Photronics, Inc.
Q3 2015 Earnings Call Transcript

Published: 19 Aug 2015

[Operator:]

Welcome to Photronics’ third quarter earnings call. During the presentation, all participants will be in a listen-only mode. Afterwards, we will conduct a question and answer session. At that time, if you have a question, please press star then one on your touchtone phone. If at any time during the conference you need to reach an operator, please press star, zero. As a reminder, this conference is being recorded Wednesday, August 19, 2015. I would now like to turn the conference over to Pete Broadbent.

[Peter Broadbent:]

Thank you and good morning everyone. I would like to begin by introducing a new member of our management team

[Troy Dewar:]

Thank you, Peter. Let me say I’m happy to be here and a part of the Photronics team, and I look forward to meeting many of you over the coming months. I want to thank you for joining us for the conference call this morning to discuss our third quarter 2015 results. Before we begin, I’d like to remind all participants about the Safe Harbor provision under the Private Securities Litigation Reform Act of 1995. Any statements we make during this presentation, except for historical events, may be considered forward-looking and may be subject to certain risks and uncertainties that could cause actual events to differ materially from those projected, including uncertainties that may affect the company’s operations, marketing, pricing, competition, procurement, manufacturing efficiencies, and other risks detailed from time to time in the company’s SEC reports. These statements will contain words such as believe, anticipate, expect, or similar expressions. Today’s call will be archived on our website until we report our fourth quarter 2015 results. Joining us today on the call are Dr. Peter Kirlin, Chief Executive Officer; Sean Smith, Senior Vice President and Chief Financial Officer; Dr. Christopher Progler, Vice President and Chief Technology Officer and Strategic Planning. During our remarks this morning, we will be referring to slides posted on our website under the Investor Relations link. Now I’d like to turn the call over to Peter Kirlin. Peter?

[Peter Kirlin:]

Thank you, Troy, and good morning everyone. Please turn to Slide 3 in our slide presentation. We reported a solid quarter, growing revenues to $131.7 million, which is near the high end of our guided range. This was the second quarter in a row where we delivered both sequential and year-over-year growth. The uptick in Q3 was largely the result of an increase in high end FPD sales and strong execution by our team. Total FPD sales were $27.7 million, up 18% sequentially driven by an increase in next generation AMOLED masks built on our new P-80 lithography tool. Semiconductor mask revenues were essentially flat with mainstream sales up $2.9 million and high end sales down $2.7 million. Mainstream sales recovered to Q1 levels of $65 million and high end memory was strong. The drop in the high end IC mask business came from weakness in the foundry logic mask market. As projected during our last conference call, we completed the qualification of our new high end flat panel display photomask P-80 lithography and CLIOS [ph] inspection equipment that we recently installed in Korea. We are the first FPD merchant or captive to have the next generation of mask making equipment, and our customers moved to aggressively capitalize on our industry leading position. As a result, the P-80 ramped very quickly and we exit the quarter at full utilization. In addition, demand for mainstream FPD photomask was strong with sales up $1.1 million sequentially or 13%. Our high end IC memory mask business continued to be strong, essentially flat with Q2. We are now definitively in the heart of the next generation DRAM ramp. Conversely, our high end logic mask business was down $2.5 million sequentially, reflecting challenges our customers are having within their own businesses. Importantly, our execution for our key logic customers was strong in Q3 and we believe that we have not lost any market share in this segment. Furthermore, as we have stated before, we are fully qualified with our key customers at next generation logic and memory nodes, and we have more capacity than all of our merchant competitors combined, so we are well positioned to benefit when the logic business starts to improve. Our mainstream IC business rebounded from the Chinese New Year holidays as projected during the last call. Coming in at $65 million, revenues were flat with Q1. Looking back over the last five quarters, with the exception of Q2 mainstream photomask revenues have been in the $64 million to $65 million range. Our superior execution has generated incremental market share gains that have offset the small erosion in blended ASPs typical of this mature market segment. Shifting gears to earnings, with our strong operating leverage and diligence on cost controls, we outperformed on our gross and operating target margins. As Sean will discuss, the gross and operating margins on incremental revenues were 94% and 84% respectively. We exceeded our target of 50% this quarter by combining our routine cost down programs with a reduction in outsourcing. The latter was driven by the completion of our operational integration plan for PDMC, our joint venture in Taiwan, and the concomitant reduction in outsourcing to DNP in Japan. As a result, we generated earnings of $0.17 per share, which exceeded our guidance range of $0.06 to $0.13 per share. Looking forward, we believe that Q4 2015 will be another strong quarter for us. Our FPD business is running at full utilization with strong demand at the high end. I would like to remind everyone that Q4 will be the first quarter in which we will have the full benefit of the P-80. 20nm DRAM is now solidly in production and we are approaching mid-cycle in the ramp where reticle demand has historically been very strong. 28nm and 14nm foundry logic, while somewhat erratic, are gaining traction with our customers. This makes predicting one quarter versus the next challenging, but there is little doubt that these logic nodes will gain greater adoption moving forward. Finally, 3D NAND and crosspoint memory are on the horizon and we expect to see the business start near the end of the calendar year or in the first half of calendar year ’16. Our capacity is online and we are fully capable for all of these nodes, so we are optimistic that we will hit on all cylinders as our customers go to full production on this wide array of opportunities in the coming quarter. Before I turn the call over to Sean, I would like to congratulate the team on their excellent execution this quarter. As they demonstrated once again, while everyone is focused on delivering on the growth opportunities in front of us, they are also committed to taking actions needed to improve our productivity for the benefit of our customers and our shareholders. Now I’d like to turn the call over to Sean. Sean?

[Sean Smith:]

Thanks Peter, and good morning everyone. I’ll provide a brief analysis of our financial results for the third quarter of fiscal 2015, review our operating results, balance sheet, cash flows, and forecast for Q4. Please turn to Slides 5, 6 and 7, which shows our sequential quarterly IC and FPD revenue performance. Total revenue for the third quarter was $131.7 million. As Peter mentioned, revenues for IC photomask were $104 million as compared to $103.8 million for Q2. Revenues for high end IC photomask, which are 45nm and below, were $39 million or 38% of total IC sales. Sequentially, high end IC revenue was down $2.7 million primarily related to softer demand from foundry logic customers. Mainstream IC sales during the quarter were $65 million, a sequential increase of $2.9 million primarily related to increased global demand. Revenues for FPD photomask were $27.7 million, up 18% or $4.2 million sequentially. The increase was related to increased AMOLED orders that Peter alluded to. High end FPD revenue was $18.1 million, which was up $3.1 million on a sequential basis. Breaking out sales geographically, 67% of total sales were from Asia, 26% from North America, and 7% from Europe. Now let’s continue through the income statement. Gross margin for the third quarter was 28.3%, up 230 basis points sequentially. The increase was primarily related to the following items

[Operator:]

[Operator instructions] Our first question comes from Edwin Mok with Needham & Company.

[Edwin Mok:]

Hey, thanks for taking my question. First question I have on the gross margin, Sean, I think Peter mentioned that you guys did less outsourcing to DNP. Did I understand that correctly, and is that the normalized level now? Any color you can provide on that?

[Sean Smith:]

Yes, essentially as Peter mentioned, it represents a realignment of our site-to-site movement as our Taiwan facility has been qualified at advanced nodes, therefore we have less outsourcing to Japan, enabling us to absorb more of our fixed costs and increase margins. As I said, Edwin, in the prepared remarks, this is now in our base and we expect to target 50% incremental margins going forward.

[Edwin Mok:]

With that but lower high end IC sales this quarter, is there a way you can quantify what is your utilization right now for your factory for high end IC?

[Sean Smith:]

We don’t specifically comment on utilization for competitive reasons, but certainly we had additional capacity, certainly as we talked about decreased foundry logic orders to handle more business.

[Peter Kirlin:]

Yes, I think what we’ve said in the past, Edwin, is we have enough powder in the gun to hit or exceed $150 million in revenues, so that remains true.

[Edwin Mok:]

I see, okay. Great. Sorry about the background noise there. Can I ask you about crosspoint technology in terms of if that could potentially become the growth driver for you guys, and when do you think that can be a contributing factor for your business?

[Peter Kirlin:]

We have to be a bit guarded regarding what we say about crosspoint, but what we can say is we’ve been qualified to build those reticles for quite some time. We’ve been involved during the development, and in my prepared remarks what I said is we see it as a growth driver for us as we exit the calendar year into the first half of 2016.

[Edwin Mok:]

Okay, that’s helpful. Then I guess in the high end IC side or high end semi side, sales have been somewhat lumpy, right? Any way you can kind of let us think about as you move forward in the next few quarters, what could give us confidence that that business can stabilize or return to more consistent growth trend?

[Peter Kirlin:]

As you stated, our high end IC business is moving upwards. It’s up and to the right, but it’s kind of a sawtooth as different technology nodes come in and go back out, based on either market factors or yield issues our customers have. What I would say is we as a team have worked to try to assemble more and more growth drivers up and to the right. That’s been our tactic, to try to average out the sawtooth, to make it--there will still be teeth in it, but maybe the teeth are less severe, and I think you really saw that this quarter. We had the FPD business come in at the high end nicely [indiscernible], and our high end memory was stable. What I would highlight there is if you look at Micron’s [indiscernible] during analyst day, I think they made a pretty strong statement about where they want to be with their DRAM business at the end of the calendar year, right - more than 50% bit conversion, and in order to do that, what they need is reticles. So we’re very confident, as I said in my prepared remarks, about the tone of our high end memory business. Six months ago, it was in the sawtooth mode. Now, it’s in strong ramp mode. So we’ve got FPD, we’ve got memory, and then we have 14 and 28nm logic, and that’s where, I think we all understand there’s inventory overhang in the channel and there is still yield challenges, so that’s kind of moving in fits and starts. So we have four pieces of growth driving our business right now, plus very sturdy, stable performance in our mainstream business, and as we exit the calendar year we’ll see 3D NAND and hopefully the crosspoint kick in. So the sum total of that is more and more growth drivers, so any impact on the business that one has should be diminished.

[Edwin Mok:]

I see. Okay, great, Peter. Last question I have, and I’ll let the other guys ask. I remember on the analyst event earlier this year, you guys had, correct me if I’m wrong, I think it’s 30% gross margin and 17% operating margin targets. With the higher gross margin this quarter, are we sticking with those targets for now, or do you think long term you can surpass those numbers?

[Sean Smith:]

Edwin, we always look for continuous improvement, and in the past when we’ve laid out targets and once we hit those targets, we re-establish new targets. So we like to get there first before we talk about higher targets, but we certainly have aspirations for them.

[Edwin Mok:]

Sounds great. That’s all I have. Thank you.

[Operator:]

Our next question comes from Tom Diffely with DA Davidson.

[Tom Diffely:]

Yes, good morning. Sean, looking at the margins, obviously a very impressive increase sequentially in the margin structure, and it sounds like you think this is the new baseline. Curious - was there anything from the mix that helped the margins this time, or is it truly just the overall business and better operating structure?

[Sean Smith:]

It’s related to, certainly as Peter in his prepared remarks made, constant cost reduction efforts. We had the FPD business pick up during the quarter, better utilization of our tool base, so as we look forward, this is a new base, so as I mentioned we do expect a target 50% drop-through on incremental revenue based upon the Q3 baseline.

[Tom Diffely:]

Okay. It sounds like you guys have done continuous improvement in your operations for as long as I can remember, so I’m just surprised that it jumped so much in this one quarter. Apparently it’s just the DNP outsourcing is a big chunk of that, it sounds like.

[Peter Kirlin:]

Yes, Tom, just to remind everyone, our JV closed -- you know, this quarter we celebrated the one-year anniversary, so most integration plans have a 12-month trajectory. So the local team in Taiwan did a very excellent job in executing the integration plan, supported by our corporate team, and it lagged just a bit but it wrapped up more or less when it should have. One thing that I think was never clear - when we did the JV, the critical layers for the most advanced masks were actually built in Japan. They were never made in Taiwan by DNP. So as part of the integration plan, we needed to shift all of the reticle flow for the entirety of the sets to Taiwan, and that required a qualification that required us to put the tools in place in Taiwan, ramp the process technology, and then go through a full-blown wafer qual with our customers there. You know how long that takes, so here we are.

[Tom Diffely:]

Yes, okay. All right, sounds good. So Peter, how long during the quarter has the new tool for flat panel been up and running? Was it just a half quarter?

[Peter Kirlin:]

Yes, what we said last quarter was we hoped to get it up and qualified by mid-quarter, and we executed--again, the team in Taiwan executed to that plan and we had about a half-quarter’s worth of revenue benefit from the tool. One thing I would also say is since I’ve been at Photronics, I’ve never seen a tool ramp from zero to full capacity so quickly. There is a lot of demand for the capability that tool has.

[Tom Diffely:]

Okay. Now, we continue to hear a lot of things coming out of especially Korea about the push now to get these high end AMOLED screens out there, so it sounds like you have the right tool at the right time for that. I guess looking at the capex, Sean, it looks like we’ve peaked here on a quarterly basis, on a four-quarter moving basis. Would you expect the capex to trend back down to kind of the normal $80 million range over the next few quarters from a trailing four-quarter basis?

[Sean Smith:]

Yes, we’re going to provide capex guidance, Tom, for next year in our December call, and we did say at the analyst day that our first outlook for next year was at a peak of about $75 million, so yes, we would expect it to trend down.

[Tom Diffely:]

Okay. Peter, looking on the memory side of the business, obviously the DRAM is working really well right now. When 3D NAND starts to ramp up, what is the relative mask cost of 3D NAND versus planar NAND, and then maybe throw in versus DRAM as well?

[Peter Kirlin:]

Yes, I’ll direct that question to Chris. He’s probably best in a position to answer it. Chris?

[Christopher Progler:]

Sure, thanks Peter. Tom, I don’t know if we can comment on the mask cost, but generally the 3D NAND sets tend to have more layers in them but fewer critical layers, so I think it’s similar kind of set composition in total. Of course, it’s a new device, new technology, so we do expect a higher re-spin ratio for NAND because things will be getting tweaked and tuned as manufacturing ramps, so we think the re-spin percent - this is the number of masks that get reordered in a given set, we think will be higher. So I would say consider it comparable to similar nodes for planar NAND but more--we are hoping for more design activity because it is a new technology that’s being adopted.

[Tom Diffely:]

Okay, and then what about NAND versus DRAM, then?

[Christopher Progler:]

DRAM, the masks on average, many more critical layers. It still drives the technology curve much more aggressively than NAND, and we expect that definitely continue. More layers in DRAM now, more multi-patterning. We’re seeing use of things that have been used on the logic side for a while, we’re seeing in DRAM, so I think you can expect, well, I’ll say more than 20% increase in DRAM layers compared to NAND, and also node-over-node, so that layer count is really going up, and critical layers as well.

[Tom Diffely:]

Okay. Most of what you’re doing today is in the high 2x node. Any difference between the big slug of 20nm business yet for DRAM?

[Christopher Progler:]

We are seeing that particular node ramping, a lot of masks being built; so yes, I would say we’re seeing that ramp for sure.

[Tom Diffely:]

All right. Peter, last question, just a broader question on China. What’s your exposure there today? What are you views of kind the near term cross-currents, and what is your long-term opportunity there?

[Peter Kirlin:]

We see China as a clear growth opportunity for our business, both in FPD and in IC. We saw in China last quarter the business actually was up $1 million quarter-over-quarter, and I’m not so sure we gained market share. Maybe we gained a little share, but the business there is also in growth mode, so we’re in the process of establishing a sales and customer support office there and as Sean said, most everything we try to do is step by step, and that market clearly is the next wave of growth for industry, and we’re taking a very pragmatic approach to developing the business there. But without a doubt, it looks like a significant opportunity for us.

[Tom Diffely:]

Great, sounds good. Thank you.

[Operator:]

Again ladies and gentlemen, if you have a question at this time, please press the star then the one key on your touchtone telephone. Our next question comes from Patrick Ho with Stifel Nicolaus.

[Patrick Ho:]

Thank you very much. Peter, maybe first off in terms of some of the comments you made on the high end logic foundry business, you mentioned both market conditions as well as yield issues related to ramps. From your perspective in the July quarter, was one a bigger impact than the other, and how do you see it trending into the current October quarter?

[Peter Kirlin:]

As I said, it’s very difficult to know exactly how that business is going to materialize in any one quarter, but we did see--we really saw the business slow down at the beginning of the quarter, and if anything, the tone is a bit better now than it was when we started. So if we use that as a guide, we would say that this quarter looks incrementally better than the last, but two weeks from now something could change and the business could soften again. So very reluctant, Patrick, to say exactly how it’s going to end up, but right now incrementally it looks better, where we sit right now.

[Patrick Ho:]

Okay. Moving on to the flat panel display side of things, obviously we’re starting to see the emergence of the AMOLED trend. Can you comment on how sustainable this ramp is, and maybe to use a baseball analogy, what inning do you believe we’re in, in this ramp?

[Peter Kirlin:]

Well you know, I think we’re maybe in the first or second inning of the next--you know, the QHD to UD transition, we’re probably in the first inning, maybe the first to second inning of that transition. As I’ve mentioned, we’re the only game in town right now that has a mask making tool that really can build the mask required to make that transition an easy one for our customers, so we have a lot of room to run there.

[Patrick Ho:]

Okay, great. Final question from me in terms of going back to your IC business for a second, the memory business obviously is quite strong right now, particularly at the high end. As 3D NAND ramps up at the end of this year and into next year, do you believe that will be supplemental to the DRAM business that you’re seeing today, or does that kind of offset maybe a potential peaking of the high end DRAM business as we get into the first half of ’16?

[Peter Kirlin:]

I think that’s a good question. We’re quite bullish on the DRAM business over the next one to two quarters, and I think as you said correctly, after that ramp peaks the reticle demand coming from DRAM will start to fade away. The good news is that as that starts to fade away, the 3D NAND in particular should be coming up nicely, and layered on top of that is the 3D crosspoint memory. So our hope is that the net of all that is upward, but we certainly don’t think it’s going to be downward.

[Patrick Ho:]

Great, thank you very much.

[Operator:]

Our next question comes from David Fondrie with Heartland.

[David Fondrie:]

Hey, good morning. Congratulations on a nice quarter. In the past, you’ve talked about the lack of investment by some of your competitors, or your competitors on the merchant side. I wonder if you can give a little flavor, is that still the case? Do you believe that they’ve somewhat backed off from the investment in the high end?

[Peter Kirlin:]

That indeed is still the case. We do a lot of work to check the channel at multiple levels, and so far our large merchant competitors have backed off on investing in next generation technology, so right now we’re the only one.

[David Fondrie:]

Talking about the P-80 and the opportunity in the flat panel displays, are the captives investing in that kind of a tool, and I guess the next question is if you are running at capacity or near capacity on that tool, is there a possibility you would qualify another tool?

[Peter Kirlin:]

Yes, there is one captive that we--and again, we do a lot of work to check the channels. There is one FPD captive that has a P-80, that basically has the duplicated tool set on order, and it should be delivered towards the end of the calendar year, so there will be capacity coming online into the business. Unlike the IC business, the FPD photomask market is considerably smaller, so we add--we’re very deliberate in when and how we add capacity and capability. We like to add them both, if we can, simultaneously. Having said that, we’ll continue to watch the market. We’ll see how the business evolves, and clearly if we believe that we can load another tool, given we already have all the process technology we need to exploit it, we’ll make that move.

[David Fondrie:]

Peter, following up on that, is that tool only for AMOLED, or can it be used for high end regular flat panel displays?

[Peter Kirlin:]

It’s used for both, and it offers substantially improved capability for both. I guess the other thing I would say is we’re not done improving on our process technology that supports that tool. We believe we have significant room to run with the performance we can extract from it, so it is indeed valuable for both. But I think we have said before in our calls that Samsung had recently ramped their A3 line for AMOLED displays in Korea, and that line has the next generation of stepper made by Canon instead of Nikon, and it was waiting for a better photomask and we delivered it. It’s a very happy marriage right now.

[David Fondrie:]

Great, thanks very much. Appreciate it.

[Operator:]

Our next question comes from Tom Diffely with DA Davidson.

[Tom Diffely:]

A quick follow-up here. So in an environment when inventory issues are hurting a lot of companies’ mid to low-end chips, your mainstream business seems to be doing quite well. Curious if it’s just Pete’s leadership in that space, or is there something specific about your mix of business?

[Peter Broadbent:]

Thank you, Tom.

[Peter Kirlin:]

Yes, Pete likes those kudos. What I would say, Tom, is we have a very strong global team in this market. We’ve been doing it forever, and I’m not in any way trying to diminish Pete’s leadership, but this is truly--this is 1,500 people working quite hard deliberately together to provide superior service and industry-leading pricing for our customers. That’s what we’ve done for 46 years. Of everything this quarter, if you asked me what I’m most pleased with, I’m very proud of what the team’s doing in the mainstream business.

[Tom Diffely:]

Similar to Dave’s question on the capacity added at the leading edge, I get the sense that some of your competitors have taken capacity off at the lower end nodes too, and as IOT ramps over the next couple years, it seems like this might give you a nice advantage at the low end of the market.

[Peter Kirlin:]

You’re right in everything you just said. One of the reasons why our revenue has not dropped is our competitors are actually incrementally exiting the business, and we actually last quarter had a piece of lithography equipment, new piece of lithography equipment qualified in the mainstream market because we were out of capacity on a certain node. So yes, for us on some nodes that you would find very surprising, we’re sold out or nearly sold out.

[Tom Diffely:]

All right, great. Thank you.

[Operator:]

I’m not showing any further questions at this time. I’d like to turn the call back over to our host.

[Peter Kirlin:]

Okay, thank you everyone for participating on this morning’s call, and we look forward to talking to you again during the quarter. Thank you.

[Operator:]

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