Onto Innovation Inc.

Conference is being recorded. At this time, I would like to turn the conference over to Mike Schaefer, Investor Relations. Please go ahead.

Thank you, Rachel, and good afternoon, everyone. Onto Innovation issued its 2023 fourth quarter and full year financial results this afternoon, shortly after the market closed. If you did not receive 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. I would like to remind you that the statements made by management on this call will contain forward-looking statements within the meaning of federal securities laws. Those statements are subject to a range of changes, risks, and uncertainties that can call actual results to vary materially. For more information regarding the risk factors that impact ON2 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. 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 our CEO, Mike Klasinski.

Mike? Thank you, Mike. Good afternoon, everyone, and thank you for joining our call today. As you may have already seen, On2Innovation had a strong end to the year with fourth quarter revenues exceeding the high end of our guidance range. This was primarily due to stronger than projected demand for Dragonfly inspection systems to support packaging of memory and logic devices for AI applications. We expect this demand to continue as reflected in our increased guidance range for the first quarter. Financially, we're starting to benefit from tighter controls and operational efficiencies, which resulted in generating over 28% of cash from operations in the quarter, while still supporting the multi-quarter surge in demand for the Dragonfly systems. We expect improvements in margins will soon follow, bringing us back in line with our long-term operating model by end of the year. So let's begin with our specialty and advanced packaging customers where the boom in AI spending lifted revenue from this market by 17% over the prior quarter and set a consecutive quarterly record. In fact, since the start of the year, quarterly revenue for the specialty device and advanced packaging markets has grown 65%. While on an annual basis, revenues have risen from 220 million in 2020 to just over 500 million in 2023. Several markets have contributed to this growth, including power semiconductors, where demand for our solutions increased 50% this year. But the greatest and most consistent growth has come from our longstanding partnerships with the top semiconductor manufacturers and their increasing investments in advanced packaging, including chiplet and 3D memory architectures. Over the next several years, as these architectures increase in complexity and interconnect density, we expect additional process steps to create the need for more dragonfly inspection and new metrology applications. For example, in the fourth quarter, we shipped several of our newer front-end metrology systems, including echo films and aspect metrology, to leading manufacturers and OSATs for emerging packaging applications. Another highlight for the quarter was our lithography team shipping three systems as planned to two customers supporting mobile and high performance compute applications. To complement our lithography tools and provide additional technology for leading edge panel manufacturers, we announced the availability of our latest Firefly G3 panel inspection system in the fourth quarter. This third generation of our Firefly panel tool now includes all of the metrology capabilities of the Dragonfly G3 and shares the same high-performance optical design. This tool's inspection and metrology capability is being used to qualify glass panel substrates as well as more traditional panels. It is fully integrated with our software solutions, which we expect will help our customers accelerate their ability to reach productivity and yield targets especially for the next generation of heterogeneous packaging technologies. Turning briefly to the advanced nodes, as we projected, revenue from these customers declined in the fourth quarter, and we believe it has finally reached the bottom. Consistent with historical performance, the revenue was split nearly equally between DRAM, NAND, and Logic. Although revenue was light overall, we continued to receive early orders for gate all-around pilot lines, And in the fourth quarter, we received approximately 20 million of additional orders for Atlas and Iris systems for deliveries in the first half of 2024. We're optimistic that these placements indicate a strengthening of our position when volume ramps occur, likely in early 2025. Now I'll turn the call over to Mark to discuss our financial performance in the fourth quarter and guidance for the first quarter.

Thanks, Mike, and good afternoon, everyone. As Mike highlighted, we closed the fourth quarter with revenue of $219 million, up 6% versus the third quarter, and a revenue milestone for us in 2023, exceeding our guidance range while achieving a high mark for revenue within the year. Fourth quarter EPS increased 10% sequentially to $1.06, exceeding the midpoint of our guidance but constrained by the decline in our high margin advanced nodes business and lower services parts revenue within the quarter. Looking at the quarterly revenue by markets, advanced nodes, which had revenue of $18 million, declined 30% over Q3 and represents 8% of revenue. Specialty device and advanced packaging, with record revenue of $158 million, increased 17% over Q3 and represents 72% of revenue. Software and services, with revenue of $42 million, declined 8% over Q3, while representing 20% of revenue. Fourth quarter operating expenses were $56 million at the low end of our guidance range of $56 to $58 million. We continue to actively manage costs while realizing the benefits of our cost reduction initiatives put in place early on in the year and driving our OPEX run rate back to Q4 21 levels. Our operating income of $56 million was 26% of revenue for the fourth quarter compared to 24% for the third quarter. Our net income for the fourth quarter was $52 million 24% of revenue versus 23% for the third quarter. Both operating income and net income performance versus the third quarter highlight our improving operating leverage within the year. Now moving to the balance sheet. We ended the fourth quarter with cash and short-term investments of $698 million, an increase of $150 million from the beginning of the year with operating cash flow of $62 million within the quarter, representing 28% of revenue and achieving a quarterly record for operating cash flow. Inventory ended the quarter at $328 million, a decrease of $18 million from Q3, representing a 14% reduction of our day's inventory outstanding. Even with ramping dragonfly production requiring us to procure long lead time items, we do expect further reduction in inventory days outstanding as inventory optimization remains a critical working capital focus area to drive consistent cash flow performance levels exceeding 20% of revenue. Accounts receivable increased $17 million to $227 million in the quarter, and our sales outstanding increased two days to 94 days. Now turning to our outlook for Q1, we currently expect our revenue for the first quarter to be between $215 million and $230 million. We expect gross margins will be between 51% to 53%, as we continue to experience historical lows in the advanced nodes business and only the initial phases of our supply chain reductions taking hold in the quarter. For operating expenses, we expect to be between $58 million to $60 million. Higher versus Q4 primarily due to the annual reset of payroll taxes and other compensation components. For the full year 24, we expect our effective tax rate to be between 14% to 16%. which does not assume any impact for potential tax legislative changes that may occur during the year. We expect our diluted share count for Q1 to be approximately 49.8 million shares. Based on these assumptions, we anticipate our non-GAAP earnings for the first quarter to be between $1 per share to $1.20 per share. Looking forward to 2024, critical focus area for us continues to be our targeted programs for operating improvements necessary to return to our operating model. And with that, I will turn it back to Mike for additional insights into Q1 in 2024. Mike?

Thank you, Mark. Our guidance range for the first quarter reflects continued strong demand for our DragonFly inspection systems to support increases in AI device production. By way of comparison, our inspection business in the first quarter is expected to be three times larger than Q1 of last year. before the generative AI and LLMs started to hit the market. In contrast, advanced node spending is still at historical lows, but we do expect advanced node revenue to pick up a bit in the first quarter and gain some strength through the year. Broadly speaking, we see advanced packaging, especially for the leading-edge AI devices, will be a healthy multiyear driver for our business. were encouraged by the recent comments from TSMC during their earnings call in which they are forecasting a 50% CAGR through 2027 for the AI application processors. In addition, they also are forecasting greatly increased silicon content for networking and edge devices that will begin adding neural processing in phones and PCs. Gartner provided a similar outlook with their expectation that AI semiconductor revenues forecast to be about $140 billion by 2027, a more subdued 27% CAGR. What we find exciting is that in addition to the growth rate for AI devices, we expect an increase in capital intensity of process control for those devices as manufacturers increase stacks of DRAM, implement denser and smaller interconnects, and include a greater number of chiplets per package. The increase in complexity will require greater emphasis on the interconnect quality and the number of steps will increase with layers and complexity. By continuing our partnerships with leaders in this market, we're developing the technologies they require to maintain their pace of innovation and meet production yield targets. We're only in the dawn of the AI era, and the outlook is very exciting. We expect AI packaging to be a strong driver for 2024, with our backyard backlog already extending into the second half of the year. However, the timing and magnitude of the recovery in advanced nodes remains uncertain, even as we see tool utilizations improving and incremental technology buys increasing. Based on the strength of our AI packaging business and gradual recovery in the advanced nodes, we project low double-digit growth for the year. With that, Rachel, we'll open the call to your questions. Rachel?

Thank you. If you are dialed in via the telephone and 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, please press star 1 to ask a question. Our first question comes from Vedvati Shrotri with Jefferies. Hi.

Thanks for taking my question. The first one is, you know, So last couple of quarters, you've talked about multiple orders, I think going to $230 million for your packaging revenues. Could you talk about the order momentum you're seeing? Is that kind of the trajectory that continues as we go into next quarter?

Going into the next two quarters,

So the backlog is there. So going into the next two quarters will be strong, and that's reflected in the increase in our guidance. Second half, as we mentioned, we've got some backlog that extends all the way through the second half. Not at the same level, but it's still early, and we'll see where our customers start to increase as they come out of Chinese Lunar New Year.

Sorry. And for my second, if I may ask a follow-up. So, you talked about the front-end metrology tools starting to get used in packaging application. Could you compare and contrast what kind of use cases there are for front-end tools versus, you know, what Dragonfly did on the inspection side?

It's different types of metrologies and more complex. So in some cases, we could be looking for voids in metals, or we're looking for metal thicknesses that the Dragonfly doesn't do as well as the Echo product line does. And there's different applications for that, whether you're looking at TSVs or bump, the creation of the metal stacking of bumps and bond pads, things like that.

There's some other applications as well, but that gives you an idea.

Okay, that's helpful. Thank you.

Our next question comes from the line of Craig Ellis with B. Reilly Securities.

Yeah, thanks for taking the question. Mike, I wanted to start with a couple with you. One, Great to see the strength in advanced packaging in Dragonfly. The question is this. Given how robustly that business has ramped up 3x year over year, can you talk about some of the manufacturing and fulfillment issues? How are you doing on capacity, any constraints, et cetera, as you look to meet demand that exists through your industry? first quarter guide and then just the further momentum in the second quarter?

That's a good question and it's a good concern, but I'm actually very impressed with our team. They've done a great job working with our suppliers, working internally, moving resources from one factory to another, for instance, from California to Minnesota in order to ensure that we're able to meet the ramp with the level of quality that customers expect from us, and even increase it again. So we talked about a Q4. We're increasing the capacity again for the first half of the year as well. So far, the team's done an outstanding job working through everything, and we don't see, you know, we're overcoming every hiccup that we see.

Yep. Got it. Okay. Good to hear it. And then secondly, you did mention that you expect some pretty modest advanced nodes to pick up in the first half of the year and that to accelerate. Can you talk about which end use areas are the first to see increased tool shipment activity? And how would you expect the other end use areas to layer on as you go through the second half and into next year?

I think it's mostly logic and then followed by DRAM. And again, these are incremental improvements. I think there's still, as I mentioned, still a lot of uncertainty is when we'll see real volumes picking up, maybe in the second half or maybe into early next year. But we're definitely seeing some incremental improvements. We've even seen some incremental improvements in NAND. But that'll be a little bit further out.

Sure. And then if I could just sneak one in for Mark. Mark, nice to hear that the efficiency enhancements are benefiting things like cash generation with record operating cash flow. The question is on impact to gross margin. You indicated you expect to be back in the target model by the end of the year. What's the contour for getting there? Is it totally linear from here? or is it really more back-end loaded with a little help from advanced nodes? Thank you.

Yeah, Craig, certainly as we look at the model for the year, I mean, our goal is certainly to show quarter-over-quarter improvement in gross margin. It really comes down to just executing similar to what we did with operating expenses and working capital management, just executing what we have in place right now for supplier management, price management, commodity pricing and executing the supply chain initiatives that we have. It does certainly help to have advanced nodes back in the area of where it was previously. I mean, that is our historically higher margin business. But again, there's a lot of things in our control from a cost perspective that we still need to get moving in the year to continue to show that improvement.

Got it. Thanks, guys.

Your next question comes from the line of Brian Chin with Stifel.

Hi there. Good afternoon. Thanks for letting us ask a few questions. Maybe, Mike, where have you managed to keep lead times on the Dragonfly, given the demand and your ability to stay in front of it? And more broadly, when talking to customers online, What are your discussions around second half capacity needs for AI packaging? And shouldn't we really think about second half expansion being a function of expectations for growth in the AI market in 2025? Is that kind of the right way to think about that?

Yeah, Brian.

So from a lead time perspective, of course, you know, in the packaging world for forever, we had very short visibility and we would always build to a forecast or projection so lead time somewhat misleading but I would say around you know two quarters sort of lead times right now be given the high demand for the dragonfly the second half expansion is a is a question right now I think there's more certainty in a 2025 another round of expansion that our customers are are looking at their order books and influx and seeing if the capacity they have that they're bringing online now in the you know in the last three quarters q4 q1 q2 will be enough to get them through the second half or if they need to add additional capacity okay but but we've been given more more stronger indication that 2025 would be a year that they need to add

Okay, got it. But I guess looking at your 1Q guide, sort of your commentary about the full year, it looks like you still have, even though you have a harder compare probably than a lot of peers with maybe one of the few companies guiding for growth in first half versus second half last year, it looks like based on overall improvement in the business, you see some pickup in the second half, although maybe you're kind of tempering it at the moment.

I'm tempering it at the moment. Okay.

Fair enough. And then maybe, Mark, a question of additional follow-up on the gross margins. Obviously, Advanced Nodes is very cyclically depressed, and you're not calling for that big of a pickup in that business at the moment this year, but you do expect to be in the model, back in the target model. So it kind of suggests that when you just get any sort of pickup, not even close to prior peak levels, but some take up in the advanced nodes, you should be really comfortable within that target model, probably even exceeding it.

Yeah, absolutely. I mean, when we get those numbers back up, certainly things we're doing now from a cost and operational standpoint are going to accelerate that.

Yeah, and how many points to drag on gross margins is the depressed revenue level in advanced nodes right now?

Yeah, I wouldn't comment specifically on that. I would just say, you know, we've always stated that Advanced Nodes was well above company average, and, you know, the inspection business was at company average.

Okay. Thank you.

Your next question comes from the line of Charles Shee with Needham.

Hey, good afternoon. The first question, Mike, I think one quarter ago you were expecting the AI chip packaging related revenue to be up by 50% in Q4. What was the actual number? Because given you did beat your guidance by roughly 10 million, probably it's a little bit over 50 would be my guess, but I really want to hear what was the actual number.

Yeah, that's a good question, Brian. Sorry, Charles, but I don't have that number in front of me. However, nearly all of the upside we saw in the quarter, if not all of it, was tied to the AI packaging. So basically that $10 million increase is primarily from that.

Got it. The second question, I think it's interesting you mentioned the aspect. I believe, I mean, being adopted, if I heard you correctly, for AI packaging applications. When I look at the aspect, it seems like a top-tier OCD systems portfolio, and it's interesting that's being adopted for packaging. Can you provide a little bit of color? What exactly is that used for?

Well, it's some unique capability.

Remember, it was designed to measure the channel holes for 3D NAND. So big, big, high, deep aspect ratio metrology applications for 3D NAND. And you could imagine that there's some applications similar to that in advanced packaging that the product is being applied to. TSVs, for instance, and some other things that I'm not sure how much is public from our customers.

Got it. Is it more the HBM application or more on the logic packaging side?

Yeah, no, I think it's more on the HBM applications right now. Yep.

Got it, got it. So lastly, really thanks for the color you provided about the trend in this AI side of the business. I want to ask you, what's the status for the HBM in terms of orders? I think when you started seeing all these orders, you started to see from one customer primarily, the HBM customer. And then last quarter, you talked about a second HBM customer becomes aggressive. The third one felt like it was still a little bit muted. Was that the same? Like one quarter later now is the status? And when do you think the third The third guy is going to pick up orders.

We think the third guy is picking up. So not saying who's who, but in the shell game of one, two, three, we think the third is also picking up now and investing. And they have some, you know, unique technology that they think is going to help, you know, give them some market share advantages.

Thanks, Mike. You're welcome.

Your next question comes from the line of David Dooley with Steelhead Securities. If you're speaking to me, I'm unable to hear you. Please check the mute button.

Yeah, I'm sorry. I'm on mute. Yeah, I'm on mute. I'm sorry. My first question is on gross margins. Just so I understand, it sounds like gross margins will improve without volume or mix because of cost reductions and what you've been focusing in on. Is that accurate?

Yes. Yes.

Great. As far as the AI inspection revenue, could you help us understand whatever the growth rate you had last year was, you know, how much do you think this is driven by units and or how much do you think it's driven by much greater levels of intensity? And then as a follow-up to that, as far as onto goes, does your business have a, which is a greater piece of this inspection business? Is it high bandwidth memory or the GPU inspection? Thank you. Thanks, Dave.

So, I mean, a year ago, AI wasn't really on the radar. So I would say, and you know the volumes or the pure number of wafers tied to AI is not that high. So this is really about capital intensity. This is really about the complexity of these advanced architectures and how much precise metrology and inspection is required to yield these devices. I think that's always been something we've talked about for years, that in these really advanced applications, our dragonfly tends to shine. It's the Swiss Army knife containing both inspection, metrology, unique capabilities, and clear find that our customers have driven us to ever greater levels of performance. As far as the mix goes, I think the capital intensity difference is higher for Logic, but there are three HBM players. So at least right now, what we've said is our backlog was roughly half and half, HBM and Logic.

Okay, thank you.

Your next question comes from the line of Mark Miller with Benchmark Company.

Thank you for the question. You mentioned gate all around. You're getting some traction there. I'm just wondering when does that fully ramp? Is it later this year, 2025? And also about the new fab, the funding by U.S. and Europe and Japan for new fabs, internal chip production. When does that start to really become full bloom?

Yeah.

So as far as when gate all around really ramps, that's, That's the million-dollar question we all would like to know. I don't have any great clarity there. You know, right now we bet on an early 2025. There are some signs. I read recently, you know, N2 is certainly they're seeing stronger demand, so maybe that pulls in. But we're not seeing anything yet. definitive one way or another where that ends up ramping. We just know our job right now is to make sure we have as strong a position in GATE all around as possible, so when it does ramp, we can benefit the most we possibly can. As far as the fabs around the world that are being incented, whether it's Europe, Japan, U.S., we've already taken some orders for at least, and I don't know I don't know on memory about the European, but for sure in Japan and in the U.S., we've already taken orders. But these are very small, and those fabs aren't, obviously, as you know, ramping just yet.

Thank you.

Once again, if you would like to ask an audio question, please press star 1. To cancel this request, please press star 2. Your next question comes from the line of Vedvati Shrutri with Jefferies.

Hi, thanks for taking my question again. So you provided some color on the power of the specialty markets, which are growing 40% this year. Could you talk about what you're seeing into 2024? Does this continue to be strong, or are you starting to see weakness there?

No, we continue to see very strong specialty device and packaging going into 2024. So well over.

I just meant the power piece of it. Does the power piece of it grow as well?

Ah, power. Sorry.

No, we think it could grow. We're more comfortable with kind of flat at this record level. and there's opportunities for it to grow. We're working with customers and certain timing of their expansions. One of the things that we benefit from being process control is our value proposition isn't just tied to expansions with these customers. It's tied to output and the quality of the output. So some of these fabs still have a lot of opportunity to improve yields, and therefore improve output without huge capital expense. So a lot of customers we're talking to are still – we're still focusing on that value proposition and seeing some traction there.

I see. And if I may double-click on that. So as far as I understood, you know, most of your China revenues really come from the power revenues. So is that – Could you talk about the non-China versus China spend and how that's looking? Is it different from each other or are the trends different from each other in the two markets?

No, I don't believe they're different. We have activity in Japan, Europe, US, as well as China, including in discussions into 2024. So I wouldn't say there's any difference from that perspective.

Okay.

Thank you. Your next question comes from the line of David Dooley with Steelhead Securities.

Yeah, a couple more questions from me. Mike, could you talk a little bit more about the lithography tool deliveries during the quarter? I think I missed some of the detail. I think you said there was three systems, two customers. I didn't catch which applications. I was wondering if you could also elaborate. Are these new customers or are they current customers that are bringing more tools online?

Good question.

You pretty much got it. There are two applications, mobile and high-performance compute. So those are the primary applications. And there are two existing customers, so buying products. Repeat business, so it was repeat orders from existing customers.

And would you expect to see this customer base continue to expand, or as far as the growth in that segment in 24, if it does grow, is it going to come from current customers or adding new customers, or how should we think about that?

Well, we already have a new customer that we've talked about for glass. So that's a new customer, and we mentioned we'll be shipping that tool sometime in the summer. But the bulk of the 2024 will be repeat business, and then I think in 2025 we'll see more new customers as well as some repeat business as well.

Is that class substrate customer for a logic application?

I believe so.

Okay, final question from me is, and I'm sorry if you already mentioned it, you talked about how your packaging revenue has grown dramatically, I think 3x last year. What would you guess the growth rate would be for that segment of your business in 2024?

I don't know specifically because with that comment, I was speaking about Dragonfly and Dragonfly systems in particular. It's continuing to grow. That much I know. How much I don't have in front of me. The whole segment, specialty devices and advanced packaging, will be pretty high, double digits.

Okay, thank you.

This concludes today's question and answer session. I will turn the call back to Mike Schaefer for any additional or closing remarks.

Thanks again to everyone who joined us on the call today. A replay of the call will be available on our website at approximately 7.30 Eastern Time this evening. We'd like to thank you for your continued interest in Onto Innovation. Rachel, please conclude the call. Thank you.

This concludes today's call. Thank you for your participation and you may now disconnect.