Onto Innovation Inc

NYSE:ONTO

Earnings Call Transcript 2023-Q2

[Operator]

Good day and welcome to the Onto Innovation First Quarter Earnings Release Conference Call. Today's conference is being recorded.

At this time, I'd like to turn the conference over to Mike Sheaffer, Investor Relations. Please go ahead.

[Mike Sheaffer]

Thank you, Cynthia. And good afternoon, everyone. Onto Innovation issued its 2023 second quarter 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 Plisinski, Chief Executive Officer, and Mark Slicer, Chief Financial Officer.

I would like to remind you that the statements made by the 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 Onto Innovation's results, I would encourage you to review our earnings release and our SEC filings. Onto 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 we specify otherwise. 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 Plisinski. Mike?

[Michael Plisinski, Chief Executive Officer]

Thank you, Mike. Good afternoon, everyone. And thank you for joining our call today. I'll begin with shipment timing of shipments for three lithography tools which impacted our second quarter results and third quarter guidance. All three tools were for a specific customer and scheduled to ship near the end of the second quarter. During the quarter, we accepted a customer request for specific enhancement package to be added to the tools in manufacturing. We estimated this could be installed and tested in the quarter, but ultimately the full verification took longer than planned. The customer has since approved this new functionality and the tools are included in our outlook for the third quarter.

In aggregate, the second quarter revenue and third quarter outlook remains consistent with our prior guidance of just over $400 million for the sum of those two quarters. This reflects the weak demand from our advanced nodes customers, being offset by strong power semiconductor revenue and the more recent resurging demand for our Dragonfly inspection systems to support heterogeneous packaging and high bandwidth memory customers. In fact, we expect this specific demand to drive more than $90 million in revenue over the next three quarters. I'll provide additional details about our outlook in a few minutes, but first let's dig a little deeper into the second quarter.

We'll start with our specialty and advanced packaging customers where revenue from this customer group grew by over 20% from the prior quarter. Revenue from our power device customers grew over 35% and included our product portfolio of inspection metrology and software solutions. This was our largest market in the quarter and, in fact, revenue exceeded total power device revenue in all of 2021.

Building on this demand, in the quarter we announced the intent to expand our metrology portfolio with the release of Element S material metrology and Atlas S OCD metrology, each specifically designed to address challenges in the compound semiconductor manufacturing.

We've already secured orders for these tools and shipments will begin in the fourth quarter. With these additional products, we believe we are positioned to address an estimated 80% of process control steps in this high growth market, which is estimated to require 10 times the current volume of wafers by 2030.

In advanced packaging, we delivered over $20 million of inspection systems to customers ramping heterogeneous packaging lines to support growing end market demand for high performance compute. The flexibility of our Dragonfly systems switch integrates sub-micron 2D defect detection 3D metrology and our unique Clearfind capability into a single system is proving to be a powerful tool for the heterogeneous packaging applications used in high performance compute. For example, Clearfind technology is able to detect residue on die to die or die to substrate interconnects and ensures good die bonding, while our 3D metrology sensors provide critical stack height information and coplanarity data for the package. This metrology is proving essential to controlling yields and is leading to higher attach rates.

In sharp contrast, revenue from our advanced nodes customers declined 43% in the quarter. However, even as capacity buys wane, R&D investments have continued. And in the second quarter, we were pleased to see further proliferation of Iris films when it was successfully qualified by a top 3 DRAM manufacturer in the quarter.

In addition, we delivered several Atlas OCD systems to two customers for gate-all-around applications. We believe that declines in advanced nodes will reach a bottom in the third quarter, with strong demand in specialty and advanced packaging continuing in the second half of the year.

Before moving to our outlook for the third quarter, Mark will now cover the financial results for the second quarter.

[Mark Slicer, Chief Financial Officer]

Thanks, Mike. And good afternoon everyone. As Mike highlighted, we closed the second quarter with revenue of $191 million, down 26% over the same period last year, and below the second quarter guidance range of $195 million to 203 million due to the shift in timing of the three JetStep systems Mike commented on.

Despite the lower revenue, we did achieve an EPS of $0.79 for the second quarter, within our EPS guidance range of $0.75 to $0.90. The revenue decline from the same period last year is primarily due to the decline in our advanced nodes business, which had revenue of $38 million and represents 20% of revenue.

Specialty device and advanced packaging revenue of $112 million represents 69% of revenue and software and services had revenue of $41 million, which represents 21% of revenue.

We achieved 53% gross margin for the second quarter, exceeding our guidance range of 50 to 52%, driven by the favorable mix, shipping fewer JetStep systems and seeing an initial favorability due to our supply chain optimization efforts.

Second quarter operating expenses were $59.9 million, within our guidance range of $58 million to $60 million. We are still executing to our cost reduction activities. However, we have continued to maintain a slightly higher level of investment in R&D initiatives, as Mike mentioned, aligning to R&D engagements in planar films and power semiconductor applications.

Our operating income of $41 million was 21% of revenue for the second quarter, compared to 29% from the prior year. Our net income in the second quarter was $39 million or $0.79 per share.

Now moving to the balance sheet, we ended the second quarter with cash and short term investments of $610 million, an increase of $62 million from the start of the year, with operating cash flow of $31 million within the quarter, representing 17% of revenue for Q2.

Inventory ended the quarter at $352 million, an increase of $14 million. We continue to actively manage down our inventory levels across the network. However, we had increases in lithography and services inventory within the quarter. We are projecting a decline in Q3 and are now targeting to be between $275 million and $300 million by the end of the year.

Accounts receivable decreased $22 million to $188 million in the quarter, and our days sales outstanding decreased 6 days to 90 days. With our inventory reduction goals and focus on cash collections, we expect to return cash flow to consistent performance of over 20%.

During the quarter, we did not execute any share repurchases. We have $32 million remaining under our existing $100 million authorization.

Now turning to outlook for Q3, we currently expect revenue for the third quarter to be between $205 million and $225 million. We expect gross margins will be between 50% to 51%, primarily due to lower advanced nodes revenue, which typically carries higher margins above our corporate average, as well as the shift of the JetStep systems built in Q2 now shipping in Q3.

For operating expenses, we expect to be between $57 million to $59 million. For the full year 2023, we expect our effective tax rate to be between 14% to 16%.

We expect our diluted share count for Q3 to be approximately 49.4 million shares. Based upon these assumptions, we anticipate our non-GAAP earnings to be between $0.85 per share to $1.05 per share.

We are making progress towards reducing our fixed cost structure by optimizing our supply chain and manufacturing sites, while maintaining our strategic priorities and several R&D programs and ensuring our ability to deliver financial performance in line with our long term operating model.

The team has made significant progress to date, expanding our second shift to drive higher absorption of fixed costs, while improving cycle times and outsourcing several non-core sub-assemblies to global supply chain partners.

We have set aggressive but achievable targets with our global partners, consolidating our supplier base by greater than 50% over the next two years, while also simplifying our key components, such as moving to a common automation system, which will drive a 25% cost reduction and as part of our identified savings for 2024 and 2025, as highlighted during our recent Analyst Day.

With that, I will turn it back to Mike for additional insights into Q3 and the remainder of 2023. Mike?

[Michael Plisinski, Chief Executive Officer]

Thank you, Mark. As Mark mentioned, we expect the third quarter to be up 18%, reflecting an increase in both process control and lithography revenue over the second quarter. Expected increase in process control revenue is mostly driven by capacity expansions and higher process control intensity to support heterogeneous integration of GPUs and high bandwidth memory.

Combining these two powerful technologies into a single package is enabling customers like Nvidia to supply the specialized compute platforms to support the growing demand for large language model applications by hyperscalers and corporate enterprises. These assembly processes are more complex. And with multiple die becoming a single package, the impact to yield of a single interconnect failure is much higher. The proven ability of our Dragonfly G3 system to reliably monitor for these failures is driving the projected increase in demand of over $90 million in revenue, which we mentioned earlier.

We also project demand for our portfolio of products supporting power semiconductor customers to remain near current record levels. We still see headwinds in the advanced nodes, primarily from DRAM manufacturers, and we expect revenue to decline again in the third quarter, which we believe will mark a bottom for front end memory overall.

We're optimistic for a possible recovery in the second half next year as customers like Samsung are beginning to talk about the launch of new smartphones and PC promotions in the second half of 2023 being a catalyst for customer inventory reductions going into next year.

In summary, we see strong demand for our products to support power semiconductor device manufacturers and heterogeneous packaging in both wafer and panel substrates. In these markets, we believe our portfolio of connected solutions provides differentiated value, further contributing to the adoption rate we're seeing.

In the advanced nodes, though spending is down significantly this year, our customer collaborations are resulting in new tool of record positions for our Iris planar films metrology and integrated metrology, while progressing the capability of Atlas OCD metrology to new applications and more challenging transistor geometries. We expect these new product positions should lead to higher wallet share when investments resume in the advanced logic and memory markets.

At the same time, we're implementing the structural improvements to operations and supply chains that should result in a stronger financial foundation as we close in 2023 and prepare for the new year.

I'll now turn the call over to Cynthia for questions from our covering analysts.

[Operator]

[Operator Instructions]. And we will take our first question from Charles Shi with Needham.

[Charles Shi, Needham & Company]

Mike and Mark, really just want to start out with some of the commentary around heterogeneous integration and high bandwidth memory. So on high bandwidth memory, can you kind of provide us a little bit further outlook beyond what you think the $90 million over the next three quarters? Do you think high bandwidth memory, the wafer starts is going to grow? In what kind of fashion? Is it like more linear as some other management team seems to believe or you think it's going to be a much higher growth? Any indication from our customers on high bandwidth memory will be great.

But then a related question really is about – very specifically about CoWoS. I know heterogeneous integration probably cover a lot of stuff, not just about CoWoS, but specifically on CoWoS, was how much opportunity you're seeing today? Can you quantify for us?

[Michael Plisinski, Chief Executive Officer]

I'll answer the last one first. Regarding CoWoS, when we talked about heterogeneous integration specific for AI, I think it's pretty clear that, for instance, Nvidia who's driving a lot of this is tied to TSMC and CoWoS. So that's a fairly significant driver for us and for that $90 million that we mentioned.

As far as HBM and the growth overall, what we're seeing is a pretty rapid increase in demand right now. Part of it is capacity expansions. Part of it is, I think, a little bit of process control intensity increase. Certainly, that's the case in the CoWoS area. So it's hard to say how that rapid increase continues into 2024. We certainly expect additional orders in 2024. And we're already having some of those discussions beyond the first quarter. But is it going to continue on this rapid trajectory, this rapid growth trajectory? Or will it start to slow down, that's going to remain to be seen and a lot will depend on how quickly, I believe, the enterprise customers adopt AI and these large language models for applications internally.

[Charles Shi, Needham & Company]

Can I ask a second question. Maybe advance nodes, you said advanced notes, you believe it's bottoming in Q3. Can you clarify a little bit more because advanced nodes for you guys is not just about memory, but also advance foundry logic. Between these two, I think you said memory is bottoming in Q3, but what about advanced foundry logic ? Can you clarify if I heard something wrong?

[Michael Plisinski, Chief Executive Officer]

I think what I was talking is, overall, we think the bottom is there primarily from DRAM, so DRAM has been the biggest drop. Advanced logic has been a little more stable. And we've seen that have less of a big impact on our advanced nodes trajectory. So we do think advanced notes – do we know if logic is going to snap back right away? No, but we do see several new fabs being built, everybody's aware of Samsung in Taylor and TSMC, Arizona, and opportunities at Intel as well. We continue to see and seed pilot lines and delivery systems as those fabs are being constructed and starting to take some initial systems. But we have also seen the construction delays announced by several of these manufacturers. So do we hope for some growth in the second half next year? For sure. But we're already starting to see that plateauing on advanced logic, as it is. So DRAM is the big change.

[Charles Shi, Needham & Company]

I see. The DRAM comment, is it more on the HBM related – reaching that inflection point, is that the mainly the HBM being the driver? Or do you see the standard DRAM, maybe the CapEx is also seeing some inflection point? Just want to ask a little bit more on that DRAM comment.

[Michael Plisinski, Chief Executive Officer]

Yeah, I think it's certainly the more common DRAM that's driving the drops we're seeing. HBM is great and it's great for our packaging business, and it's picking up some DDR 5, 4, but it's not enough to make up for PCs and smartphones that are down. So, DRAM overall is impacting us because of the vast rest of the market outside of high performance compute.

[Operator]

We'll take our next question from Craig Ellis with B. Riley Securities.

[Craig Ellis, B. Riley & Co.]

I just wanted to see if I could start with you, Mike, and look beyond the calendar third quarter because it seems like with the panel litho shipment timing issue that we will have these three and maybe more tools. So I was hoping you could clarify how many tools we'll rev rec in the third quarter there? And then from there, can you just talk about the gives and takes for fourth quarter revenue, not looking for specific guidance, but just want to understand how the gives and takes play out as we exit the year?

[Michael Plisinski, Chief Executive Officer]

It's actually a continuation of what we're guiding in the third quarter. So we see power semiconductors for the fourth quarter remaining fairly strong, demand there is strong, we're going to introduce the new tools. That will help a little bit, but that is more a driver for 2024 in the power semiconductor space.

And then heterogeneous packaging, our support specifically for AI devices, i.e. Nvidia and some of the 00:20:08 and HBM that were mentioned, that we can see continuing to strengthen straight through the year. So those are the positives. Obviously, the litho will remain sort of stable and continue once we catch up with the with the shift here with the three tools.

And then the advanced nodes, that's the tailwind. So as I look at Q4, it's a lot of the same stores, real strong in heterogeneous packaging, real strong in power, advanced node is a bit of a tailwind.

Overall, we expect to be similar levels of guidance for the fourth quarter. We'd expect it to be around the same.

[Craig Ellis, B. Riley & Co.]

Mark, I'll follow up with you. So, the company had a program for optimization, and I think, just more careful expense management. And that was about $27.5 million. At the Analyst Day, there was a $25 million program that was announced. Can you just help us understand to what extent are benefits from those programs factored into the third quarter's guide? What does it mean for the exit level of gross margin this calendar year? So, where can gross margin be in the fourth quarter? And then how much of the benefit of those two programs do we see hit in gross margin and OpEx next year?

[Mark Slicer, Chief Financial Officer]

Let me start with the – coming off the analyst day and the comments around the $25 million of optimization in 2024 and 2025, that activity, we're executing now. Obviously, we haven't seen – the bulk of those savings are expected to be in 2024 and 2025. We are, as I commented in my prepared remarks, seeing some of that now and some slight shifts of suppliers and things like that. So we're still focused on that.

I think for Q3 and Q4, we still have a lot more work to do. Certainly, we have seen some savings and operating expenses, as it relates to taking costs out and offsetting the kind of annualization year-over-year. Certainly, in the back half, we're focused on that, those continued reduction plans. The Q3, we do have, certainly, some of that continue to be baked and where we are from a gross margin and OpEx standpoint.

I think as we look at the decline in advanced nodes, fortunately, we have programs in place right now. We're looking and executing even further reductions in Q3 and Q4 as we look towards that decline, and making sure that we can continue to drive gross margin accretion back up above the 53% to 54%.

Our goal from a full year perspective is still to target that 53% to 54% and align to the long term operating model of getting back to 55% plus longer term. So, that's our target.

[Craig Ellis, B. Riley & Co.]

So, that would imply that you should be at least 54% in the fourth quarter to get to 53% to 54% for the full year, Mark?

[Mark Slicer, Chief Financial Officer]

I won't comment on it specifically, but I think from where we are and trying to figure out what the business will be in Q4, I think our goal is obviously to continue to drive that – target 53-plus in Q4.

[Operator]

We will take our next question from Brian Chin with Stifel.

[Brian Chin, Stifel Financial]

Maybe start with Mike, I think you have really good, strong visibility on the packaging and specialty side of the business. Visibility is clearly not great in terms of the advanced nodes. But would you characterize the level of not just DRAM, but also memory investments, including non-volatile memory? Does it feel like it's below sort of normalized kind of maintenance or even sub maintenance levels at this point? Does that give you some of the conviction in saying that Q3 looks like a bottom right now?

[Michael Plisinski, Chief Executive Officer]

Meaning couldn't go lower. It is pretty low. I don't know if I've ever seen this much of a drop for this long of a period of time. So, yeah, I think that – then you're starting to hear from our customers as well that they're beginning to see signs of price increase and inventories are coming down and that kind of thing. So, yes, we're below maintenance levels. And when it recovers, I don't know. But I'm not expecting a very quick snap back. We're not planning for that. That'd be a nice surprise. But right now, that's why we're saying we expect Q3 to be the bottom.

[Brian Chin, Stifel Financial]

Lithography has always been a bit bumpy and a bit lumpy for you guys. But it sounds like – obviously, you take the three units. If you parked them in 2Q, you're kind of revenuing up. And you've taken out of the third quarter guidance, you're kind of flat. But given that dynamic and you maybe – you shipped six tools in 3Q, that kind of flattish preliminary fourth quarter outlook, is that really saying that the X500 lithography ships maybe back to normalized levels, maybe down a few units Q-on-Q and then you make that up with some of the growth that you're seeing in the other businesses?

[Michael Plisinski, Chief Executive Officer]

Yeah, we think that the litho will be – it depends a little bit on timing because we're trying to catch up on things. So there may be one or two tools that would move forward into the first quarter. But it was more or less normalized at that $20 million or so that we've always talked about. So $20 million, $25 million revenue.

[Brian Chin, Stifel Financial]

Just framing up sort of specialty business where that's a synergy you've talked about in terms of technology and customer synergies. And I think you'd expect to bear more fruit this upcycle than kind of what you're able to progress on last upcycle. So if you look at kind of calendar 2022 and already you're having some pretty good run rates on the specialty side of the business, how much larger in three years could that specially revenue for you guys be relative to the counter 2022 year when you guys were at $1 billion and that was going to be a smaller amount of the revenue contribution to $1 billion? How much bigger could specialty be in three years, say?

[Michael Plisinski, Chief Executive Officer]

Compared to current level, it depends on spending from the customers, right? So the estimate out three years is always tough, but I can say that our adoption rate is only beginning. So we're just winning new customers. I think we added five new customers in the quarter. So those are just initial sales by a couple of tools. And there's going to be repeat sales as they continue to grow. And every one of those customers is a potential to sell more of the portfolio. So we have opportunities to not only continue to add customers, but continue to grow our portfolio within the customers. So if we're looking at where we end up for this year, I wouldn't be surprised if we could double that revenue in three years given the growth dynamics in the industry and given our positions and the new products we're releasing and the value that we're delivering with these connected solutions, these integrated portfolios to solve unique problems.

[Operator]

We'll take our next question from David Duley with Steelhead Securities.

[David Duley, Steelhead Securities]

As far as high bandwidth memory goes, could you just talk about how much more inspection and intensive it is versus just a standard DDR 5 product?

As my second question, as far as your advanced nodes business goes for calendar 2023, how much would you expect the memory business to be down and how much would you expect the foundry logic to be down?

[Michael Plisinski, Chief Executive Officer]

Again, I'll start with the last one. For 2023, I don't have the numbers directly in front of me, but I would expect memory to be down probably double what logic is down. Doesn't help you too much, but I don't know if logic might be down 20%. DRAM memory might be down double that, 40%.

As for HBM and the attach rates, the process control intensity versus normal DRAM, it's a good question. The number of applications, so I would say it's two to three times more, process control intensive, at least for our applications, on our Dragonfly, than normal DRAM and DRAM packaging. And that's because of the layers and the amount of metrology and inspection involved in preparing these die to be stacked and to be connected to either die in the stack. So there's a lot more metrology coinciding with our inspection in order to make those packages yield.

And the metrology is on our inspection tool, so that drives the utilization of our inspection tool, it's all integrated, just not to add any confusion.

[David Duley, Steelhead Securities]

As far as high bandwidth memory goes and your outlook there, I'm assuming that's just what the one lead DRAM manufacturer. I don't really think the other guys have a lot of product in the marketplace at this point. Is that the way to look at it? Or are you working with more than one guy in high bandwidth memory?

[Michael Plisinski, Chief Executive Officer]

We're working with more than one, but one certainly dominates more than the other.

[Operator]

We will take our next question from Vedvati Shrotre with Jefferies.

[Vedvati Shrotre, Jefferies LLC]

I guess I wanted to ask about the packaging a little bit more. So you talked about the $90 million opportunity over three quarters, is that more towards HBM versus like a CoWoS capacity? Can you characterize kind of what the split is between heterogeneous integration versus HBM?

[Michael Plisinski, Chief Executive Officer]

Yeah, I would say 60/40. So a lot of it is on the logic side. So CoWoS and, say – and then the rest on the HBM.

[Vedvati Shrotre, Jefferies LLC]

For my follow up there, you have TSMC talking about doubling their CoWoS capacity, Amkor is sort of tripling their 2.5D capacity. So how should we think about – like, how does this translate into a revenue opportunity for you? Is it like a direct link of doubling capacity means doubling revenues for you? Or how does that equation work?

[Michael Plisinski, Chief Executive Officer]

So far, it looks that way. There's a very high attach rate of what we're seeing. Right now, that would be how I'd model it. If yields improve and they start to drive, let's say, a normalization and an optimization, they may reduce the process control, but if anything, we're seeing an increase in process control as they're trying to improve yield, and that's why I mentioned the increase in process control intensity. So we think maybe even – since the beginning of the year till now, maybe 20% or more increase in process control intensity on the logic side, so heterogeneous packaging on the logic side [indiscernible].

[Vedvati Shrotre, Jefferies LLC]

If I think about what your install base was in 2021, 2022 for like a Dragonfly inspection tool, most of that was for kind of smartphone markets where they do [indiscernible]. How is the fungibility of those tools? Like, as the utilization is low on maybe smartphones, are they fungible? As in, can they be used from in an info process to a CoWoS process? Is that a possibility? Or do you need a different set of tools or different concepts?

[Michael Plisinski, Chief Executive Officer]

Generally, they're in different lines. So it's the tools that have to be moved. And the tools are configured very differently for your traditional fan out or just traditional bump. The amount of sensors and the capabilities like Clearfind, which is another option on our tool, those are all required for the HBM and for the heterogeneous – the logic side. So it's not really fungible. We haven't seen anyone trying to move our product, our existing tools into those lines. It's all new tools.

[Vedvati Shrotre, Jefferies LLC]

So does that mean that gross margins sort of end up higher when you're addressing, like, a CoWoS HBM application versus what it was historically?

[Michael Plisinski, Chief Executive Officer]

I believe so. But we'd have to get back to you on that.

[Operator]

We will take our next question from Mark Miller with Benchmark.

[Mark Miller, Benchmark Company LLC]

The $90 million volume purchase order for process control, how does that order ship in terms of the third and fourth quarter? Is it equally divided or is it going to be more back end loaded?

[Michael Plisinski, Chief Executive Officer]

That we're working on. So, we're projecting the $90 million. And when it's finalized with the customers, we'll be able to provide clarity on the rollout of that and the follow on, the size of the follow-on additional orders we expect. But I would expect Q3 to be a little lighter, Q3 and Q4 and Q1 to be maybe semi equal between that ramp.

[Mark Miller, Benchmark Company LLC]

To date, you've announced 18 power customers first time orders. Any new power customers this quarter or the June quarter?

[Mark Slicer, Chief Financial Officer]

We had five new power customers this quarter.

[Operator]

And there are no further questions at this time. I will now turn the conference back over to Mr. Sheaffer for any additional or closing remarks.

[Mike Sheaffer]

Thanks, Cynthia. Just a quick reminder for everybody about three upcoming events. First, Onto management will be participating in the Needham Semi Cap Virtual Conference on August 23. Second, we'll be participating in the Jefferies Semi Conference in Chicago on August 29. And third, we will be at The Benchmark Conference in New York City on September 13. Thanks again for joining us today. A replay of the call is going to be available on our website about 7:30 Eastern Time this evening. We'd like to thank you for your continued interest in Onto Innovation.

Cynthia, please conclude the call. Thank you.

[Operator]

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