Photronics, Inc. (PLAB) Earnings Call Transcript & Summary

Good day, and thank you for standing by. Welcome to the Photronics' Q2 Fiscal Year 2022 Earnings Conference Call. [Operator Instructions]. As a reminder, this conference is being recorded, Wednesday, May 25, 2022. I would now like to turn the conference over to John Jordan, Executive Vice President and CFO. You may begin.

Thank you, Tonia. Good morning, everyone. Welcome to our review of Photronics' fiscal 2022 second quarter results. Joining me this morning are Frank Lee, our recently appointed Chief Executive Officer; Chris Progler, our Chief Technology Officer; and Eric Rivera, our Corporate Controller and Chief Accounting Officer. The press release we issued earlier this morning, along with the presentation material, which accompanies our remarks, are available on the Investor Relations section of our web page. Comments made by any participants on today's call may include forward-looking statements that include such words as anticipate, believe, estimate, expect, forecast, or in our view. These forward-looking statements are based upon a number of risks, uncertainties and other factors that are difficult to predict. Actual results may differ materially from those expressed or implied, and we assume no obligation to update any forward-looking information. At this time, I will turn the call over to Frank.

Thank you, John, and good morning, everyone. I would like to begin this morning by stating how honored I am to be with you today as the new CEO of Photronics. Since joining the company in 2006, I have had created and our operation and strategy in Asia, including the formation of 2 joint ventures with Dai Nippon Printing Company and also the recent geographic expansion of our operations into China. Turning to the financial results. We once again delivered a second -- record revenue in the second quarter, improving 8% sequentially, our strong end market demand, the further price realization across IC segment and also the continuous production ramping up of our Xiamen and Hefei operations. In addition to the top line growth, we expand our growth and operation margins. Gross margin was 36% and operational margin, 25%. The net result was EPS of $0.49. Cash generation was also strong as we end the year with $247 million in net cash, which position us to continue investing in profitable growth opportunity. As CEO, I fully commit to continue our organic growth strategy, the revenue growth and margin expansion. And also we'll keep exploring additional growth initiatives. For revenue growth, the growth is achieved by winning more share in a growing market right now. We have been working closely with our customers to meet their needs in technology and capacity road map. We are building partnerships with several key customers, and we also signed many long-term purchase agreements, so-called [ LTPA ] with our key customers. This kind of approach serves us very well to make a critical investment, and it helps us to quickly get return on our investment. Our recent IC and FPD operation into China are a very good example of this approach. As the market leader, Photronics has become a trust partner and key suppliers of our customer in both IC and FPD. In addition to revenue growth, our profitability has been improving continuously. This is achieved by the very execution of 3 major key items. The product mix optimization, the effective cost management, and operational efficiency enhancement. On top of these actions, we have implemented some pricing adjust strategy based on current market supply-demand imbalance situation. My third commitment is to explode new strategies to further our growth initiatives. I'd be very involved in this process since joining Photronics. We have a very good relations with our customers, vendors and value partners throughout Asia. With the emerging trend of global supply chain restructuring include IC manufacturing localization such as [ Made in USA ]. Photronics will solidify our activities and relationships in these other agents, in other geographies. I'm very certain that with our strong existing global footprint and the successful experience in Asia, we will be far ahead with in this business, in our business. We have performed very well through the first half of 2022, and we are on track to have the best year in the history of the company. I'm very proud of our team. And together, we will continue to outperform beyond 2022. Thank you very much. And this time, I turn the call to John.

Thank you, Frank. Good morning, again, everyone. Second quarter was another record quarter for Photronics, our fifth consecutive record quarter. Revenue improved 8% quarter-over-quarter and 28% year-over-year as demand across the board remained strong. We're executing on our growth strategy by investing in technology aligned with market drivers, and partnering with customers by establishing long-term purchase agreements that enable us to quickly and profitably ramp new tools while maintaining high utilization on existing tools. This quarter is another proof point that, that approach is working. IC revenue grew 12% sequentially and 30% year-over-year on strong global demand for our photomasks. High-end demand was driven by foundries in Asia and U.S. as semiconductor content in consumer goods continues to increase with more chips in electronics, automotive, appliances and many more applications, new designs continue being released to satisfy this demand. Advances in communication infrastructure, such as the rollout of 5G are another catalyst in demand growth. This proliferation of chips is a driver of photomask demand and for Photronics. As use of semiconductors continues to proliferate and demand growth continues beyond the capacity to supply it, it creates a change in pricing environment, primarily in trailing edge masks, but also in the high-end business that is helping us further expand margins. which I'll discuss in more detail later. FPD was down slightly quarter-over-quarter, primarily due to a decrease in mainstream LCD. High end was slightly higher, thanks to continued strong mobile demand. Growth in displays for mobile applications offset a decline in G10.5 larger mask demand. We expect demand to remain strong for AMOLED and LTPS displays used in mobile applications, some increase in G10.5 and continued reliable demand from mainstream LCD displays. Revenue from products shipped to China customers achieved another record quarter, improving 8% sequentially and 58% year-over-year. We are the clear market leader in this growing region. Our past business development and operational expansion initiatives are reaping the benefits we anticipated. Gross and operating margins improved during the second quarter, benefiting from the high leverage in our operating model and well demonstrated discipline in keeping costs low. Gross margin of 35.7% and operating margin of 25.5% are both well within the long-term ranges we communicated in February. We fully expect this business environment to continue well into the future. We have based our investment plans and that expectation, and we anticipate that the increased margins will be sustained by the demand-supply imbalance due to limited trailing edge capacity. Our target model, which will take us into fiscal 2024, has been updated to reflect these new growth opportunities and is included in the supplemental slides posted to our website this morning. Our approach to these target models is to be realistic without being aggressive, although in retrospect, consistently improving business conditions in the photomask space and our execution have suggested that the model should be updated. The updated target model layers in only the revenue increments anticipated from our currently planned CapEx investments and the pricing opportunities provided by continuation of the current business environment with consideration at the low end of the target that at 3 years into the strong semiconductor business cycle, the risk of a downturn is increasing. Income tax provision increased due to the increased earnings and net income to noncontrolling interest increased with the strong performance of our joint ventures in China and Taiwan. Changes in foreign exchange rates resulted in an $8 million gain in other income, equivalent to approximately $0.07 a share. As a result, diluted earnings per share were $0.49. We strengthened our balance sheet during the quarter with cash and equivalents increasing to $329 million, and debt decreasing to $83 million, resulting in net cash of $247 million. We generated $44 million in cash from operations and received $10 million in contributions from our JV partner for IC capacity expansion in Asia. CapEx in Q2 was $16 million, and we received a little over $1 million in government subsidies for investments in China. This brings our total CapEx for the year, net of subsidies, to $33 million. We still expect CapEx of $100 million in 2022 as we increase our mainstream IC capacity and increase the size of our facility in Taiwan. Before I provide guidance, I'll remind you that our visibility is always limited as our backlog is typically only 1 to 3 weeks. And demand for some of our products is inherently uneven and difficult to predict. Additionally, the ASPs for high-end mask sets are high. And as this segment of the business grows a relatively low number of high-end orders can have a significant impact on our quarterly revenue and earnings. Given those caveats, we expect third quarter revenue to be in the range of $205 million to $215 million, driven by a continuation of favorable end market demand trends across both IC and FPD. Based on those revenue expectations and our current operating model, we estimate adjusted earnings per share for the third quarter to be in the range of $0.45 to $0.55 per diluted share. As Frank said, we're on track to deliver the best year in the company's history with strong end-market demand, strategic capacity expansions, higher profitability and a strong balance sheet to support further growth initiatives. Business conditions and execution by our team across the organization brought us within the ranges of our previous target model and support new projections. Achievement of that new target model will continue to create and deliver more value for our shareholders. I'll now turn the call over to the operator for your questions.

[Operator Instructions] And our first question comes from Patrick Ho of Stifel.

And Frank, first off, it's good to hear your voice, and congratulations on the job, and best of luck going forward. Maybe a first question on the demand environment. Obviously, that looks very healthy moving forward in both mainstream and high-end ICs. Are any of the recent Chinese market volatility changing your outlook at least in the near term in terms of potential pullbacks in that region then? Or are you still seeing continued strong demand in the IC market in China?

Thank you, Patrick. The Shanghai City lockdown initially has slow down all the business activities in China, especially in the Shanghai area. So we do see some new product tape-out slowdown initially. However, the situation has been gradually recover. And recently, we see the new order, new tape-outs start to come in. So I think there's an impact. However, it's short and it should be fully recovered already.

Great. That's helpful. And maybe as a follow-up question for John. Obviously, the operating leverage was excellent this quarter as well as is a nice pleasant surprise to see the new target model. I guess what gives you confidence because you were looking at some new target model metrics of over 40% gross margins, 30% operating margins, numbers we've never seen from the photomask industry as a whole. Is it more the pricing aspect? Or is it the demand and just the revenue growth that's driving this improved margin leverage?

Good question, Patrick, and essentially yes to all of the above. So the -- I call it the business environment, but it provides us a lot of opportunity for pricing that we haven't -- we've never had before. And we've got -- as Frank mentioned, we have long-term purchase agreements with many customers, some of which we've kind of renegotiated and there are others coming up for renewal, some are 1 year, some are longer than 1 year. And as they come up for renewal, the prices -- the opportunity is still there to continue the price increases. So a lot of our locations are at capacity. So we're -- the operating leverage is outstanding from those locations and then the opportunities created by the business environment to improve pricing, we expect to continue well into the future. And I think you've read the same things that we've read and most of what you read supports that assumption.

And our next question comes from Hans Chung of D.A. Davidson.

Congratulations on strong results. So first question, just -- can you elaborate more the pricing adjustment during the quarter, like where -- is it across the board? Or what kind of magnitude? And then where are we now in terms of the pricing? How much room can we further to increase, going forward?

Hans, nice to meet you, and thanks very much for the question. So we don't generally talk about the specific amounts of pricing adjustments because it's really competitive information. But we've been able to increase prices in the mainstream primarily because there's such limited capacity. And the mainstream demand is expanding so ubiquitously just because of the use of nonleading edge chips in everything we do. But we've also had opportunity to increase our high-end pricing as well for similar reasons and because of our technology leadership. So without talking about specific amounts or percentages, the environment is there and we're able to take advantage of it, and we expect it to continue going forward. I hope -- did that answer the question?

Yes. Yes. Yes, that helps. And then I guess the follow-up is, so as we move to our new target model, right, and with further higher margins, and that will be also assuming further the price increase over time. And just to get a sense that to what degree that the -- in terms of pricing, we might start to see that our customer may start to consider, turn to the captive, the options. I know this might be not the economy at this moment, but just trying to get a sense like how far are we to there? I mean if we can see our target amount of that 40% margin.

Yes. Right now, the capacity issue, we believe will last into next year, at least. The main reason, of course, is the long lead time of the equipment. Same as wafer fab equipment, our photomask equipment to -- deliver time has become very, very long. So the demand increased a lot. However, on the side, it will take time to provide some capacity to the customer -- to the market. So we believe the price increase, there's a very high possibility it will continue into next year.

Okay. Okay. And then...

I might also kind of supplement that with a comment about the captives photomask business as well with the amount of investment and resources required for the leading-edge chips these days, the captives are reluctant to invest in mainstream capacity, and they are also -- we understand they're also inclined to start outsourcing more of that mainstream demand, the mainstream photomask business. So -- we're looking -- we haven't incorporated any of that into our model, but we fully expect that to also be an upside to the model.

Got it. Got it. That's helpful. And then last question, just regarding your capacity we continue to expand our capacity. So what would be the capacity run rate in terms of revenue by the end of this year? And then I guess just assuming, I say by end of this year, what will be the decreased level in capacity to market demand exiting that -- this year?

Okay. So the -- our guidance for next quarter and one can assume -- we don't give full year guidance, so we'll have to draw an assumption about fourth quarter. And into next year is based on the additions to capacity that we've already incorporated into our CapEx budget for this year. So as those tools, those new tools, come online, we've incorporated the revenue -- the incremental revenue from those tools into our guidance expectation and into our target model. So what we have forecast is essentially capacity, to the extent we have it and continue increasing it. There are some locations that are not operating at capacity, and that's based on the geographic demand profile. But for most of our locations, their operating capacity, that capacity will expand as we add those this year, point tools in mainstream and then next year, high-end tools. I might want to point out, as that I mentioned it in my comments, but our long-term model target model is based only on the CapEx that's in this year's budget and some of which will be delivered in next year, but there is no CapEx -- additional CapEx that we would plan for next year in addition to what's already ordered from this year or 2024. So one can expect the capacity to increase for those CapEx additions. But again, those are not incorporated into our target model.

Our next question comes from Gus Richard of Northland.

Great quarter. Could you just give a little color on the sequential increase in revenue? Was that mostly price or was there some volume component to that?

It was both. Mostly price, but some volume.

Okay. And then in terms of the long-term purchase agreements, is that still primarily FPD or is it starting to spread out into the IC business?

Actually it start with IC because we do have this kind of agreement with certain key foundry customers for several years. But right now, we are expanding the customer base to sign the contract. So at this moment, it covers both IC and FPD customers.

Okay. Got it. And just roughly, how much of your revenue is under long-term purchase agreements?

Yes. We don't really report that number, Gus. It's a pretty substantial amount, especially in Asia.

Okay. Got it. And then I think this is the first time I've heard you mention high-end pricing improving. Is that correct? And is it beginning -- the price increases in the high-end beginning to catch up with mature -- or can you talk about those 2 segments of IC and sort of how they're behaving?

Yes. The price increase actually started last year in the mainstream market. However, the capacity shortage situation start to migrate into high-end IC area also. So in this year, we started a negotiation with the key high-end IC customer and the new price start effective -- become effective in -- at the beginning of Q2.

I understand. That's very helpful. And then in terms of capacity utilization in IC mature versus mainstream, are you basically both of those running flat out now? Or do you have incremental capacity in the mainstream?

We are building the incremental capacity step by step. However, as I mentioned, the tool lead time is becoming an issue. So the capacity incremental has to be done quarter-by-quarter, but not at the same time.

I see. And then last one for me. In terms of the foundry outsourcing, I'm sure they're busy with the EUV masks. Sort of are they outsourcing 14-nanometers and above? So where is the breakpoint on what they outsource and sort of how do they think about what they put out into the merchant market?

The amount of outsourcing from captive has increased year by year. And with the growing demand in the high-end the captive are also short of mainstream and middle-end capacity. And we do have customer talked about some kind of long-term outsourcing agreement. So we are in a process talking to customers about this kind of outsourcing strategy.

And keep in mind, Gus, the outsourcing by the foundries is not limited to mainstream. There's also -- we also do high-end work for foundries.

Right. What I was trying to get at is are they -- I think you're capable of 14-nanometers and I'm wondering is there outsourcing up to that level?

Yes. 14...

Is there any plans internally to be capable of doing like a 10-nanometer mask set? Or -- I think that's -- or now -- or certain layers?

Chris, I want to -- Chris, you want that?

Yes, I can make a comment. Got you. 14 logic is pretty healthy outsourcing among the foundry captives and the IBM. So that node is pretty well placed into commercial mass making. I would say that 7, 8-nanometer node, just starting to look like qualifications will initiate. So maybe some started last year. some will continue this year. And we have capability for those nodes as well.

Can you do the EUV masks blanks -- masks as well or just the other layers?

We have an EUV process. We -- since 2017, we've had a joint development agreement with IBM in New York. So we build all of their EUV masks. That's admittedly kind of a pilot line, but if they go through full device demonstration, full yield down to kind of 28-nanometer pitch, which is 5-nanometer node class mask, so -- we have a solid, I would say, front-end EUV capability in Photronics. And we're delivering those masks, not in huge numbers, but in higher and higher units every month. As far as an EUV really transitions to commercial mask-making at large, I think that's still a couple of years away. We're seeing kind of the Tier 2 people now put in EUV tools. By Tier 2, I mean, the second adopters are putting in single unit EUV systems. So it's starting to become a little more pervasive, but it's still fairly narrowly confined to a small number of designs. And of course, the large -- the big 3, everybody knows, TSMC, Samsung and Intel, for EUV, they're still building most all of their mask internally. So I think we'll get there. We watch the market closely and we evolve our capability, thanks to the IBM partnership. But I think probably at least 3 years out before the EUV goes full commercial.

That makes complete sense. Thanks so much.

Ladies and gentlemen, there are no further questions at this time. I would now like to turn the call over to Frank Lee for closing comments.

Thank you. Thank you for joining this morning. Photronics is in a great position, and we are continuing to move forward, and we will achieve our long-term goals. I'm very confident that Photronics employee across the world will continue to exceed expectations by delivering quality products and outstanding service helping us to achieve our long-term target. I'm looking forward to meeting and speaking with many of you in the near future. Having a great day, and thank you very much.

Ladies and gentlemen, that concludes the conference call for today. We thank you for your participation and ask that you please disconnect your line.