Photronics - Q3 2020

Transcript

Operator (participant)

Ladies and gentlemen, thank you for standing by, and welcome to the Photronics third quarter full year 2020 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. To ask a question during this session, you'll need to press star one on your telephone. Please be advised that today's conference is being recorded, Thursday, August 27, 2020. If you require any further assistance, please press star zero. And I would now like to hand the conference over to our speaker today, Troy Dewar, Vice President of Investor Relations. Thank you, and please go ahead, sir.

Troy Dewar (VP of Investor Relations)

Thank you, Chris. Good morning, everyone. Welcome to our review of Photronics 2020 third quarter financial results. Joining me this morning are Peter Kirlin, our Chief Executive Officer, John Jordan, our Chief Financial Officer, and Chris Progler, our Chief Technology Officer. The press release we issued earlier this morning, along with the presentation material which accompanies our remarks, is available on the Investor Relations section of our webpage. Comments made by any participant on today's call may include forward-looking statements that include such words as anticipate, believe, estimate, expect, forecast, and 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'll turn the call over to Peter.

Peter Kirlin (CEO)

Thank you, Troy, and good morning, everyone. We performed well in the third quarter, achieving strong revenue growth as supply chains returned to normal, market demand recovered, and we benefited from our broad product offerings, global footprint, and leading technology. Design activity was healthy, with dramatic improvements in high-end display and mainstream IC markets. Also notable in our results for the quarter was a strong recovery in our China business, with revenue for products shipped into China up 10% compared with the second quarter. Profit margins improved sequentially and year-over-year due to our relentless focus on cost control, which underpins our ability to leverage revenue growth into margin expansion. Our China operations were profitable for the first time this quarter. Given the size of our investment, this is a very significant milestone for Photronics. Consolidated operating margins were 12.6%, and earnings were $0.17 per share.

We added to our cash balance during the quarter, fortifying our financial position. We operate in a capital-intensive business that requires significant investment to support growth. As our China operations are well on their way to full utilization, we are actively engaged with customers to obtain long-term purchase agreements to provide support for incremental investments. Our strong balance sheet enables us to aggressively pursue these opportunities without jeopardizing our financial stability or diluting our shareholders. Year-to-date revenues were 17% better than last year. We are tracking towards our third consecutive year of record revenues. Operating income is up 60% for the first nine months of the year. Cash generated by operations has more than tripled. Our cash balance is 30% higher than this time last year. These results validate that our strategy is working.

We have followed a disciplined approach to capital allocation that places a priority on profitable organic growth, allowing us to generate solid financial results while also providing a pathway for additional investments when the market environment and customer commitments align with our competitive advantages. As semiconductor producers and capital equipment suppliers have reported the results for the second calendar quarter, it is abundantly clear that exposure to China is increasingly important. This is because the Chinese customers are investing aggressively, and it is readily apparent that Beijing's reaction to the ongoing trade discussions with the U.S. is to accelerate their efforts to become self-sufficient. Escalating capital investments generates capacity, which in turn creates an environment that is rich in new designs, spurring photomask demand.

Our decisions a few years ago to target the China market through business development efforts and by building two new manufacturing facilities have positioned us to grow with the local industry as it develops. Our IC business is clearly benefiting from those decisions. IC revenues in China were $95 million over the last 12 months and have grown at a 74% compound annual growth rate since 2016, which is notable in that it is an integer multiple of the market growth rate over the same period. We anticipate additional growth as we complete the first phase of our tool installation in Xiamen. We spoke last quarter about the impact the shelter-in-place directives had on our IC business, essentially pushing the anticipated ramp-out about one quarter.

In addition to the push-out in the qualification activities, we have also been impacted by a delay in the installation of a high-end litho tool because sufficiently skilled OEM personnel have been unable to travel to our site to do the complex work of installing the tool. This third-party issue has added an additional quarter to the timing of the production ramp of one of our lines. The installation has now begun, and we do not anticipate any further delay. New capacity should begin to generate revenue by the end of our second quarter in 2021. FPD has also benefited from our China business development efforts. FPD revenues to China over the last 12 months were $113 million, and our business has grown at a compound annual growth rate of 62% since 2016. The global display photomask market is forecast to grow 2% in 2020.

Year-to-date, FPD revenues are up nearly 50% due to our technical leadership and investment in China. Furthermore, we have kept all our factories running at capacity, while we believe many of our competitors have not. Just as in IC, we have dramatically outperformed the market as customers recognize that we have differentiated technology, we have captured market share as a result. Moreover, the next phase of our FPD investment is underway. We anticipate maintaining growth rates well above the market in 2021 as well. However, we are not free of external challenges in our display business, and the mobile market is presently soft largely as a result of two factors. First, the number of smartphone shipments is expected to decline 12%-15% in 2020, and second, Huawei's de-Americanization of their supply chain has temporarily paused their new product roadmap.

Given that Huawei was the global mobile phone market leader in Q2, their pullback is having a material impact on the photomask market, which is new design-driven. We expect this effect to be temporary as Huawei is well on their way to completing the redesign of their current product line, and the roll-out of 5G networks is furthering the adoption of AMOLED as phone makers want to offer the most advanced displays for the premium sector of the market. Given the near-term softness in demand, we have decided to pull forward the legally mandated annual PM of our Hefei facility into Q4. As a result, we expect FPD revenues to be down sequentially. On the new business front, we are beginning to see demand for masks to build advanced mini-LED backlights as they start to penetrate mainstream display applications.

Within the landscape of large-screen TVs, the market is presently formed around older technology LCDs with a separate passive backlight or some version of OLED such as LG's White OLED or Samsung's QD-OLED. The emergence of active matrix mini-LED backlit LCD displays sits between these two technologies and enables traditional LCD displays to offer visual performance similar to OLED TVs. The industry is in the very early stages of the commercialization of mini and the related micro-LED displays, but there is little doubt that these technologies will find their niche in the rapidly expanding solid-state display marketplace. This is yet another example of the increased need for photomasks to support a plethora of innovative new products in the display space. Given our position as the market and technology leader, customers are increasingly turning to Photronics to support the development of new display products and/or technology.

During the quarter, we took another step to strengthen our company as we announced that Daniel Liao will be joining our board of directors. Daniel brings a wealth of relevant experience. His knowledge of the semiconductor industry, principally with Lam Research Corporation, where he still serves as senior advisor, plus his experience with technology development operations will be tremendous value to our board. With his appointment, we now have seven board members, including four independent directors. We have made improvements to our corporate governance over the last few years, addressing diversity and tenure. I know from discussions with our investors that these are important issues for you, and we have been and will continue to be mindful of crafting policies that align us with corporate governance best practices.

Looking forward, our business has momentum, and we are on a long-term trajectory of revenue growth, margin expansion, and improving returns on capital. I am very pleased with our performance for the first nine months of 2020 and remain confident that we will continue to improve. Before turning the call over to John, I would like to personally thank all of our employees for rising to the challenge of operating a global company in the face of a multitude of challenges presented by the coronavirus. By working together, we are protecting each other while our customers enjoy the service and performance that separates us from the competition. I am very proud of you all. Now I'll turn the call over to John to provide additional commentary on our performance and outlook.

John Jordan (CFO)

Thank you, Peter. Good morning, everyone. We resumed strong revenue growth in the third quarter, increasing 11% sequentially and nearly equaling the record levels of our first quarter. Revenue of $157.9 million was 14% better than the same quarter last year, the 12th consecutive time we have achieved year-over-year revenue growth. During our second quarter call, we reported that demand trends were continuing to improve. As the third quarter progressed, that improvement manifested in strong order and revenue growth. Many of the supply chains that were initially impacted by the shelter-in-place mandates returned to normal, and end-market demand mostly recovered. IC revenue improved to $108.7 million, 12% better than second quarter due to strong mainstream demand driven by a recovery in foundry logic in Asia. High-end IC was essentially flat.

Looking forward, while we do see signs of stable to improving underlying demand trends across many markets, the latest Department of Commerce announcement of restrictions against Huawei creates an additional level of uncertainty across the supply chain. It is too soon to be specific on how this new regulation may impact our business, as we, along with the rest of the industry, are still working through the detailed language of the law to ensure we are in compliance. In addition to trade policy, there are still possible headwinds from any potential government restrictions to address health concerns. FPD revenue improved to $49.2 million, up 7% sequentially and 30% compared with last year, driven by increased demand from our targeted high-end sectors. G10.5+ demand nearly doubled from very low second quarter levels that were limited by shelter-in-place edicts.

Demand for mobile applications, including both AMOLED and LTPS technologies, also improved as panel makers released new designs for the next generation of smartphones. The display market environment is very dynamic. As Korea continues to transition production capacity away from LCD to OLED or AMOLED, China is ramping G10.5+ capacity to expand their LCD leadership position while also further penetrating the mobile AMOLED space, and Taiwan invests in micro-LED to develop differentiating technology. However, as Peter mentioned, the restrictions against Huawei are causing a temporary dislocation in the supply chain. This uncertainty is behind our decision to perform the annual preventive maintenance in Hefei this quarter and will have an impact on the revenue forecast reflected in our fourth quarter guidance.

Long-term, due to our technology leadership in the display market, we will continue to work closely with all of our customers to help them navigate these challenges with photomasks that enable their product development objectives. As we have seen demand improve for both IC and FPD during the third quarter and continuing into the fourth, we are running at high utilization rates across all of our high-end facilities. Notwithstanding the near-term uncertainty just discussed, we anticipate maintaining relatively high utilization rates over the next few quarters. This presents both opportunities and challenges. The opportunity is to optimize our cost structure and carefully manage cash flow to deliver optimum profit and returns. However, while there should be chances to improve revenue with mix and incremental productivity increases, the next significant growth catalyst will be the capacity additions planned for 2021.

Third quarter revenue reflected an annualized revenue run rate above $630 million, with the last piece of our Xiamen investment to come online by the end of our second quarter in 2021. The next phase of our FPD investment will follow closely, which should assure continued revenue growth in 2021 and beyond. Gross margin improved to 23.9% in the quarter, and operating margin expanded to 12.6% as operating leverage and cost management allowed us to grow the bottom line more quickly than the top line, and China operations made a $1 million positive contribution to operating profit. Looking forward to fiscal 2021, we expect to continue making progress toward our 15% operating margin target, which will require our usual resolute focus on cost reduction, always of primary importance.

Below the operating line, other expenses of $2.1 million included interest expense and the primarily unrealized effect of the remeasurement of U.S. dollar-denominated balance sheet items of our foreign subsidiaries. Tax provision and non-controlling interest were in line with expectations, resulting in $0.17 per diluted share for the quarter. Our cash balance increased $23 million during the quarter. We generated nearly $17 million in cash from operating activities and received a $10 million capital contribution from our JV partner as part of the funding of our upcoming Xiamen investment. Capital expenditures in the quarter were $7 million. Total debt at quarter end was $53 million, and net cash was $208 million. We have revised our forecast of total CapEx for the year to $80 million due to changes in the timing of cash payments for certain tools.

As always, we have some flexibility on exact timing of CapEx to allow us to respond to changing market conditions. Our financial position remains strong with sufficient liquidity and manageable debt. The business is a strong cash generator, and the combination of our disciplined working capital management and financially strong customer base mitigates collectibility risk. When we determine that the uncertainty brought on by the coronavirus and the geopolitical situation has subsided, we will consider revisiting the share repurchase decision to reinitiate that return of cash to shareholders. Before I provide fourth quarter 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. Geopolitical risk related to government actions to address health concerns or trade policy may have an impact on our operations, the operations of our customers or suppliers, or end-market demand, resulting in an adverse impact on our industry and therefore our results. I will also point out that our fourth quarter has one less day than the third quarter and five fewer days than the fourth quarter of last year. Given those caveats, we expect fourth quarter revenue to be in the range of $148 million-$158 million. There are signs of strong end-market demand across both IC and FPD.

However, there's also uncertainty related to new U.S. trade policy regulations that may likely soften demand during the quarter, and as we discussed, we are also planning an annual PM in Hefei. Based on our revenue expectation and our current operating model, we estimate earnings for the fourth quarter to be in the range of $0.12-$0.19 per diluted share. We are pleased with our performance through the first nine months of 2020. Our market-leading position and financial strength have enabled us to navigate the challenging environment over the last few quarters, and we believe will help us continue to outperform the market going forward. I will now turn the call over to the operator for your questions.

Operator (participant)

Thank you and as a reminder, ladies and gentlemen, to ask a question, you will need to press star one on your telephone. To withdraw your question, please press the pound key. Please stand by while we compile the Q&A roster and our first question comes from the line of Tom Diffely with D.A. Davidson. Your line is now open.

Tom Diffely (Managing Director and Senior Research Analyst)

Yeah, good morning. Thanks for taking the question. Peter, first on Huawei and the disruptions there. Are you seeing or did you see any disruptions during the quarter, or is this all projected potential disruptions in the fiscal fourth quarter?

Peter Kirlin (CEO)

Yeah, we really started to see the effect in the last months of the quarter. We're seeing it now. We think it will be behind us. It will be behind us as we exit the quarter, maybe a little sooner. So it's about a quarter dislocation spread one-third over Q3 and two-thirds into Q4 the way we see it, but we don't have complete clarity. We don't have complete clarity on what's happening there.

Tom Diffely (Managing Director and Senior Research Analyst)

Okay. And then maybe just a clarification. It sounds like the Huawei panel issue is with the handsets, but I was under the impression that the Hefei facility Gen 10.5 was much more on the TV side of the business. So maybe you could square those two items.

Peter Kirlin (CEO)

Yeah. So if you look at the focus of Hefei, yes, it is large panels, but we also build a lot of semi-critical and non-critical AMOLED layers there. And we move our FPD business around our global footprint to maximize our revenue and profit. As you know, we've been running at capacity, and that includes Q2 when our revenue dropped to $46 million. The reason the revenue dropped was the mix of product, even though all the factories were sitting full. So the way we see the business normally, so if you look at our facilities, first of all, we don't PM all of them every year. We don't do that. But we do PM all our factories in Asia that sit in science parks because generally those PMs are mandated by the science park and/or the government.

So this is an activity that normally we do in December when demand is at an ideal or at a minimum, rather, not an ideal, but at a minimum in our markets given the annual cadence of the end-market demands. So we've pulled the mandated PM in Hefei forward a quarter because we believe this quarter will be the quarter where the demand profile for the industry is at its minimum. So anyway, yeah, that's why we're doing it. We'd like to get it out of the way when the market is weakest.

Tom Diffely (Managing Director and Senior Research Analyst)

Okay. Is that typically a one- to two-week event?

Peter Kirlin (CEO)

Yeah. Everything will be turned off. It varies, but in the way the government requires us to do it there, everything will be turned off cold for four days, and the rewarm-up takes two to three. So we lose about a week's worth of output in China as a result of the PM. And the PM in Xiamen for the year has already been done earlier in the year. So again, we try to make adjustments or we try to time these things so that they have minimum impact on revenue and profit.

Tom Diffely (Managing Director and Senior Research Analyst)

Okay. That makes sense. And then moving over to the mainstream business, the strength that you saw, was that pent-up demand from closures in the first calendar quarter, or do you think it reflected what kind of the end-market natural run rate is?

Peter Kirlin (CEO)

No. I think the snapback in the mainstream largely was driven in China, and it was a snapback related to what we didn't see in the second quarter. So the business in Q3, there was the normal tone plus some additional demand that we would have seen in our fiscal Q2.

Tom Diffely (Managing Director and Senior Research Analyst)

Okay. That makes sense. And then, John, final question here. When you look at your comments about expanding margins, is that just your ongoing cost control efforts, or is there something in product or mix related that would help you expand margins as well?

John Jordan (CFO)

Yeah. I don't like giving the answer to all of the above, Tom, but it's a combination of mix and cost reduction and China's improving revenue and margin performance.

Tom Diffely (Managing Director and Senior Research Analyst)

Okay. Thanks. I'll hop back in the queue.

Operator (participant)

Thank you, and our next question comes from the line of Patrick Ho with Stifel. Your line is now open.

Patrick Ho (Managing Director of Research Technology)

Thank you very much. Maybe just following off of Tom's question regarding the market environment, Peter posted very strong results in the third quarter, talked about the demand trends. Did you see any potential pull-ins that may have come out of the October quarter? Because traditionally, your October quarter is your strongest quarter of the year. So I'm just wondering whether you saw any of those dynamics that might have boosted 3Q, but maybe at the expense of 4Q.

Peter Kirlin (CEO)

No. In fact, we did not. So we think our fourth quarter, the demand we'll see is maybe endogenous is the word or the right word to use. We do expect to see the mobile market, unlike a typical year, pick up sequentially Q4 to Q1. Likewise, if you look at the market forecast, the same phenomenon is projected for the TV market. The FPD market is very dynamic and very fluid right now. Korea is turning off, as you know, effectively all their G8.5 LCD capacity, being shifted.

The first business for that shift, in fact, we expect to see in the current quarter, at least as far as our one customer's current concern, the shift from LCD to OLED will begin QD-OLED in the current quarter. So we see a bunch of LCD capacity coming offline, shifting into OLED capacity in Korea. That's one dynamic under our feet. Another dynamic under our feet is the bottoming of the demand for mobile displays. The third dynamic underneath our feet right now is the continual turning of the screw of the trade war between the U.S. and China, specifically as it impacts Huawei. I'll say it again, right?

Huawei is not the same household name as Samsung or Apple, but they were the global, not Chinese, but the global market leader in mobile handsets in the second quarter of the year. So you dislocate their product roadmap, and it's going to rattle through the business. So anyways, all three of those factors are moving, and they are not reflective of typical seasonality. So we do not see the second half of the year as typical in its demand profile.

We see this quarter as the bottom, and we see it improving probably even mid to end of this quarter, which we expect to see the market picking up. I will also say that. Frankly, I would also just say again, we ran at capacity in the current quarter. We believe if you take the blend of what the competitors saw, we think they were running at about 70% utilization in the current quarter with the market worsening. So we are pleased with how we're doing.

Patrick Ho (Managing Director of Research Technology)

Fair enough. Maybe as a follow-up question for John, I agree that there's a lot of moving pieces for gross margins. But given that you've got several investments underway for both of your facilities in China, are you confident, at least from an absorption side of things, that they'll get absorbed pretty quickly and not negatively impact gross margins from a fixed cost basis? And what I'm getting there is, again, there are a lot of moving parts, mixed revenues, and all of that. But do you feel confident that the demand prospects will help absorb the new fixed costs that are coming in over the next few quarters?

John Jordan (CFO)

Yeah. Patrick, and keep in mind those new fixed costs are coming in a couple of quarters hence. And as we've related in past calls, we have a mandate to make sure we've got customer commitments before we invest in the new capacity. So we're pretty well assured that as we qualify the new tools, the new lines, there will be demand there, and we'll be able to ramp. I don't want to say quickly, but in pretty good time so that our absorption ramps up commensurately.

Peter Kirlin (CEO)

Yeah. I would add to John's comments, Patrick. Our variable margin drop-through was 48% this quarter. That's sort of kind of, because you've been with us a long time, what you would expect out of our business. So there's, as you said, the way we see it, there's competing efforts, right? One is we're adding fixed costs, but at the same time, we continue to work very hard to pull costs out of the existing business model. And as I said in my prepared remarks, we had positive operating income out of the combined China operations for the first time, period. So the business sort of kind of right now is settling into business as usual, finally. So we expect it to perform like it has historically as we layer on revenues on the top line. I think we're through the knot hole.

Patrick Ho (Managing Director of Research Technology)

Great. Thank you.

Operator (participant)

Thank you, and ladies and gentlemen, this does conclude today's questions and answers at this time. Actually, I do have one question from the line of Gus Richard with Northland. Your line is now open.

Gus Richard (Managing Director)

Yes. Thanks for taking the question and squeezing me in. In terms of the mature IC market, how has pricing in that market been? Is it still on its normal trajectory, or are you seeing any changes?

Peter Kirlin (CEO)

Yeah. No. It's pretty much on its normal trajectory. As we described now, reinforced, the snapback in the mainstream was really foundry logic in Asia. Pricing in that market is really pretty stable. So yeah, there's really nothing out of the ordinary in the mainstream business.

Gus Richard (Managing Director)

Okay. And then in terms of startup activity in China, are you seeing any impact from new companies forming to "de-Americanize" Chinese products?

Peter Kirlin (CEO)

Yeah. I think I mentioned Huawei earlier. We don't really have a first-order effect from Huawei at all. What we see is how Huawei buys affects our customers. That's where we see the de-Americanization and the shift in the business in the semiconductor suppliers that we're selling to. In fact, one of the reasons we see a snapback in our IC business is the de-Americanization of the Huawei supply chain because the ICs are being replaced, but the displays are still the same, right, in the phone. So our customers still see us in China as enabling their mission in life. So as long as that continues, I think we're going to be fine. But we obviously see demand shifting from the U.S. and Europe as a result of that to China, right, in our business. That's how the de-Americanization is presently impacting us.

Gus Richard (Managing Director)

And just for a final bit of color on that point, is that mostly logic? Is it analog? Or can you give any color as to what part of the market?

Peter Kirlin (CEO)

Yeah. It's mainly mainstream is the way I would answer the question. It's mainly mainstream because that's where the sweet spot right now in the capability of China resides, and it's mainstream in its any and all of the above.

Gus Richard (Managing Director)

Okay. So 28 nm and above or 45 nm and above?

Peter Kirlin (CEO)

Yeah. 28 nm we categorize as high-end, so it's 40 nm and above.

Gus Richard (Managing Director)

Got it. Okay. Thanks so much.

Operator (participant)

Thank you. And ladies and gentlemen, there are no further questions at this time. I would now like to turn the call over to Peter Kirlin for any closing remarks.

Peter Kirlin (CEO)

Thank you for choosing to spend some time with us this morning. We appreciate your interest and support. While there are obvious challenges we are facing this year, we are encouraged by our performance and demand trends in our market. 2020 is on track to be another record year for Photronics, but we are working hard to maximize our financial returns to enhance shareholder value. I look forward to updating you as we advance.

Operator (participant)

Ladies and gentlemen, this concludes today's conference call. Thank you for participating. You may now disconnect.