Photronics, Inc.

Good day, and thank you for standing by. Welcome to the Fortronics Q1 Fiscal Year 22 Earnings Conference Call. At this time, all participants are in a listen-only mode. After the speaker's presentations, there will be a question-and-answer session. To ask a question during that session, you press star 1 on your telephone. As a reminder, this conference is being recorded Wednesday, February 23, 2022. I would now like to turn the conference over to John Jordan, Executive Vice President and CFO. Sir, the floor is yours.

Thank you, Chris. Good morning, everyone. Welcome to our review of Photonics' fiscal 2022 first quarter results. Joining me this morning are Peter Curlin, our Chief Executive Officer, and Chris Progler, our Chief Technology 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 webpage. The presentation material contains non-GAAP financial measures. A reconciliation of GAAP to non-GAAP financial measures may also be found at the end of the presentation. Comments made on today's call may include forward-looking statements. These forward-looking statements are based on a number of risks, uncertainties, and other factors that are difficult to predict. We refer you to the documents we file with the SEC for a discussion of the risks that may affect our future results. 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'll turn the call over to Peter.

Thank you, John, and good morning, everyone. I am pleased to report strong sales and earnings for the first quarter, a period that is typically seasonally soft. As in-market demand was strong and our global team worked hard to deliver another record quarter or fourth in a row, demand activity remains elevated across the semiconductor and mobile display industries. We are clearly benefiting from the investments in capacity and capability that have positioned us to outgrow the markets. We are seeing an acceleration of the trends that drove us to achieve record performance in 2021, and are confident that 2022 will be even better for Photronics, our customers, our employees, and our shareholders. While it's great to see the growth in revenue, it is even more rewarding to see our profitability step up over the last several quarters. Our long-term investors know that we repositioned the business nearly five years ago and launched an initiative to build new IC and SPD factories in China. both larger than any other existing facility in the company. The result of this has been record revenues for the past four years running, with a clear line of slate to a fifth in 2022. On the other hand, our profitability was compressed as we built and ramped these two new facilities. We experienced the typical invest-to-grow scenario for a manufacturing company, where short-term financial pain is traded for long-term gains so long as the team executes. Our FPD factory ramped the full Phase I capacity in FY20, and our IC factory did likewise in FY21. With the initial ramps complete, the Power Rail long-term model is now coming into view. We set a new three-year financial target model at our December 20 investor day. We targeted gross margins in the mid to high 20s, and operating margin in the mid-to-high teens, which represent prior peaks for Photronics. Our recent results have rendered the December model obsolete, as we have operated in the upper end of the range in the second half of 2021, and we were well above it in Q1. As a result, we are announcing new long-term targets to reflect our current performance and the leverage in our new business model. I will say more about this in a few minutes. In addition to strong growth in revenues and profit, operating cash flow was up 125% over last year. This further strengthened our balance sheet, enabling us to continue pursuing our investments in profitable growth to expand our leadership position and improve our return on invested capital. This has been a major objective of our investment strategy, and we are making progress on improving this metric. Our investment strategy is supported by three pillars, revenue growth, margin expansion, and exploration of strategic partnerships. Our success in growing revenue depends on having the right tools in the right location with the right technology at the right time, coupled with solid execution and strong customer relationships. One measurable result of this approach has been our expansion in the market in China, which is the most rapidly growing geographic market today for semiconductors and displays. The Chinese customers are growing fast, and we are growing faster, with a 36% CAGR over the past three years. As a result, products shipped to China represented 40% of our trailing 12 months revenue at the end of Q1. In addition, we are leveraging our technology leadership in AMOLED displays, and their penetration into smartphones to grow our FPD business. These displays are becoming more common across premium as well as mid-range phones, as performance advantages are well known, and the cost of basic AMOLED displays comes down. For the most advanced displays and premium smartphones, the mask intensity is increasing to enable the expanded functionality of displays, such as embedded touchscreen and fingerprint sensor, which is great for us. Looking forward, We expect the FPD photo mass market to be flat in 2022 with growth in 2023 driven by industry investments in Korea and China. We're investing in new FPD capacity with orders placed for tools that should come online mid 2023. To support these investments, we have recently signed customer supply agreements that are expected to add 10% to FPD revenue. and we are in conversations regarding additional agreements to add 10% more. A recent development feeding into our growth is the resurgence of legacy semiconductor foundry demand. We view this as the rebirth of the ASIC market. It has placed increased demand in the mass sector as industry supply growth has been limited historically. This has caused least times to expand and has created pricing leverage in this sector for the first time in decades. We are sold out of mainstream capacity in Asia, and to better exploit this opportunity, we are investing in incremental capacity by installing point tools at several of our factories, including the expansion of one of our facilities in Taiwan to make additional clean room space for these tools. We believe the growth and legacy foundry, coupled with the mass and intensity of this segment, plus strong pricing leverage, positions us to profitably grow in this sector. The legacy family sector is driving revenue growth as well as margin expansion, the second pillar of our investment strategy. Sustained pricing strength is evident globally as we implemented double-digit price increases in Taiwan and China in 2021 and are actively raising prices in Europe and Korea. A significant driver of gross margin improvement in Q1 was pricing, which we believe is sustainable, giving us confidence to invest in capacity expansion and raise our long-term targets. As we grow our business, the inherent operating leverage in our model will further expand margins and drive improved financial performance. Finally, we are continually exploring strategic partnerships to grow our business inorganically. This pillar focuses on opportunities that would extend our position as the market leader by either bringing capacity or capability to help us better serve our customers. We have a history of successful M&A and joint venture formation and believe this can be an important piece of future growth. Before turning the call over to John to review our financial results and provide guidance, I'd like to take a moment to present our updated target model. As I mentioned earlier, we provided a three-year target model in December of 2020. Due to strong market dynamics and our successful execution, We achieved those targets within one year and are now operating well above them. In order to help investors understand where we are heading, we are providing updated targets elaborated in the supplemental slides on our company website. We have increased the revenue ranges to reflect strong demand and continued investment in capacity. Margins at both the growth and operating level are higher as we anticipate mainstream I see pricing benefits to be long-lasting. We've established a strong moat with AMOLED technology and FPD. And we continue to target 50% incremental margins. So, for our new long-term model, we see gross margins reaching the mid-30s and operating margin in the mid-20s. This improvement in profitability should produce higher cash flows in EPS, including earnings approaching $2 per share and free cash flow of $200 million annually, elevating the financial profile of our business and ultimately creating greater value for our shareholders. I'd like to emphasize that this level of financial performance has never been achieved by the company, yet is right in our line of sight, and our review represents transformational change to our business model. This is the gold medal for all the hard work by the entire team over the past five years. I want to take a moment to thank all of our employees for your sustained effort and the shared sacrifices it took to get here. I am humbled by what you have accomplished and it is truly an honor to lead you. In conclusion, we have made a great start to 2022, performing above expectations and raising our long-term outlook. End market demand is strong, and we are investing to increase capacity to better serve our customers. We have a great team that continues to exceed expectations, and I'm confident that our best days are right in front of us. At this time, I will turn the call over to John.

Thank you, Peter, and good morning again, everyone. First quarter revenue improved 5% quarter over quarter and 25% over first quarter last year. as demand continued to be robust for both semiconductor and mobile display photo masks. We have had notable success in aligning our operations with market trends and once again saw the benefits of these investments as we achieved record revenue in what is typically a seasonally soft period. ICU revenue improved 3% sequentially and 24% year-over-year as strong demand continued in Asia. from mainstream and high-end logic. The proliferation of chips used in multiple end-use applications, such as the rollout of 5G, propagation of consumer electronics, and the electrification of an increasing number of the products we use every day, including automotive, is driving what might be characterized as an explosion in the design of new devices. In addition to growing volumes, the supply-demand dynamic is driving pricing power across the industry, as Peter mentioned, enabling pricing action globally for mainstream masks. FPD revenue increased 8% over Q4 revenue and 27% over last year's first quarter revenue. We have an enviable market position in advanced displays for mobile applications, specifically AMOLED and LTPS, due to our industry-leading technology and first-class operations. Demand for G10.5-plus masks was also stronger this quarter, adding to high-end growth. Demand for products shipped into China was strong again this quarter, improving 6% quarter-over-quarter and 69% year-over-year. China continues to be an important market for both ICU and FPD photo masks in our business development initiatives and operations expansion are paying off as we establish Photronics as a clear market leader. Margins expanded again this quarter due to the operating leverage provided by higher volumes, implementation of price increases in mainstream IC, and continued focus on cost controls. Gross margin of 31.5% and operating margin of 20.1% are both above the long-term ranges we communicated in December 2020, and that led to our decision to update the ranges in our target model. Peter discussed the factors underlying the model, and we're confident in our ability to maintain improved margins and deliver on the new targets. Below the line, income tax provision increased due to the increased earnings and the distribution of earnings among the various tax jurisdictions where we operate. Net income to non-controlling interests increased with the strong performance of our joint ventures in China and Taiwan, and other income was due primarily to unrealized gain on foreign exchange. Diluted earnings per share was $0.38, a 15% increase over the $0.33 in Q4 and nearly triple the $0.13 EPS in Q1 last year. Cash and equivalents increased to $314 million and debt increased to $97 million, net cash of $217 million. Resulting from operating cash flow of 59 million, as Peter mentioned, more than double the cash flow in the same period as last year, and $15 million from our JV partner as their contribution for the impending capacity expansion in China. We invested $19 million in CapEx during Q1, which indicates free cash flow of $40 million for the quarter, and our CapEx forecast for the year remains at $100 million. primarily for increases in mainstream IC capacity and deposits on tools to be delivered in 2023. We spent $2.5 million to repurchase PLAB shares in the quarter, which brings the total spent of the current $100 million authorization to $68 million. Since we began the repurchase program in 2018, We've repurchased 12 million shares and returned $130 million to shareholders through share buybacks. Before I provide guidance, I'll remind you that our visibility is always limited, as our backlog is typically only one to three 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 second quarter revenue to be in the range of $188 to $196 million, driven by a continuation of favorable end-market demand trends across both IC and mobile FPDs. Based on those revenue expectations and our current operating model, we estimate adjusted earnings per share for the second quarter to be in the range of 32 to 38 cents per diluted share. First quarter got fiscal 2022 off to a strong start, continuing the performance of 2021. Revenues are growing, margins are expanding, Cash flow is increasing, and we see performance improving in the second quarter as well as longer term, as we indicated in our updated target model. I will now turn the call over to the operator for your questions.

Thank you. To ask a question, you'll need to press star 1 on your telephone. To withdraw your question, please press the pound key. Stand by as we compile the Q&A roster. And again, to ask a question, press star 1 on your telephone. Our first question comes from Tom Differly of DA Davidson. Your line is open.

Yes, good morning. Thank you for the question and impressive new guidance, our target model. So, Peter, I guess the question I have is maybe talk a little bit more about the sustainability of the mainstream pricing and perhaps where it is in regards to what it would take to support the purchase of new equipment to add capacity in that space.

Yeah, so you can see, Tom, right, that historically our mainstream business was running for 10 years at about $250 million, you know, annually, where, you know, in a mature market, there'd be a few percent of, you know, price down and we'd gain a few percent of market share. And as a result of that, Harvard Avenue is really remarkably stable. You know, leading the quarter, you know, we're at a $333 million run rate. You know, we're sold out. throughout Asia. We're raising prices. We're nearly done. We're in the top half of the ninth inning raising prices in Korea and in Europe. So basically, globally, with the exception of the U.S., we have double-digit price increases now in place everywhere. Typically, you hear us We went with one to two weeks worth of backlog. Mainstream right now, the backlog is two to three months. So we're operating at about a 25% deficit in our capacity to market demand. We're going to try to add, we won't be able to add, given the tools we can intelligently add this year, We'll hope to get back most of that, maybe get 15%, 20% back by the end of the year. Our expectations for growth and demand is we'll end the year in the same hole or a bigger one than we start. That's what we see in the market. So if we can get capacity up 15% to 20%, we still see the market leading us to have about a 25% deficit at year end. And as I said, you know, in prior calls, right, we look back at the ASIC market, and when that market was booming, the photomass revenues to semiconductor revenues was running about 3%. You know, the closest, you know, where this business is most concentrated is China today, right? And when we look at that market right now, we see today Photomass revenues are running about 2% of China silicon revenues. So that's double the photomass content of the global market. Right now, photomass, the semiconductor industries for the last 10 years have run 1%. China is running 2%, given our estimates, what we see. And we see the photomass market in China right now growing at about double, so about 25% the growth rate in the silicon market. So, you know, you kind of put all those things together and, you know, that's where our, you know, that forms the mosaic that we see and view the market through. And when we look at our competitors, we see them doing the same thing. They're trying to add point tools. We don't think they're going to be any more effective than we are at raising capacity. There's a 25% to 30% deficit today. There's likely going to be a 25% to 30% deficit at the end of the year. That's kind of what we see. Even though we're all trying to cobble together point-to-investments to raise output.

Okay, that's a very helpful thing. I'm curious, is the strength you're seeing on the mainstream side, is it certain segments or is it across the board? Things like

power we hear a lot about but is it a certain segment or a couple segments that are really driving that strength well it really um it's the way we the lens through which we view it is more through the lens of technology nodes and what really is driving it is 90 65 55 and 40. um and there's some shift moving to 28. Now, whether you call that a legacy or a mainstream or high-end node is up to debate, I guess. But right now, it's really 40 and 65 is the sweet spot, and 90 and 28 are strong. So that's where the bulge in the business is concentrated.

Okay, great. And then the last question, then. On the capital spending side... Does adding these point tools materially change the capex you expect for the next one to two years?

No, you know, our capex, you know, has been running about $100 million, right? We expect that's what it's going to run. You know, this year it's a, you know, John did some, you know. So, you know, we continue to look at $100 million spent. And, of course, as the business grows and earnings grow, your operating cash flow grows. So at that spend level, it creates more free cash flow. You can see at this quarter, right, $60 million of operating cash flow, $40 million of free cash flow. So this is all quite good.

Okay. Thank you for your time.

Thank you, Tom.

Thank you. And as a reminder, to ask a question, you'll need to press star 1 on your telephone. To withdraw your question, please press the pound key. Our next question comes from Aaron Martin of AIGH Investment Partners. Your line is open.

Hi. Good morning, guys. Congratulations on a great quarter, great execution in a strong market. Appreciate you updating the long-term model, and I understand things are a little fluid, but I'm trying to understand, you know, if I look at Q1 and the Q2 guidance and, you know, the run rate there and, you know, especially Q1 being the seasonally week order and heading into the second half of the year, if we just annualize, we're already past, you know, the low end of the target model. from a top line, and then you talk about exiting this year still with the industry and a significant deficit to demand and hoping to add, you know, through these kind of point tools, adding, you know, 15% capacity, which then puts you over the top end of, you know, your long-term target model. So with that in mind, I'm trying to reconcile that with, You know, it sounds like we're there today almost already with this being a two-, three-year target model.

Yeah, so thank you for that question. So, first of all, the capacity add is on the mainstream business alone, which is right now at a $330 million, you know, run rate. So when you do the math, you have to apply the math to that segment of the business. But having said – having made that clarification, I guess, is the right way to describe it. You know, part of the capex this year is also for FPD deposits, and we're also investing, you know, in our high-end business. But anyways, if you look at 800, right, on the top line, for the last four years, we've been on a 10% CAGR. If you just project that forward to 2023, which this target model is focused on, it takes you to that $800 million, you know, number. And the improvements we're making in our operations, likewise, it's very easy to just rationally run the numbers forward to see that nothing on the chart is anything other than a projection of the last several quarters and several years of business performance to hit $800 million. So the way we kind of look at this is $800 million is just more of the same, but it's more of the last four years. So it ought to have a tremendous amount of credibility. 850 is aspirational in two years and 775 sort of kind of says, well, we get a downturn in 2023 that we don't expect, but could happen. So that's how the model, you know, kind of reflects itself into the market.

And, Aaron, just from an accountant's standpoint, this model is not a thumb in the wind just assuming continuation of certain trends. It's a bottom-up by operating location of what we expect the CapEx to generate in additional revenue and the pricing that we expect to maintain. So it's a... It's a bottom-up generated model that we expect to be able to accomplish. And as you pointed out, we could be almost there with our current performance, but there's a big stretch between $775 and $850. And if we just maintain that 10% CAGR that we've done over the last four years, $800 should be fairly well assured.

I think you guys would both be personally disappointed with just maintaining. I don't know you guys to be that way. But going back to the bottom-up analysis, let's talk about the backlog, I don't know if it's even fair to call it that, the unusual lead times right now, and then how you've been parlaying that into longer-term commitments from some customers I want to make sure I got the numbers there on the 10, you know, 10% was the 10% of what, and then what you can add upon that and how, you know, what can we, how can we take the current market conditions and turn that into, you know, long-term, you know, maybe three, four years down the line, um, a different, can, is this going to end up being a different model where you have more visibility?

So, yeah, so let me answer that because it really is a tale of two markets, right? So our investors, I think, There's something that is widely misconstrued, and that is our FPD capacity for the last several years running has been sold out. So our investors, I think, assume the market is strong. The reality is our largest competitor in FPD, which is SKE, they were down sequentially 16%. We were up 8%. That's a 25% swing. Our second largest competitor, you know, isn't a public company, so I won't name them. But what we hear from the market is they're empty, which, of course, doesn't mean they have nothing, but it means they have lots of unutilized capacity. So the contractual commitments we just, you know, entered into are for FPD. They're for tools. we're going to be installing in 2023, you know, ramping in the second half of 2023. So we have 10% in the bag. The other 10%, the conversations are very mature. So I would be disappointed, very disappointed if we don't wrap them all up by the end of March. So we're very close to sealing the other 10. So shortly we'll have capacity commitments in hand for 20% more of our FPD business, despite the fact that the market right now generally is not strong. What is strong is AMOLED. We have a technology moat there, and it's allowing us to fill our factories when our competitors cannot. But more importantly, customers are making multi-year, two-, three-year commitments to out another, there's a year between here and there and there's a two to three year contractual commitment hung on the end of that because of the strength of our technology. So that's where the 20% is. It's on a business that last quarter was running at a $240 million run rate. That's where the commitments are. As far as the IC business is concerned. We have the mainstream and we have the high-end. And the high-end business is behaving, you know, typically, I guess, is the way I would describe it. You know, we have one to two weeks' worth of backlog. We don't have, you know, atypical levels of backlog. And the mainstream, again, which is running along in a $330 million cliff, We have two to three months worth of backlog there. And the way I answer Tom's question, we believe that, and it's hard to know, but you know, when the next downturn happens, if the market kind of continues like it is, we're going to be seeing with 25 to 30% more demand than capacity. Our business typically rose over 10 to 15% in a downturn. That's a typical number. So if the next downturn is typical, given where we're operating now, and if that doesn't change, we will still have more mainstream demand than we will have capacity. And it won't just be – that won't just be photronics. That will be the photo mask industry, in which case the pricing stability will stick because there will be no reason for anyone to lower price because you can't gain more market share when you're sold out.

So that's our current... In terms of the difference in market share between AMOLED and LCD or other generations, what do you estimate your market share in AMOLED relative to other displays?

Yeah, we don't typically give... market share numbers, but you can see that 75% of our FPD business is high-end, and the high-end is dominated by AMOLED. That's basically what we sell. We have to obviously keep our tools full, and it's a constant challenge to balance our lines because a typical mass set has You have high-end layers, mid-end layers, and mature layers. But we have our factory right now optimized to build as much AMOLED business as we can. We really can't make any more.

Okay. Thank you very much. Congratulations again. You did an incredible job.

Thank you. Thanks, Aaron.

Thank you. Again, to ask a question, please press star 1 on your telephone. To withdraw your question, press the pound key. Our next question comes from Richard Greenberg of Donald Smith. Your line is open.

Yeah, thanks. I think you answered my question in the previous questioners, but I remember your previous model did sort of built in a recession, and it sounds like you've potentially done that with the lower end. I think that answers that. The second part of my question was, what are you assuming in this model of you use all this free cash flow for? It seems like you're not really assuming any additional buyback, even though that's a possibility or acquisition. There's no incremental either revenues or less shares outstanding or further growth assumed with that free cash flow. Is that correct?

So Richard, we maintain the capital allocation strategy that we've had. First priority is organic growth. Second is whatever M&A opportunities, allegiances, alliances, partnerships, et cetera. And then the third would be share repurchase. So that's our ongoing capital allocation strategy. We still have $32 million of our $100 million authorization available, and we maintain that strategy.

Right. I understand that, but I'm just saying that would all be incremental to the model that you show here, right?

That's exactly right, Richard. Thank you for that.

Okay. And I guess my second question is, You know, Peter, at some point it seems to me with margins like this that the semi-manufacturers will, you know, find this kind of much more expensive for them to go merchant and they'll just bring more in-house. What is their capability to do that and how much of a concern do you have that, you know, the competition will ramp up from the manufacturers themselves to produce masks?

Yeah, well, most of the captives, they're not most, actually all the captives, their focus is the high end. And some of them, for example, Intel or Samsung, don't build mainstream photo masks. So I guess they could try to do what... we're trying to do, which is find a way to economically expand capacity into the mainstream sector. But a lot of the tools we have, Rich, that build mainstream photo masks used to be owned by people like Intel and Samsung. So they got out of the business, sold us the tools. So getting back in the business is going to be very expensive. So I think current pricing as we've said, doesn't support that. I think if we go through the downturn the way I described it, with no loss of pricing leverage, the next upturn will be raising price again. So I think if we're able to go through a downturn with no price erosion, another upturn with pricing power, we may be reaching a point then we're adding new lines that have the appearance of generating acceptable financial returns. And that view won't be unique to us. It will be germane to other merchants, the captives. And what happens then, I really can't tell you, but I think we're a cycle away from really needing to worry about your questions.

Okay, great. Thanks a lot, guys.

Thank you, Rich.

Thank you. Ladies and gentlemen, there are no further questions at this time. I will now turn the call over to Peter Curlin for closing comments.

Thank you for joining us this morning. I am proud of the entire Photronics organization as they have worked hard to meet elevated customer demand while keeping costs low and maintaining high quality. We are optimistic about our future and believe that we are on track to deliver against our updated target model. Look forward to updating USME forward. Have a great day. Bye to all.

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