This conference call transcript was computer generated and almost certianly contains errors. This transcript is provided for information purposes only.EarningsCall, LLC makes no representation about the accuracy of the aforementioned transcript, and you are cautioned not to place undue reliance on the information provided by the transcript.
spk03: Good day, and welcome to the On2 Innovation third quarter earnings release conference call. Today's conference is being recorded. At this time, I would like to turn the conference over to Michael Schaefer. Please go ahead, sir.
spk09: Thank you, Cynthia, and good afternoon, everyone. On2 Innovation issued its 2022 third quarter financial results this afternoon shortly after the market closed. If you haven't received a copy of the release, please refer to the company's website where a copy of the release is posted. Joining us on the call today are Michael Plosinski, Chief Executive Officer, and Mark Fleischer, Chief Financial Officer. As always, I'd like to remind you that the statements made by management on this call will contain forward-looking statements within the meaning of the federal securities laws. Such statements are subject to a range of changes, risks, and uncertainties that can cause actual results to vary materially. For more information regarding the risk factors that may impact on to innovation's results, I would encourage you to review our earnings release and our SEC filings. ON2 Innovation does not undertake the obligation to update these forward-looking statements in light of new information or future events. Today's discussion of our financial results will be presented on a non-GAAP financial basis, unless otherwise specified. And as a reminder, a detailed reconciliation between GAAP and non-GAAP results can be found in today's earnings release. I will now go ahead and turn the call over to Mike Blazinski. Mike?
spk07: Thank you, Mike, and good afternoon, everyone, and thank you for joining our call today.
spk05: We'll begin with a brief review of the new U.S. trade restrictions and their impact on ON2 innovation. We will then cover business and financial highlights from the third quarter and close with our outlook for the fourth quarter and calendar year 2023. So let's begin. On October 7th, the Commerce Department announced new regulations essentially restricting U.S. semiconductor equipment suppliers from selling to and supporting facilities in China fabricating logic devices below 15 nanometer design rule, DRAM below 19 nanometers, and VNAND with over 127 layers. Specifically drawn to innovation, packaging and specialty device customers account for over half our year-to-date revenue in China, and those customers are not directly affected by these new rules. Furthermore, several multinational corporations that produce advanced products have already been granted licenses, which extend to key suppliers such as Onto Innovation. So in total, these new restrictions negatively impacted our revenue guidance for the fourth quarter by about $10 million. The estimated impact to 2023 revenue is roughly $80 million. In our closing remarks, we'll provide a preliminary view of 2023 accounting for China, market headwinds in memory, and the opportunities we see to continue to outperform the industry. Now, turning to the third quarter, we're happy to report the On2Innovation team delivered another strong quarter of $254 million in revenue, an increase of 27% over the prior year. More importantly, margins were at the high end of guidance, resulting in record net income for the company. Contributing to that strong financial performance was our Atlas Metrology, which set a quarterly revenue record with nearly all of the revenue supporting process nodes at 5 nanometer and below. We are projecting our metrology business to grow over 40% this year, well ahead of current WaferFab equipment growth projections. We believe this outperformance is a result of establishing early leadership positions in several technology transitions, including the adoption of gate all-around transistor structures and high-stack VNAND. For new gate-all-around structures, materials concentration is of growing importance for accurate etch and deposition control. Some customers recognize X-ray systems moving into fabs from labs are too slow for this high sampling application. Recently, we demonstrated the capability to provide accurate composition metrology while simultaneously measuring critical gate dimensions, all at volume production speeds. If adopted in production, we expect this unique capability to increase our attach rate of Atlas metrology by over 10%. We also see attach rate expansion in the high stack VNAN market, where shipments of our Atlas metrology and powerful AI diffract software are on pace to triple the shipments made in 2021. In addition, we're expanding the adoption of high aspect ratio metrology and acoustic metrology for VNAND with over 200 layers. By year end, we expect these systems to be qualified in four of the top five NAND manufacturers. This increases our attach rate for the eventual market ramp of this memory, which will deliver data center, edge compute, and mobile devices, a 40% increase in bit density, and a 28% smaller form factor. Wrapping up our highlights for advanced nodes, our expansion into planar films continues with three new tier one customers taking delivery of five evaluation units in the quarter. This year we're on track to exceed $50 million in revenue, a 34% increase over 2021 with additional growth projected in 2023. Now turning to our specialty and advanced packaging markets, revenue contracted in the quarter primarily due to the revenue recognition of multiple lithography systems in the prior quarter. Inspection revenue increased over the second quarter, led by a 30% increase in demand from the rapidly expanding compound semiconductor power device market. The global transition to electric vehicles is driving the need for more productive process control solutions to both improve yield and factory output. Our Dragonfly G3 with production proven sensitivity below a quarter micron coupled with new software algorithms to accurately separate critical defects from nearly identical but acceptable process variation is essential for automotive applications where defect control is not simply a matter of profit but is essential for human safety. Another secular trend we've been highlighting is the shift to a heterogeneous system and packages. Our opportunities to date centered on the JetStep X500 for substrates and the Dragonfly G3 for inspection and micro-bump metrology on the wafer. We now see interest expanding to higher resolution Fano packages on panels and have received orders for four JetStep 3500 systems. This customer purchased our connected StepFast technology which integrates our die placement metrology and Discover Analytics to provide a fully integrated lithography solution to address overlay challenges inherent to the fan-out process. We expect to ship the first system in the fourth quarter and additional systems in the first half of 2023. Finally, I'm pleased to announce in the third quarter we delivered a JetSTEP 3500 to a customer in Korea to support R&D for next-generation foldable OLED displays. Our stepper was selected due to the performance benefits and flexibility of our lithography platform. If the R&D effort is successful, it could open an estimated 300 to 500 million TAM in 2025. Now I'll turn the call over to Mark for a review of the Q3 financial highlights and our Q4 guidance.
spk04: Thanks, Mike, and good afternoon, everyone. As Mike highlighted, we had another strong quarter with third quarter revenues of $254 million, up 27% over the same period last year, and $4 million above the midpoint of our previous guidance. Breaking down the revenue by market, advanced nodes revenue of $111 million grew 57% year-over-year and represents 44% of total revenue. Specialty device and advanced packaging achieved $101 million in revenue, grew 14% year-over-year, and represents 40% of total revenue. Software and services of 42 million grew 8% year over year and represents 16% of total revenue. Our gross margin increased to 55%, our highest quarterly performance year to date. We are pleased with the team's ability to execute a quick sequential quarter recovery, driving a 300 basis point improvement compared to 52% in the second quarter. Our product mix was certainly a factor driving this improvement However, we continue to experience supply chain disruptions and inflationary cost pressures within the quarter. We have active programs working with our suppliers and logistics companies to manage these gross margin headwinds and to minimize the impact in future quarters. Third quarter operating expenses were $61 million at the midpoint of our previous guidance. We did see an increase sequentially by approximately $2 million from the second quarter, primarily from further R&D investments and programs critical to our customers' roadmaps. However, we continue to drive operating expense leverage, as on a year-over-year comparison, operating expenses as a percent of revenue decreased by 200 basis points. Our record level operating income of $78 million, or 31%, continues to demonstrate the leverage in our operating model, as our operating margin increased approximately 200 basis points, both sequentially and as compared to a year ago. Our record level net income in the third quarter was $67 million, or $1.35 per share, up 38% over the same period last year, and 3 cents above the midpoint of our previous guidance. Now moving to the balance sheet, we ended the third quarter with cash of $553 million, up $41 million since the start of the year, generating $87 million of year-to-date cash flow from operations, representing 12% of revenue. Inventory increased to $308 million in the quarter, to support the increasing certain safety stock levels as a hedge against ongoing supply chain disruptions and to prepare for 2023 given the long lead time nature of our components. However, as Mike noted earlier, with approximately 80 million of our projected revenue for 23 being impacted by the recent China restrictions, we are now reassessing our optimum levels of inventory and would expect a return to the mid 200 million range for inventory levels in 23. Accounts receivable remained relatively flat at $236 million in the quarter, and our day sales outstanding increased one day to 84 days, primarily due to the timing of revenue within the quarter. As commented on during previous quarters, we continually assess our capital allocation strategy, which includes the balance between internal investment, M&A, and share repurchases. All three continue to be a primary strategic focus for the company. During the quarter, we repurchased approximately 172,000 shares of common stock, resulting in a return to capital shareholders of approximately $11.5 million. The share repurchase was executed under our existing $100 million share repurchase authorization. This repurchase reflects our confidence in our strong earnings potential, our ability to generate strong cash flow, and our commitment to delivering value back to our shareholders. Now turning to our outlook for Q4, we currently expect revenue for the fourth quarter to be between $244 million and $256 million, reflecting the impact of approximately $10 million in projected China revenue Mike had mentioned earlier. We expect our gross margins will be between 54% to 55%. For operating expenses, we expect to be between $60 million to $62 million. For the full year 22, we expect our our effective tax rate to be between 12% to 13%. We expect our diluted share count for Q4 to be approximately 49.3 million shares. Based upon these assumptions, we anticipate our non gap earnings to be between $1.25 per share to $1.40 per share. And with that I will turn it back to Mike for additional comments on the and further insights into 23. Mike? Thank you, Mark.
spk05: In the fourth quarter, we expect another increase in demand for our process control solutions from power device manufacturers. We project this will be our second largest market in the quarter, marking the first time a specialty device market reaches this level of relative revenue. Our largest market in the fourth quarter will be Advanced Logic, which we expect will grow 30%, including initial shipments to a logic factory in Arizona. We expect DRAM to be down slightly and revenue from NAND customers to be down significantly after growing in the third quarter. In addition, we expect to ship a record number of Novus Edge tools to support wafer capacity demand for EUV process nodes. Based on our healthy backlog, supporting commentary from customers, and ASML's guidance on EUV demand, we forecast revenue for both Novus Edge and Element Metrology will increase again in 2023. Stepping back from the quarter, over the last two years, global weight for fab equipment revenue has increased 50%. During that same period, onto innovation revenue is projected to nearly double, growing twice as fast as the industry. We achieved this performance by not only focusing on the growing share in our served markets, but also by successfully expanding into new markets, with innovative connected solutions tied to secular trends in artificial intelligence, edge computing, and new power devices. We expect many of these trends to drive growth next year in several of the segments we serve, such as panel packaging, bare wafer, and compound semiconductor manufacturing. We believe this will reduce the impact onto innovation of a projected 20% decline in global wafer fab equipment spending next year. At this level of global decline, we expect our revenue in 2023 to decline about 10% to 15%, including the negative impact of about $80 million from new restrictions on equipment sales to China. Though still early, we currently see the first half of 2023 will be the bottom, followed by an incrementally stronger second half. While maintaining the pace of innovation our customers rely on, We will take advantage of this pause in the market to focus on untapped product, supply chain, and operational synergies, further strengthening our business foundation to support the next wave of growth, which will surely follow. With that, we'll open the call for your questions. Cynthia?
spk03: Thank you. If you would like to ask a question, please signal by pressing star 1 on your telephone keypad. If you are using a speakerphone, please make sure your mute function is turned off to allow your signal to reach our equipment. Again, press star one to ask a question. We'll pause for just a moment to allow everyone the opportunity to signal for questions. We will take our first question from Craig Ellis with B Reilly Securities. Please go ahead.
spk08: Yeah, thanks for taking the question, and Mike, thanks for providing some color on how you see calendar 23 shaping up for the company. I just wanted to start with a clarification on the comments on the China BIS impact. So it sounds like the impact is really inside of the advanced node segment. Is that correct, or is it touching some of the other segments as well?
spk05: Correct. It's within the advanced node segments and primarily the domestic manufacturers in China.
spk08: Got it. Got it. Okay. And then the second question really relates to some of the color you provided for calendar 23. It seems like the SAM expansion that's been a strength of the company in 2022 has good momentum into 2023 with planar films, panel litho, and compound semi. Can you just talk a little bit more about what you see happening there and to what extent is customer expansion or other things at play in each of those areas?
spk07: Sure.
spk05: So actually, a couple of them are driven by artificial intelligence. So if you look at the advanced compute and the constraints that markets have seen in the high-end chips, a lot of that constraint comes from packaging from the IC substrates. And so we see continued growth in the panel panel packaging to support artificial intelligence. Now, on the front end, those are printed on, you know, using EUV technology. So the wafer manufacturers have been increasing capacity, and they're very, very conservative. So they do this over, they plan it out over a multi-year cycle, and they're planning some fairly aggressive expansions to support specifically EUV technology. What that means for us is there's higher levels of process quality control required that the Novus Edge and the Element are uniquely suited for. So we have a pretty healthy backlog for both of those going out actually through 2023 and into 2024. So that's driven by that side. And then looking at the compound semis, it's all around automotive and electrification of vehicles. It's around the push for renewable energy and the changes in the grid, the smart power grids that are required to really take advantage of large distributed locations for energy source, you know, energy creation. So that's where we see all the driving coming from compound semis. In 2022, despite the growth we've seen, I think it was somewhat constrained by a lack of ability to get, in particular, lithography equipment. We had several customers that couldn't expand because they couldn't get litho. We would expect that as the markets sort of cool down on the front end or in some aspects of the front end, that that'll free up some demand and allow some of our customers and compound semi to maintain their expansion plans. Hopefully that helps.
spk08: Yeah, that helps. And then the last one before I hop back in the queue, Mike, I think towards the end of the year, the company has in the past engaged with volume purchase agreement type of activity with its customers. And so the question is, as you get to the end of the year and look ahead to 2023, what's the indication you're getting from customers in terms of the company's share of wallet and share of new programs that are going out there?
spk07: So, good question. I'd say it's mixed.
spk05: So, from the volume purchase perspective, customers are, you know, various levels of customers are doing different things. Memory is certainly down. You know, logic is down, but a lot less. So from that perspective, it's captured in the numbers we were talking about. From a share gain perspective, which you might have been really trying to get at, there I think the indications are quite positive for us. As I mentioned, much of that expansion into new markets, like for planar films, is against an entrenched competitor. Some of what we're seeing on the use of the Atlas platform to do compositional metrology is against another competitor. And it's all around the value proposition we brought to the table shortly after the merger when we said, hey, look, we can push OCD beyond the limits, optical CD metrology beyond what we believe our peers can, and they've been pushing X-ray solutions, which challenge our customers because they're too slow. So by being able to drive more and more applications onto our platform, we think we're getting a bigger piece of that spending pie.
spk07: Got it. Thanks, Mike. Welcome.
spk02: We will take our next question from Mark Miller with the Benchmark Company.
spk03: Please go ahead.
spk01: Congratulations on another record quarter. In terms of the... the rebound in the second half next year, what do you see driving it? Is that some of the new fabs that are just starting to come up?
spk07: So it's different.
spk05: Overall, we're seeing a down year for next year, but I think in some areas we're seeing strong growth. So panel level packaging, planar films, which is really around just spreading our technology into more of the customer base. So Even though that market may be down, our ability to grow revenue within it is going to grow because we're gaining share. And then in the power devices, the electrification of vehicles, we still see that compound semi going up next year. That said, we certainly see DRAM or memory coming down, both NAND and DRAM, and we see logic coming down as well. So some of the advanced nodes are coming down a bit.
spk01: You have five, I think there were five Irish tools that are in evals. How many total eval tools do you have out there?
spk05: Oh, it's probably a little bit more than five, but you have to remember these tools, we've already done, let's say, 30 million or so in revenue in 2021, and we're on track to do another 50 this year. So it's not – these tools are for evaluation less to prove the technology, more to prove that we can measure against their baseline. So it's very FAB-specific evaluations. So as we continue to add more customers, their first step is generally an evaluation unit to prove it out and then roll it out across their factories.
spk01: Thank you.
spk05: Yep.
spk03: As a reminder, if you would like to ask a question, please press star 1 at this time. And we will take our next question from Hans Chung with DA Davidson. Please go ahead.
spk00: Thank you for taking my question. So first, I want to talk about the gross margin. So can you give us some puts and takes for 2023, given that we're going to have the rent in the software retail product, which has lower margin. But we also have some new product continue to run up with higher margin. And then at the same time, we probably see the easing supply chain dynamics that may help on the cost side. But we also have lower revenue scale. So just wonder how should we think about the gross margin trend going to next year, given those those factors.
spk04: Yeah, no, thanks, Han. It's Mark. Yeah, I mean, I won't give specifics on the gross margin rates, but certainly, you know, as we look to 23, I mean, it's certainly a focus item as we look at the mix and what that generates from a gross margin perspective. I mean, obviously, we've commented on the litho tools and that margin profile going up during the year. We're certainly focused on that from an optimization standpoint. to drive further benefit to gross margin. So that we expect and we will have that certainly in our models for next year. When we look at the full gross margin picture, we're looking at operational efficiencies, we're looking at our plant network and how we're driving alignment and leverage within that. So that will hopefully drive gross margin improvement. We're not actually right now seeing any decreasing headwinds or, you know, lessening of costs. I mean, labor costs are up across the board. Our suppliers, you know, freight costs, they haven't returned to pre COVID levels, but they've come down, but they're still higher. And, you know, we're still experiencing significant, you know, headwinds in that regard with regard to pricing and price increases. So, I mean, those are all factors and we're trying to work, you know, as I said in my comments with our vendors and, and our logistics partners to work on better contract terms, pricing, and how we can negotiate things in a favorable manner that won't continue to put that pressure on gross margin.
spk05: Yeah, so Hans, just to add a little bit of color, you articulated all the variables. Mark described the various actions we're taking along those variables. But if you look at our track record, Even with lower revenue levels, we have a history of maintaining gross margins and doing what is necessary to maintain those gross margins. So I think you'll see more of that as we look forward into 2023.
spk00: And then can I follow up with just the overall cost structure, like what portion of the COX and OPEX are variable versus fixed? And just trying to get a sense that if we see revenue down like 10% to 15%, then what kind of the decline or trend for the overall operating costs?
spk04: Yeah, I mean, we don't have the specifics on that, Hans. I mean, certainly the process we're going through right now as we look at our annual operating plan for next year. We're looking at costs across the company and trying to see where we continue to drive reductions that don't disrupt our innovation and make sure we're balanced in what we do cut or reduce. So, again, I don't have the split by exactly what's variable and non-variable, but we're certainly looking at the variable costs first and look at the profile of the operating structure to make sure that it's as Mike just mentioned, you know, still moving in the direction of meeting the financial commitments that we had in our long-term operating model.
spk00: And then lastly, can you kind of elaborate a little bit more on the acoustic metrology? It seems like it's kind of a very strong value proposition for the mainland. How strong is the value proposition for like more than 200 there, like you highlight, and then what kind of revenue opportunity are we looking at?
spk05: Yeah, so as we discussed, it would be about a 10% increase in attach rate, and so I would say, you know, maybe it's two to three tools per 20,000, 30,000 wafer starts, you know, Again, this is still early, so customers are still optimizing their lines and working out their sampling strategies and things like this. So it's an incremental improvement. It's an incremental attach rate on an already strong position that we have in NAND. But it is a unique capability. So you're right to call out both the echo acoustic metrology for hard mask layer. It's very unique in being able to measure the hard mask layer critical for edge control. And then the aspect metrology for high aspect ratio metrology, basically those bit channels going vertically across those layers that become very difficult to measure over 200 layers or 200 stacks.
spk07: Thank you.
spk03: We will take our next question from Trevor Janowski with Needham. Please go ahead.
spk06: Yeah. Hey, Mike. Hey, Mark. This is Trevor on for Quinn Bolton. Thanks for letting me ask a question. Can you provide any more color on the China impact? Specifically, what is causing the quarterly impact to pick up in 2023 versus the 10 million in fourth quarter?
spk07: The quarterly impact to pick up in 2023. So I don't think we said it was going to pick up...
spk06: Sorry, like the run rate, if you just take the $80 million and run rate it.
spk05: Yeah, so then I think it would still be a pretty – a bigger impact than the $10 million, right? Yeah, yeah, exactly. Yeah, okay. So why – yeah, so when you said PICO, I thought you meant growth. No, I think it's just the order. So, you know, the customers that were ordering in Q4 – you know, wasn't going to be the same mix we expected and actually had booked throughout next year. So, you know, we'd gained some share in some of the other areas. I'm not going to give details, but we had expanded our customer base and share within our customer bases, which would have been reflected in nice growth in 2020, 2023, which now will not be there. Does that make sense?
spk06: Yeah, definitely. Thank you for that. And for my second question, it's about your backlog. Have you seen any cancellations yet or a pickup in order delays over the recent months?
spk05: We've seen some pushing around of orders, for sure. No cancellations due to market. We had one single tool cancellation due to basic... Something unrelated to markets, so a financial issue with that particular company. But outside of that, there's been no cancellations, some movement on orders, and that's about it.
spk07: Okay, that's helpful. Thank you, Mike. Welcome.
spk03: And at this time, there are no further questions. Mr. Schaefer, I would like to turn the conference back to you for any additional or closing remarks.
spk07: Thanks, Cynthia.
spk09: We'd like to thank everybody for joining us today. A replay of the call is going to be available on our website by about 7.30 p.m. this evening. We'd like to thank you for your continued interest in On2Innovation. Cynthia, please conclude the call. Thank you.
spk03: Thank you. This does conclude today's call. We thank you for your participation, and you may now disconnect.
Disclaimer