Advanced Energy Industries, Inc.

Good afternoon, everyone. Welcome to Advanced Energy third quarter 2021 earnings conference call. With me today are Steve Kelly, our president and CEO, and Paul Odom, our executive vice president and CFO. If you have not seen our earnings press release, you can find it on our website at ir.advancedenergy.com. There you also find the third quarter slide presentation. Before I begin, I'd like to mention that we'll be participating at several investor conferences in the coming months. Let me remind you that today's conference call contains four looking statements. They are subject to risks and uncertainties that could cause actual results to differ materially and are not guarantees of future performance. Information concerning these risks can be found in our SEC filings. All four looking statements are based on management estimates as of today, November 8, 2021, and the company assumed no obligations to update them. Medium and long-term targets presented today should not be interpreted as guidance. On today's call, our financial result will be presented on a non-GAAP financial basis unless otherwise specified. Excludes from non-GAAP results are amortization, stock compensation, integration and transition costs, unrealized foreign exchange gains or losses, and restructuring items. A detailed reconciliation between GAAP and non-GAAP measures can be found in today's press release. With that, let me pass the call to our president and CEO, Steve Kelly.

Thank you, Edwin. Good afternoon, everyone. and thanks for joining the call. In the third quarter, we delivered results above the midpoint of our guidance. Stronger factory output pushed our revenue, gross margin, and earnings per share to the upper part of our guidance range. Demand remains extremely robust across all of our target markets. In addition, our new products continue to be well-received by customers who depend on AEs innovative technologies to achieve their efficiency, power density, and precision power goals. We remain focused on the key factors driving our long-term success. Industry leading innovation, strong customer relationships, outstanding quality, a strong leadership team, and a culture focused on results and speed. Over the course of the year, we have taken substantial steps to increase the capabilities of the Advanced Energy Leadership Team. Our latest addition to the team, Eduardo Bernal, joined the company in September as our EVP and COO. Eduardo has an impressive record of achievement in the semiconductor industry with specific expertise in operations and supply chain management. Before joining Advanced Energy, He led the global backend manufacturing organization at NXP Semiconductors and was able to drive significant performance improvements over a multi-year period. Eduardo will be based in Singapore and Malaysia, and we are delighted to have him on board. Now I'd like to touch on our supply chain challenges, specifically shortages of key ICs. These shortages continue to constrain shipments, and limit our financial performance. We are working diligently and with a high sense of urgency to mitigate the shortages, expediting suppliers, qualifying replacement parts, and where necessary, redesigning boards to eliminate problematic ICs. Many of our customers are playing an important role in the mitigation efforts by expediting qualifications of new parts, and by joining discussions with our key suppliers. We are seeing some incremental progress on the parts front, as reflected in our third quarter performance. However, the overall supply environment remains dynamic. With little slack in the supply chain, the effects of manufacturing or shipping disruptions quickly ripple through to the end customer. Given the dynamic nature of the supply chain issues, we are taking a relatively conservative approach to our financial forecast. However, given the amount of pent-up demand for our products, as indicated by our record backlog, we see considerable revenue and profit upside tied to the successful mitigation of our supply constraints. Despite the supply chain issues, we have maintained a full factory workforce in order to maximize our surge capacity. As an additional measure, we plan to keep our Shenzhen factory open into the second quarter of 2022. Now I'd like to provide more color on each of our target markets. As I mentioned earlier, demand is very robust across all of our markets. The macro trends are solid and customers are designing in our new products. In the semiconductor equipment space, our customers are forecasting strong unit growth in 2022 across a wide range of technologies. We are well positioned to benefit from this growth, given our strong position in both current generation and next generation conductor edge equipment. In addition, we expect to gain share in the coming years in plasma power applications, particularly in areas where we currently have a minor presence, such as dielectric and remote plasma source. Our new EVOS and Maxstream products for those applications are being evaluated and qualified by multiple customers and are expected to go into mass production in the coming years. In the third quarter, we secured several strategic wins at Korean and Chinese OEM customers. We also won an important remote plasma source design. In medical, we secured several wins in life science and therapeutic applications and a strategic win in ultrasound. In industrial, we secured a high-profile win in the thin-film area and received a large order for an indoor farming project. We also won several proprietary designs in power control and thermal sensing applications. In data center computing, telecom, and networking, We continue to see strong demand as multi-year digital transformation trends drive sustained infrastructure investments. In the third quarter, we secured a next generation hyperscale design with a solution featuring power density roughly double that of current generation products. We also won high value designs in telco edge, storage, and network routing applications. Before closing, I'd like to summarize our key messages. First, demand for our products is robust amid broad customer acceptance of our new products and technologies. Second, we are working diligently to mitigate the impact of supply chain constraints. Third, we expect pent-up demand for our products to drive several quarters of revenue upside above current run rate. as supply chain issues are successfully addressed. And finally, we are positioning the company for sustained revenue growth with a strong lineup of differentiated products targeting the right markets. Paul will now review our financial results and provide detailed guidance.

Thank you, Steve, and good afternoon, everyone. In the third quarter, we delivered revenue and earnings above the midpoint of our guidance. Total revenue of $346 million declined 4% sequentially, as our ability to ship products was limited by component supply and, to a lesser extent, COVID restrictions in Malaysia. Relative to our guidance, gross margins were at the high end, resulting in earnings of $0.89 per share. Customer demand remains high, and we ended Q3 with record backlog of over $770 million. The vast majority of this backlog is for proprietary products, and roughly two-thirds is for orders that are shippable as soon as we can build them, highlighting the strong demand profile. We believe this high level of shippable backlog represents meaningful upside to our current revenue levels for an extended period of time as the supply situation improves. In the near term, the availability and predictability of certain components, primarily critical ICs, remains challenging, and we expect supply constraints to continue to gate revenue. In addition, as we projected, our gross margins are being impacted by higher input costs in the form of premium buys, expedite fees, some price increases, and underutilization of our factories. The majority of these costs are transitory and will naturally improve over time. But we are also taking proactive actions to mitigate the headwinds on both availability and cost, which we expect to begin yielding results in Q4 and increase over time. These include working with our customers on cost recovery and pricing, establishing strategic supply agreements with our suppliers, and pursuing selective redesigns. During this time, we are retaining our factory capacity to be able to deliver higher revenue as parts become available and expect to maintain our broader infrastructure about flat while reallocating resources to accelerate our most important programs. While we will see some inflationary pressure in spending, We believe this approach is a good balance between managing short-term challenges and funding an extended set of opportunities for upside and long-term growth. As revenues recover, we expect to see good operating leverage and continue to believe we have the building blocks in place to achieve our medium and long-term goals. Now let me go over our Q3 revenues by market. Semiconductor sales continued near record levels at $173 million Up from last year, but down slightly from last quarter. Demand remains strong, and with Malaysia now allowed to operate at full capacity and modest improvement in parts supply, we expect Q4 semiconductor sales to grow sequentially. Revenue from our industrial and medical markets fell 3% from Q2 to $81 million. However, customer demand was broad-based, and our backlog increased by almost 50% sequentially. We saw revenue strength in thin film coatings, medical, and thermal sensing, where our teams were able to overcome some of the part shortages. Data center computing revenue was 62 million, and telecom and network revenue was 30 million, both down from last quarter due to supply constraints, which have been particularly acute for ICs used in these markets. Our order book in these two markets continues to increase. Non-GAAP gross margin for the quarter was 36.1%. The sequential decline was primarily due to increased input costs and factory underutilization. Year over year, these costs are having an approximate 350 basis point impact to gross margins. While we are making progress on mitigating actions and cost recovery, we expect margins to continue around these levels for another quarter or so as the higher cost materials roll through inventory and impact our cost of goods sold. In addition, as Steve mentioned, we now plan to extend the operation of our Shenzhen factory through the end of Q2, which will impact gross margins in the near term, but provide additional shipment flexibility. Non-GAAP operating expenses were $83.6 million, up about a million from last quarter. The sequential increase was mostly due to a full quarter of expenses from TGAM, which we acquired in June. Operating margin for the quarter was 11.9%. Other expense was $1.7 million, including $1.3 million of interest expense. We expect other expense to be in the $2 million range going forward, including the interest cost on our additional debt. Our non-GAAP tax expense was $5.6 million, or 14%, which was largely in line with our target of approximately 15% plus or minus. Earnings for the quarter were $0.89 per share compared to $1.25 last quarter. Turning now to the balance sheet, we ended the third quarter with total cash of $550 million and net cash of $153 million. Operating cash flow was $18 million and CapEx was $8.5 million. During the quarter, we repurchased $52.6 million of common stock at $86.93 per share. taking advantage of market volatility to return cash to shareholders. We also paid $3.9 million in dividends. Earlier in the quarter, we amended our existing credit agreement to increase our term loan by $85 million to $400 million, increase our undrawn revolving line of credit to $200 million, and extend the remaining term to five years. With an attractive rate of LIBOR plus 75 basis points, This refinancing provides us with additional financial flexibility for inorganic growth, share repurchase, and other corporate needs. In Q3, our days of networking capital increased to 117 days. Inventory increased by $45 million, and turns were 2.8 times, as we continued to acquire raw material to support future shipments. We believe this inventory is well matched to customer demand, and although it may take a few quarters, we expect turns to rebound as critical part shortages abate. Days payable fell to 76 days based on timing of payments. On the other hand, DSO improved to 57 days on strong collections. Now let me turn to guidance. Market demand and our order book continue to be extremely strong. However, we expect the supply environment to remain challenging in the near term. As a result, we expect Q4 revenues to be approximately $355 million plus or minus $20 million. Our Q4 guidance assumes semi-revenue will grow sequentially. We expect Q4 gross margin to be similar to Q3, based on higher material costs offset by incremental benefits of mitigating actions. Operating expenses should be flat to up slightly, largely due to the cost of inflation across a variety of areas. As a result, We expect Q4 non-GAAP earnings per share to be 92 cents plus or minus 25 cents, based on a share count of approximately 38.2 million shares. We are taking a prudent approach for the next couple of quarters, assuming that the current supply environment will continue to limit revenue at around current levels in the near term. However, we are confident that our mitigating actions will yield incremental benefits in the coming quarters. With our large shippable backlog, we expect to see revenue upside of up to $50 million per quarter over our current run rate as supply normalizes. Looking forward, we are more excited than ever about our expanding set of new opportunities and will continue to invest in R&D to accelerate our growth. As we take mitigating actions to manage component availability and cost, continue to optimize our portfolio, and rationalize our factory footprint, we expect to achieve gross margins at or above our long-term goal of 41%. We remain focused on executing our strategy and are confident in our ability to reach our long-term revenue and earnings goals. With that, let's take your questions. Operator?

Thank you. At this time, we'll now be conducting a question and answer session. If you'd like to ask a question today, please press star 1 from your telephone keypad, and a confirmation tone will indicate your line is in the question queue. You may press star 2 if you'd like to remove your question from the queue. For participants using speaker equipment, it may be necessary to pick up your handset before pressing the star keys. One moment, please, while we poll for questions. Thank you. Our first question comes from the line of Tom Diffley with DA Davidson. Please proceed with your questions.

Yes, good afternoon. Thank you for the questions. Paul, following up on your last comment, you talked about revenue going up possibly $50 million a quarter once supply constraints ease. As you talk to your suppliers, when do you think that starts? When do you see an end to the IC supply issues?

That's a good question, Tom. I think the challenge we have is in the near term we continue to see these critical parts being in short supply. But we have a highly engaged work with our supply chain, also with our customers to try to accelerate and increase the amount of parts. And While it's hard to say exactly when that will turn around, we do believe that over the course of next year it will improve. I think it's very possible by the time we get to the end of next year, we could be seeing revenues running at that level, current levels plus $50 million, which would be significant for us. We believe that could drive earnings power at that time as high or maybe higher than $6 a share annualized.

Okay, that's very helpful. And then when you look at your four segments... Could you kind of rank them in order of which ones are being the most affected by the supply constraints?

Yeah, the ones that are being most affected are higher volume markets, particularly the embedded power markets. These particular products use a higher number of these critical ICs. There's also more standardization across those products. So if you're short one of these critical parts, it might, in fact, impact multiple families. Probably the second most impacted is our industrial medical products. And then CIMI is actually performing quite well. As you see, we're continuing to operate near record levels, but certainly there are critical shortages there as well. And we could be doing much better if we had the parts in place.

Great. And then finally, when you look at the – you talked about qualifying new parts to get around some of the IC shortages. How long does that process take?

Yeah, Tom, this is Steve Kelly. We started that process in earnest three to four months ago for a number of our products. Typically, that process is going to take around nine to 12 months to do the redesign, to do the reliability testing, get the qualification from our customers. The good news for us is that our customers are highly motivated to qualify these new designs, so we're seeing record turnaround times. So it's possible we could get the calls done faster a bit quicker than we expect.

Okay. Well, thank you both for your time today.

Thanks, Tom.

Our next question comes from the line of Krish Sankar with Cowan & Company. Please proceed with your question.

Yeah, hi. Thanks for taking my question. I have two of them, too. First one, Paul, just want to follow up. You said, you know, where the revenue upset of $60 million a quarter maybe happens later next year as supply normalizes. Along the same path, How long do you think the gross margin or this component cost is going to be a drag on gross margin? Is it beyond 4Q into 1Q or beyond that too? Then I have two other follow-up things.

Yeah, I said in our prepared remarks that we thought this would last a couple of more quarters. Certainly we have a lot of these premium buys, expedites that are rolling through now, and some of that's in inventory. So that certainly is impacting Q4 and will likely impact Q1 as well. As we look beyond that, it will depend on how quickly we can move to a more stable supply level where we're paying more normalized prices for these parts. So it's difficult to say in the near term, but certainly over the course of the year, we'd expect to see some improvement. Probably the simplest way to think about it is the situation probably persists for another couple of quarters and then gradually improves from there. We don't see a silver bullet, Chris, where suddenly, magically, things get much better. But we've done a lot to take mitigating actions, including working with our customers on cost recovery, on sharing some of the price changes that we're seeing. We're working with our suppliers to have better long-term agreements and sources of supply, which should hopefully get us out of some of the premium buys and things we're having to do through distribution and other channels. And as volume begins to improve, obviously that helps our factory utilization as well. So all those factors will contribute to margins getting back to where we'd like them. It's interesting if you look at the actual numbers, it's pretty clear that if you excluded the higher cost of materials we're paying in the near term and the impact on our factories, we're certainly running at or around that 40% level. So some of these are transitory. The premium buys will pass more quickly. Some of them will be longer term, and we think there will be opportunity for price and other mitigating actions around redesign that Steve talked about earlier. But we feel confident as we look out. I think in our last call, we thought the exit rate of 2022, we could be back around that 40% level. We don't have a lot of visibility. Obviously, the timing could change, but that's, I think, not an unreasonable way to think about it.

Got it. That's a really good call. Thanks for the follow-up. The $50 million incremental revenue, is it fair to assume, given that in your prepared comments, you said there's a lot more supply constraint issues on the INM, telecom, networking, data center side, is the incremental $50 million more tied towards the legacy artisan business? Is there a way to think about it, and i.e., that's where you might see some price recovery and helping margins as the revenue comes back?

Yeah, I think it's definitely more of a mix, Krish. There's significant upside in our semiconductor products for a lot of reasons. Demand's quite healthy there. And remember, not all of the semiconductor demand is in our backlog because of our JIT bin strategy with our largest customers. So there's significant upside in the semi as well. It's fair to think that it would affect both. It would help all of our markets.

Fair enough, fair enough. And then just a final question for Steve. Steve, it seems like, you know, maybe I'm wrong on this, but I'm just kind of curious. It looks like you're moving away from servicing the hyperscalers market inside and moving, shifting more to industry and medical. A, is that true? If so, can you talk a bit about that strategy and how it should impact the long-term revenue margin profile for the company? Thank you.

Yeah, Krish, I think it's fair to say the entire company is moving towards higher value-added products. That includes what we're doing for hyperscalers and enterprise computing customers. If we take a look at INM, the industrial medical group, the most attractive part of that market is it's almost entirely sole source, at least for us. And so we have put more engineering horsepower into the industrial medical business, and we expect to grow that at a faster rate moving forward.

Thanks, Steve.

Our next question is from the line of Quinn Bolton with Needham & Company. Please proceed with your question.

Hey, guys. Thanks for letting me ask the question. I wanted to follow up on Chris's question, maybe ask it a slightly different way. If you look at the business today, obviously there's a lot of pent-up demand, but wondering how much of that affects the industrial and medical and semi-business versus the more embedded telecom and server businesses. I would think that there may be more perishable demand today. in those embedded markets, and so as the business comes back, does it come back faster in industrial and medical and semi, which are higher margin businesses, or do you think there's actually better growth off a pretty depressed level in the more embedded but lower margin businesses as you come through next year?

Yeah, let me just echo what Paul said earlier. You know, we see shortages across all of our businesses, whether it's semiconductors, industrial, medical, and the high-volume, hyperscale, and enterprise computing businesses. So it's hard to predict which comes back faster if they all come back at the same time. But I can say that we're working hard in all the businesses to close the gaps. You know, we are paying significant premiums every week to source parts from various distribution and broker channels and working closely with our customers in all the segments to meet their needs. So, you know, we really can't predict which market will come back faster than another.

Understood. And then the second question, you mentioned keeping the Shenzhen facility open through the second quarter, wondering if you might be able to quantify how much of an impact that might have on your fixed expense base. I imagine, to the extent you close that down, that there could be a nice gross margin lift in the second half of next year, especially as revenue at that point should be ramping as you start to meet some of this pent-up demand.

Yeah, that's right, Quinn. We've said that the cost of keeping that site open from a fixed cost is between 50 and 100 basis points of gross margin.

Got it. Okay, thank you.

Our next question is from the line of Mendi Hosseini with SIG. Please proceed with your question.

Yes, thanks for taking my question. Going back to your Q4 guide, what would your revenue be if there was no supply chain disruption?

Well, I think it's easy to look at that in a hypothetical, say if there was no parts disruption, you could add that $50 million in today at least. We certainly have shippable demand that's well in excess of that where customers will take the products as quickly as we can get them. And then it would be just a matter of manufacturing capacity, which we certainly have enough manufacturing capacity to meet that number. So it's really all about having the critical parts.

Yeah, let me just add to that. I mentioned in my prepared remarks that we are maintaining a full workforce in all of our factories. So we have the surge capacity to get well beyond $400 million a quarter in revenue. So we have the people in place, and as the parts appear, we can build that equipment pretty rapidly.

Okay. And then you highlighted the growth in semi-business in the December quarter versus September quarter. Should I assume that other business units will be flat to down and semi will show growth, or would other business units be flat?

Yeah, I would say, generally speaking, semi we expect to be up, probably industrial and medical flat to up, and the high volume would likely be the offset to that, the high volume being telecom and networking and data center computing. But look, it's all about what parts we get in and where they go. That's the critical thing. So it's a little hard to predict exactly the mix.

Okay. And just for the purpose of modeling and assuming that the $50 million of business were to come back throughout 2022, would you have to expand your OPEX system should I assume that your OPEX would go up maybe one or two million per quarter, or would you keep it kind of flattish from here on?

Yeah, our intent is to keep it flattish from here on. We have, as you know, Mehdi, sort of accelerated already investment in R&D because we have a lot of opportunities ahead of us working with our customers. We're very excited about those. And there will be a little bit of inflationary pressures, but our goal is to basically keep our infrastructure flat and then there'll be some inflation on top of that. But we don't need to add a lot of operating costs as revenues grow beyond just kind of your typical variable costs that are completely tied to revenue. So not much OpEx growth as revenues recover.

Got it.

Thank you. Thank you. As a reminder, you may press star 1 to ask a question. The next question is coming from the line of Pavel Malenkov with Raymond James. Please proceed with your question.

For taking the question, you've done a little bit of M&A over the past year, but I'm curious if the supply chain complications that you and everybody else clearly is experiencing might create some distress situations that you could opportunistically take advantage of. Is that a realistic scenario in terms of some of the potential M&A targets?

That's an interesting question, Pavel. What we're seeing actually is we have some targets we're looking at, but they don't want to do a transaction because their financials are distressed because of their part shortages. So it's kind of a circle here. So I think as the parts shortages start to abate, I think you'll see the potential for more deals in this space.

Okay, so kind of the opposite of what?

Yeah, kind of the opposite.

Okay, fair enough. Your dividend is now at its one-year anniversary. Congrats on that. Should we anticipate... A dividend increase at any point in 2022?

Yeah, Pavel, obviously that's something that the board will review on a regular basis. At this point, we're not really in a position to comment on that. But look at our focus right now is on growing our business. We think there's a lot of opportunities to do that organically and inorganically. We're certainly investing a lot in working capital right now to support what we think is that upsize of growth. So we'll take that in stride, but no comments on that at this point.

All right. Thank you, guys.

As a reminder, you may press star 1 to ask a question.

Thank you.

At this time, we've reached the end of the question and answer session. I'll turn the call over to Steve Kelly for his closing remark.

Thanks for joining us today. We are dealing with near-term supply challenges, but we remain firmly focused on the timely introduction of new products and technologies, the drivers of AE's future revenue and profit growth. With strong demand for our products, a record order book, and a solid pipeline of high-value proprietary designs, we are well positioned to meet or exceed our medium and long-term financial targets. We look forward to talking with many of you in the coming weeks. Thank you.