Photronics, Inc.

Good day and thank you for standing by. Welcome to the Photronics Q2 fiscal year 2022 earnings conference call. At this time, all participants are in a listen-only mode. After the speaker's presentation, there will be a question and answer session. As a reminder, this conference is being recorded Wednesday, May 25th, 2022. I would now like to turn the conference over to John Jordan, Executive Vice President and CFO. You may begin.

Thank you, Tanya. Good morning, everyone. Welcome to our review of Photonics 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 webpage. 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 Photonis. Since joining the company in 2006, I have helped create and deal our operation and strategy in Asia, including the formation of two joint venture with Dynapon Printing Company and also the recent geographic expansion of our operations into China. Turning to the financial results, we once again deliver a 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 Charmin and Hefei operations. In addition to the top line growth, we expand our growth and operation margins Growth margin was 36 percent and operation margin 25 percent. The net result was EPS of 49 cents. Cash generation was also strong as we ended the year with $247 million in net cash, which positioned us to continue investing in profitable growth opportunity. As CEO, I'm fully committed 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 shares in the growing market right now. We have been working closely with our customers to meet their needs in technology and capacity roadmap. We are building partnerships with several key customers, and we also sign 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 very good example of this approach. As the market leader, Fortranis has become a trust partner and key supplier of our customer in both IC and FPD. In addition to revenue growth, our profitability has been improving continuously. This is achieved by the varied execution of three major key items. The product optimization, the effective cost management, and operation efficiency enhancement. On top of these actions, we have implemented some pricing-adjust strategies based on current market supply-demand imbalance situation. My third commitment is to explore new strategies to further our growth initiatives. I've been very involved in this process since June 2020. We have a very good relationship 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, Petronas will solidify our activities and relationship in other geographics. I'm very certain that with our strong existing global footprint and a successful experience in Asia, we will be the far ahead winner 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 Photonics, 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 photo masks. High-end demand was driven by foundries in Asia and U.S. as semiconductor content in consumer goods continues to increase. With more chips and 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 photomass 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 to further expand margins, which I'll discuss in more detail later. FPD went down slightly quarter over quarter, primarily due to a decrease in mainstream LCDs. High-end was slightly higher thanks to continued strong mobile demand. Growth in displays for mobile applications offset a decline in G10.5 larger mass 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 for 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 operation 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 on 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 photo mass 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 three 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 non-controlling 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 a million in government subsidies for investments in China. This brings our total CapEx of the year net of subsidies to $33 million. We still expect capbacks 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 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 third-quarter revenue to be in the range of $205 to $215 million, driven by a continuation of favorable end-market demand trends across the 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 45 to 55 cents 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 organizations 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.

Certainly, ladies and gentlemen, if you do have a question at this time, please press star, then one on your touch-tone telephone. To withdraw your question, please press the pound key. Please stand by while we compile the Q&A roster. Again, ladies and gentlemen, to ask a question, please press star, then one on your touch-tone telephone. One moment. And our first question comes from Patrick Ho of Stiefel. Your line is open.

Thank you very much. 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, you know, moving forward in both mainstream and high-end ICs. Are any of the recent Chinese market volatility indicators changing your outlook, at least in the near term, in terms of potential pullbacks in that region, or are you still seeing continued strong demand in the IC market in China?

Thank you, Patrick. The Shanghai city lockdown initially has slowed down all the business activities in China, especially in the Shanghai area. So we do see some new product tap-out slowdown initially. However, the situation has been gradually recovered, and recently we see the new order, new tap-out 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 it was a nice pleasant surprise to see the new target model. I guess what gives you confidence because you were looking at some, you know, new target model metrics of, you know, over 40% gross margins, you know, 30% operating margins, you know, numbers we've never seen from, the photo mask 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 I call it the business environment, but it provides us a lot of opportunity for pricing that 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 one year, some are longer than one year. And as they come up for renewal, the prices, you know, the opportunity is still there to continue the price increases. A lot of our locations are at capacity, so where 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.

Great. Thank you very much. Thank you, Patrick. Thank you.

And our next question comes from Hans Chung of D.A. Davidson. Your line's open.

Hi. Hi, Fred, John. Thank you for taking my question. Congratulations on strong results. So our first question, just can you elaborate more on the pricing adjustment during the quarter, like where... across the board and 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?

Hi 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 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 non-leading 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, you know, without talking about specific amounts or percentages, you know, 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?

Yeah, yeah, that helped. Thank you. And then I guess the follow-up is so as we move to our new target model, right, and with further higher margin, and that would be also assuming further price increase over time. And just to get a sense to what degree that 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 economy at this moment, but just try to get a sense, like, how far are we to there? And, I mean, if we can hit our target model, like, all 40% margin.

Yes. You know, right now, the 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 photo mass equipment to deliver time has become very, very long. So the demand increased a lot. However, on the supply 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. Thanks.

I might also kind of supplement that with a comment about the captives photo mass 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're also reluctant we understand they're also inclined to start outsourcing more of that mainstream demand, the mainstream photo mass business. So 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 the capacity. as 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, let's say by the end of this year, what will be the deficit level in capacity to market demand existing 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 into our guidance expectation and into our target model. So what we 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, they're operating at 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 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.

Got it. Got it. Good. Thank you, guys.

Thank you. And our next question. Our next question comes from Gus Richard of Northland. Your line's open.

Yes, thanks for taking my questions. 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. 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 starts 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?

Yeah, we don't really...

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, you know, is it beginning the price increases in the high-end beginning to catch up with mature? Or can you talk about those two segments of IC, you know, and sort of how they're behaving?

Yes, the price increase actually start 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 start a negotiation with the key high-end IC customer and the new price start effective, become effective at the beginning of Q2.

I understand. Thank you. That's very helpful. And then in terms of capacity utilization, you know, and I see 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 two or three times 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. You know, in terms of the foundries outsourcing, I'm sure they're busy with the UV masks. You know, sort of are they outsourcing, you know, 14 nanometers and above? You know, sort of where is the break point on what they outsource and sort of how do they think about, you know, what they put out into the merchant market?

The amount of outsourcing from captive hives increase 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 talking about some kind of long term outsourcing agreement. So we are in the 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. We also do high-end work for foundries.

Right. What I was trying to get at is, you know, I think you're capable of 14 animators, and I'm wondering, is there outsourcing up to that level?

Yeah.

Yeah. Um, is there any plans internally to, to be capable of doing like a 10 nanometer mass set or, um, you know, I think that's, uh, or, or now, or, or certain layers.

Chris. Chris. Yeah, I can make a comment.

14 logic is pretty healthy. outsourcing among the foundry captives and the IDM. So that node is pretty well placed into commercial mass making. I would say the seven, eight 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 as well, or just the other layers?

We have an EUV process. 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 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 when 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 three, everybody knows, TSMC, Samsung, and Intel. For EUV, they're still building most all of their masks internally. Okay. I think we'll get there. We watch the market closely. We evolve our capability thanks to the IBM partnership. But I think probably at least three years out before the EUV goes full commercial.

That makes complete sense. Thanks so much. Sure.

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 for joining this morning. Fortran 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 Fortran's employees across the world will continue to exceed expectations by delivering quality product and outstanding service, helping us to achieve our long-term targets. 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 lines.