you start to see, what we're seeing is a real multiyear demand for panel packaging to support the high-performance compute. And so that's another exciting secular trend that we see continuing that we should take advantage of. And then the -- the third 1 that's probably a couple of years out is this migration towards electrification of vehicles. And so we've always had a strong position in the compound semi market. I think I've mentioned automotive already a few times. But the electrification of vehicle drives not only the infotainment, but a whole bunch of electronics around the drivetrain and the control of the drivetrains and there's specialty power management for the batteries and the motors. So as you start seeing and just this year, we saw what 3 countries talk about eliminating gasoline-powered of fossil fuel cars by 2030 or 2035, depending on the nation or in this case of the U.S., the state of California. So we see that as another secular trend that's going to provide some significant growth opportunities for us, again, not just on the packaging side, but also the front-end side where we have inspection metrology and our fabwide software across that supply chain.

That's also exciting trends coming ahead that will become tailwinds for Onto, hopefully. Going now more into your business. We started this conversation with Nanometrics and now that transformative transaction created Onto Innovation. Do you want to comment on how well integrated the acquisition or the merger has been and what type of synergies you've been able to identify? I got the sense that now with the front-end and back-end visibility or lending, larger volume contracts and those are ramifications -- positive ramifications from that transaction. But I'd love to get a more detailed update on that integration?

Yes. I think the integration far exceeded our expectations. So we expected to do a pretty decent job. The amount of prep, the history between the 2 companies, some of the cultural similarities we've felt would make this a successful integration. But how quickly the teams came together, how quickly the focus came on Onto, and what's best for Onto and how quickly people let go of their former methodologies, really was a testament to the team and helped contribute to the incredible accomplishments throughout the year. Starting with the synergies being able to extract the costs. We said $20 million in 3 years. And later, we pulled that $20 million in 1 year. And by, I think, the 6-month maybe mid-last year, we said, okay, $24 million all this year, it's pretty much done. We've implemented it all. It will flow through for the rest of the year, but everything was implemented. So that highlights how well the teams are working together. Even more so as the technology teams on the R&D side, releasing a record 5 new products on the metrology suite. Really, that was a result of combining the experience from both teams, rejiggering road maps to be a little more aggressive in going after new markets and new opportunities. And taking the technologies from both sides being open, was able to accelerate the development and more exciting was the positive reception the customers had of those new products. I think every single 1 of them has been signed off and approved by at least 1 customer and maybe all but 1 has been signed off by at least 2. So very good for something released about mid-last year. So within 6 months, having that kind of success, again, goes to the whole, not just the R&D team, but the field organization, the apps organizations and how well everyone came together. So I think that's a positive signs, and that's why we're seeing snapback we talked about in the fourth quarter of last year, the guidance we provided for Q1 and Q2, the first half of this year and 20% above what we stated for or what we achieved in a year ago. So I think we're on the right track and we still have work to do. But the integration, we consider it done, now we're in just the normal business optimization phase.

That's awesome, Mike. And glad to know that it's much more then cost size in terms of the efficiencies to be captured, and you're actually developing new products and being able to drive new growth engines. I know that you announced 5 new products in 2020. I'm sure you have more into the pipeline. How much can you discuss that? And how you see these new products are driving your growth on not only 2021 but even beyond? So I don't know how specific you can be on the product road map, but some glimpses of your thoughts there would be very helpful.

So the -- we won't be keeping that pace. I mean that was a very aggressive pace, 5 new products. But it was something we needed to do based on my early discussions with the customers and many of these customers I've worked with for decades, so I had some specific insights. We had some gaps to close in order to position ourselves for all this growth. And I think we did that. Now there are, of course, additional road map opportunities, and they're all, just like these, tied towards both expanding our market opportunities within accounts, so into new areas, but also share gains. So improving -- further improving the baselines we've set up to gain more share, to bring more product towards us. And as they become available, we'll certainly talk to you about it. The most recent one though is Dragonfly. So we've talked a lot about the metrology new products, but we just released the new Dragonfly G3, the new inspection tool, which is, I think, is around 50% more sensitivity and 30% faster. And then it also includes all the different sensors that we normally provide. That's critical as more and more inspection is being required in advanced packaging with the technologies that are changing so dramatically. I mean we're seeing RDL lines going from 10 microns to 1 micron in just a few years. And if you compare that against the front end, it would be a 10-year kind of migration. when they were the most aggressive, when the front end was. So the amount of change happening in back end is incredible. That's a testament to the strategic nature of packaging is playing and propelling electronics and capabilities beyond Moore's Law. There's 1 more point I want to make. That was good. That's good.

No, look, it's good. And it's good to know that you have more on the burner that is coming. And the other aspect now that beyond talking about just growth and new products, how is the product mix and the evolution of the product mix. How do you think that will impact margins? And also, the gross margin evolution that you've been enhancing improving where do you see that going?

Yes. We'll continue -- so we have a long-term model out there, 54% to 56% as we continue to grow. So you'd say, wow, but your model goes from $600 million to $1 billion, $600 million to $1 billion and that's true. So our focus is on maintaining the gross margin, obviously, driving improvements and hopefully, there's some upside there. But the real focus is on driving more profits to the bottom line and driving the operating margin up. So that's where when push comes to shove, that's where we're going to be having the most focus. The new products so far, they're all not so far and they are all additive to the gross margin. So as the new products get more adopted, they're adding more value, we can get a premium for them, that's natural. The recent acquisition we did, even though they were small, they were actually accretive to both gross margin and operating margin. So that's clearly a nice benefit that are certainly part of our focus. But no, we don't see anything all the new products. And I know we have had some investors concerned with these large volume purchase agreements that maybe that's going to bring down margins. We don't see that at all. Yes, there are some discounts expected in 1 area, but because we have much more products we're bringing together, we're able to move things around. Sure, we can give you a little discount there, but you've got to bring in these new products that you're not using right now, and those tend to balance out. So I think we're very happy with the deals that we're negotiating with our customers.

Actually, we're in the volume level purchases to be really interesting and high magnitude, I think you said $100 million plus and potentially in 2021, and those seem to be pretty significant. Do you think this is going to be kind of a new trend? Do you think more of these will come? I get the sense there's a bit of an advantage here of the merged entity being able to better play the front end and the back end and therefore, more cross selling that you can do as you were explaining. But do you think this will become kind of a new trend? And then another weapon in your toolkit is to really ramp up the growth and the size of the wallet into your customer base?

Yes. I -- we do believe that. We might not get everybody at $100 million. Certainly, there's the top 5 semiconductor manufacturers that we should be focused on. We do have other BPAs that we negotiate and work with, but they've never achieved this kind of level, so that's why we highlight on the earnings call. Another point that he made to me is when we added up the 2020 volume, that was about $75 million or so from those 2 accounts. So the combination actually enhanced the opportunity. So not just the cross-selling but enhance the amount we can bring into the account. Kind of like what I described earlier. Hey, if you want to discount here, then please take in some of the inspection, which -- and so we think there's a lot more that we can do with those now 5 new products that have come out on the metrology side. Many of those expanded our SAM into areas that we were not competing in. And then also, of course, the inspection side with the advanced packaging becoming more and more critical. We think there's opportunities to leverage some of our advanced packaging. We're already pretty strong in that area. So the leverage is a little bit less because we're already -- I think we estimate over 75% share for advanced packaging at the top 5 IDMs but there's still 25% more. And there's some other applications we're going after.

Understood, Mike. We have a few minutes left. I wanted to touch upon inorganic aspects or strategy that you may be developing plus how you're thinking about capital allocation? You obviously have a strong balance sheet. You recently completed the Inspectrology acquisition. I'm curious for your punchline on that position and expected impact in 2021 and beyond. But it would be great to get to your perspectives on M&A priorities, region or product wise and also organic deployment of capital in growth engines that you've identified.

So we won't give a lot of specifics on the details of the M&A strategy.

Understood.

But we will say that we have a much more disciplined M&A process. We've hired and dedicated resources to it. So we have now a team focused on the M&A process, much more disciplined pipeline management process. We've expanded our focus to look globally, not just with some of the names that we're very familiar with. But looking at some of the smaller companies that are still $50 million, $100 million range, but located around the globe, primarily Japan, Korea, Taiwan, where semiconductors have, manufacturers have fostered an equipment market around them. So we're looking there. I think the Inspectrology acquisition is 1 we were watching for quite a bit of time. It just made sense. We looked at it from a standpoint of the synergies we saw with just the technology, the teams, the ability to just sit right there in Massachusetts. The integration was very easy. And then when we looked at the financials and saw they were accretive, both on the gross and operating margin side became just a no-brainer. Then you add on top of it, the nice cherry where there in a very strong leadership position and overlay metrology for a market we believe is going to be growing the compound semi. We've seen some estimates, 25% CAGR over the next several years and the leverage we see with our technology. We see a lot of upside with that. So that's still those kinds of deals we're still looking at. But as we've said, in my past as the CEO of Rudolph, we're looking for more transformative deals, that would be our priority and up to another MOE.

Very well. You're becoming a larger company as you continue to think about consolidation opportunities. Mike, I think we are close to our time. But If any other remarks in terms of your long-term vision for Onto, maybe we have a couple of minutes for that. Otherwise, any other remarks that we should have touched upon and that are in your minds that we haven't. Please, feel free.

I think we covered quite a bit. I would just say or repeat that being CEO at Onto Innovation, the exciting part is how well balanced we are from a market perspective and then the secular trends that we're tied to. So we're not just waiting for DRAM to return or we're just not waiting for logic. That's altogether, 50% of the business, the other 50% is tied to specialty devices like 5G and RF and power and so end up advanced packaging trends we'd see. So from an investor perspective, that kind of track record of financial performance, but then also the markets, the breadth of the markets served with the different products. I think it's exciting for us, it should be exciting for investors. The last point I'll make, which I didn't highlight earlier is that despite the breadth of the broad product portfolio, one of the key strategies has always been to leverage the core competencies in software and optics. So to be able to provide those technical synergies at an effective, efficient way. So for the R&D dollars going into, let's say, our AI engines, applying to multiple different products and different markets, that's great leverage, and I think we'll see a lot more of that showing up in the financials.

That's perfect, Mike. Really appreciate your time, and thanks for joining us at the Morgan Stanley conference.

Thank you very much, Pedro.

Thank you.