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Ladies and gentlemen, thank you for standing by and welcome to MKS Instruments Second Quarter Earnings Conference Call. At this time, all participants will be in a listen-only mode. [Operator Instructions] I'd now like to introduce to your host for today's conference, David Ryzhik, Vice President of Investor Relations. Sir, please go ahead.
Good morning, everyone. I'm David Ryzhik, Vice President of Investor Relations and I'm joined this morning by John Lee, our President and Chief Executive Officer; and Seth Bagshaw, our Senior Vice President and Chief Financial Officer.
Yesterday after market closed, we released our financial results for the second quarter of 2020 which are posted to our website www.mksinst.com. As a reminder, various remarks about future expectations, plans and prospects for MKS comprise forward-looking statements. Actual results may differ materially as a result of various important factors, including those discussed in yesterday's press release and in the most recent Annual Report on Form 10-K and subsequent quarterly reports on Form 10- Q for the Company. These statements represent the company's expectations only as of today and should not be relied upon as representing the company's estimates or views as of any date subsequent to today, and the company disclaims any obligation to update these statements.
During the call, we will be discussing non-GAAP financial measures, please refer to our press release for information regarding our non-GAAP financial results and a reconciliation of our GAAP and non-GAAP financial measures.
Now, I will turn the call over to John.
Thanks David. Good morning, everyone and thank you for joining us today. MKS delivered strong second quarter revenue of $544 million, above the high end of guidance range. Non-GAAP net earnings were $89 million or $1.62 per diluted share which also above the high end of our guidance range. As we noted on our Q1 earnings call, our second quarter guidance assumed a negative impact to revenue from COVID-19 shelter-in-place disruptions. However, our factory constraints eased throughout the quarter and by working closely with our suppliers we were able to deliver strong results.
I am very proud of our worldwide team and how we continue to manage through COVID-19 challenges without compromising our relentless focus on serving our customers. The COVID-19 pandemic remains fluid and we continue to monitor its impact on our global operations and will respond as necessary. Sales to our semiconductor market grew sequentially driven by all product categories but most notably by our power solutions business. One of the strengths of our surrounded chamber strategy and broad technical expertise is our ability to see technology inflections on horizon and to proactively address these market needs. Several years ago we decided to strategically invest in our power solutions business in order to solve the critical edge challenges presented by extreme vertical scaling.
I am happy to announce that in the second quarter we delivered record revenue in this business. Demand for our market leading pressure measurement solutions was also strong and we secured several design wins on advanced deposition and etch tools. Our plasma and reactive gas portfolio continues to gain traction in atomic layer deposition and advanced wet clean applications. In ALD, we secured two design wins for our remote plasma sources one of which includes a key design win at a leading OEM. We also secured several design winds for our dissolved reactive gas solutions, which are becoming more important in an increasing number of applications for leading edge semiconductor manufacturing.
Our optical components and subsystems are a key strategic growth initiative within our semiconductor market. We see an attractive opportunity to strengthen our optical capability to help solve critical challenges across lithography, metrology and inspection applications. And we are investing accordingly in what we have termed world-class optics. We are very pleased to announce that we have already secured double-digit design wins over the past 18-months. As we look into the third quarter, we expect semiconductor demand to remain healthy. And we estimate our semiconductor revenue to increase sequentially. Within our advanced markets, we experience strong growth in PCB drilling applications offset primarily by lower revenue from certain industrial applications as a result of a softer macro environment and government restrictions on customers whose businesses were designated as non-essential.
As a reminder, within our advanced markets we are especially excited about the long-term opportunity in advanced electronics manufacturing which is a key driver of precision laser-based processes that enable miniaturization and increased functionality. MKS is positioned to be a key beneficiary of these trends given our unique portfolio and expertise across lasers, optics, photonics, motion and laser-based systems. In the second quarter, we secured a meaningful laser design win for a solar application with a key OEM customer and we see continued strong interest in our lasers across PCB display and advanced packaging applications. Moreover, we have secured more than 10 design wins in the first 12-months since introducing our new picosecond UV lasers with several in the second quarter alone. Revenue from our equipment and solutions division exceeded our expectations led by strong demand for our flex PCB via drilling systems.
While unit volume and content are important drivers of flex PCB capacity demand, new requirements also drive technology transitions such as the need for smaller and more accurately placed Vias as well as advanced material specifications for 5G antennas. We believe we are well positioned to address these critical technology transitions with our leading edge capstone flex PCB solution. Testing of our new high density interconnect drilling tool continues to progress as planned. And we have received positive feedback from our beta customers. In fact, we are pleased to announce that one of our beta customers has successfully qualified our HDI tool which represents a major milestone for MKS and a key validation of our HDI technology. As a reminder, 2020 remains a year focused on qualification of our beta tools and we are optimistic we will begin generating meaningful revenue in 2021.
We are encouraged by the overall stability in our advanced markets during the second quarter. And we expect this ability to continue in the third quarter as we project seasonal softness in our flex PCB systems business offset by recovery and revenue from certain industrial applications.
Before I turn the call over to Seth, I would like to comment on the recent changes in export rules announced by the Department of Commerce, which went into effect during May and June. Our global team has completed the work to ensure compliance with the new rules. We have carefully evaluated these regulations and we currently do not expect them to have a significant impact on our financial results. We will continue to monitor and respond to any changes in the regulatory environment as necessary.
And now I'd like to turn the call over to Seth.
Thank you, John. I'll cover our second quarter results then provide additional detail on our third quarter guidance. Sales for the second quarter of $544 million, up 2% sequentially and 15% year-over-year. The strong performance reflects continued strength in our semiconductor market, as well as exceptional efforts in managing shelter-in-place restrictions throughout our worldwide manufacturing and service operations. For the second quarter, semiconductor sales were $321 million, up 3% sequentially and up 50% year-over-year reflecting strong industry fundamentals.
Sales for Advanced Markets were $223 million consistent with the first quarter. As John mentioned strength in advanced electronics manufacturing applications led by demand for our flexible PCB drilling systems were offset by lower revenue from certain industrial applications. In addition, revenue from our research market was consistent with the first quarter levels which were better than we anticipated as demand appears to have stabilized. For the quarter, the revenue split between the semiconductor and advanced markets was 59% and 41% respectively. Second quarter non-GAAP gross margin was 45.3%, a sequential increase of 60 basis points and 180 basis points above the midpoint of our guidance range due to higher volume and favorable product mix.
Non-GAAP operating expenses were $129 million, a sequential decrease reflecting a continued focus on cost control being with higher than anticipated revenue volumes. Second quarter non-GAAP operating margin was 21.6%, a sequential increase of 110 basis points, reflecting strong financial leverage in our operating model. Non-GAAP net interest expense for the second quarter was $7 million and a non-GAAP tax rate which reflects a higher U.S mix of taxable income was 18.5%. Non-GAAP net earnings for the second quarter were $89 million, or $1.62 per diluted share, which exceeded the high end of our guidance range.
In the second quarter, revenue from our Equipment and Solutions Division was $64 million, a sequential increase of 25% through by strong demand for our flex PCB via drilling solutions. We expect revenue from our Equipment Solutions Division to decrease sequentially in the third quarter, reflecting a typical seasonal decline in the flex PCB drilling market. Equipment Solutions' non-GAAP gross margin increased 90 basis points sequentially to 46.5% in the second quarter, driven by product mix and higher volume.
Last quarter, we announced that the integration of ESI acquisition was substantially complete and we had achieved our target of $15 million of annualized cost energies well ahead of schedule. We are pleased to announce that exiting this quarter, we've increased these savings have now realized a total of $17 million of annualized cost synergies.
Now turning to the balance sheet. Exiting the second quarter, we maintain strong balance sheet liquidity with cash and short-term investments of $607 million and $100 million of incremental borrowing capacity under an asset-backed line of credit, subject to certain borrowing base requirements. Our net leverage ratio further decreased to 0.5x highlighting our ability to generate strong EBITDA and cash flow. Also in the second quarter, we made a dividend payment of $11 million or $0.20 per share. In terms of working capital days sales outstanding were 64 days at the end of the second quarter, compared to 65 days at the end of the first quarter and inventory turns were 2.4x compared to 2.5x in the first quarter.
Free cash flow for the quarter was a record at $118 million, or 22% of revenue and included $21 million of capital expenditures. Operating cash flow of $139 million was also a record for the quarter.
I'll now turn to our third quarter outlook. Based on current business levels, we estimate that our revenue in the third quarter could range from $535 million to $585 million. We estimate that our non-GAAP, our third quarter non-GAAP gross margin could range from 44.5% to 46.5%, reflecting anticipated product mix and revenue levels. Third quarter non-GAAP operating expenses could range from $126 million to $34 million; R&D expenses could range from $41 million to $44 million and SG&A expenses could range from $85 million to $90 million.
Non-GAAP net expense estimated to be approximately $6 million and our non-GAAP tax rate expected to be approximately 18%. Given these assumptions, third quarter non-GAAP net earnings could range from $86 million to $108 million or $1.55 to $1.95 per diluted share.
I'd like to now turn the call back the operator for Q&A.
[Operator Instructions]
Our first question comes from the line Patrick Ho with Stifel. Your line is now open.
Thank you very much and congrats on the nice quarter. John maybe first off, you mentioned the gains you've made on the Power Solutions Business particularly for etch applications. Can you detail just a little more color on the types of etch applications that they're in? Are they for like high aspect ratio etches and some of the more complicated processes that we're seeing today?
Hi, Patrick. Yes I'd be happy to comment on that. I think historically we've had a strong leadership in dielectric etch for high aspect ratio at processes that's continued. But in addition to that, we're also seeing meaningful revenue now in conductor etch and so it's a combination of both. Majority is still a dielectric etch for a high aspect ratio etch, but we're seeing both now.
Great. That's helpful and maybe on the Advanced Market side, obviously, the macro economy is having some pressure on some of these industrial markets. Do you believe that that's the only variable that will eventually cause a turn in that business or is there other I guess company specific or industry specific variables that we should be looking out for?
Yes. I think the only other thing I would point out, Patrick, is any kind of trade tensions that either will ease up or could get worse. So that we had noted in the past has affected kind of the advanced markets as well. So that would be an additional one that we always keep an eye on.
Great and final question for me for Seth in terms of OpEx. It's been strong in the June quarter and it looks like it continues to be managed well going into September. Now part of that probably is also less travel and less expenses on some of those types of areas. How do you look at OpEx particularly as the environment starts to normalize somewhat and you get to core back to normal conditions where travel picks up again and things of that nature.
Yes. Good question, Patrick. So our DNA has obviously managed the cost structure pretty diligently no matter what part of the cycle we're on. So there's definitely some savings in the quarter for to your point lower travel. It's also higher compensation in the quarter because we're performing better than we expected coming into the year. So I think those who are net out in the second quarter and Q3 as well. So I would say looking forward there'll be a little back to pre-COVID levels a little more travel but they're really not significant numbers relative to current run rates in the business.
Our next question comes from the line of Krish Sankar from Cowen & Company. Your line is open.
Yes. Hi, thanks for taking my question. I had a couple of them, John. Just wanted to follow up on the power supply, you said you're seeing traction and conductor etch and if you look at the industry incrementally the spending on the memory side is coming from NAND. So that kind of probably ties in with the conductor extraction. So I just want to verify a; is that true? And if that is true, how will your power supply business trend as the memory mix shifts towards DRAM?
Yes. I think so that is true Krish. Some of the conductor etch is being driven by NAND. But I think those kind of customers will also be equally effective or have share when it goes to DRAM. So I think between VNAN and DRAM, I don't expect a large difference. Logic would be probably a different story.
Got it. Well, it's fair enough. And then I don't know if you have good clarity into this, but do you think at some point either in the second half of this year your semi OEM customers might build inventory or do you think they're going to just be on a safer side or do you think they're going to be more pragmatic about it?
Yes. It's tough to say. The history has said that inventory always gets built up after multiple quarters of up and to the right. And I don't really can't comment on what our OEMs are doing at this moment, but it tends to just go that way as people start getting ready to make sure that they have enough material in their factories.
Got it. And then John if you can just squeeze in a question of the non-semi business on the PCB drilling side is the demand still mainly smartphone? Are you seeing other applications? And then in September you said the laser business is going to recover. Do you think that's a cyclical inflection for the industrial laser business or is it too early to call it? Thank you.
Yes. I would say for the flex PCB drilling that's really driven by flex circuits and that is still mostly driven by smartphones, but as we've commented in past other peripheral types of devices like airpods and iPad and things like that are also having increasing their flex content. So I think it's still mostly smartphones but other devices are also driving it. And then with respect to recovery in lasers, as we have talked about it's really about pulse lasers for us versus fiber lasers. And so I think we're just happy with the current status things have stabilized. We're still working very closely with OEM partners there. And that activity hasn't really changed. It's stabilized.
Our next question comes from Jim Ricchiuti with Needham & Co. Your line is open.
Hi. Good morning. Just question on the equipment business, sounds like you're seeing some deceleration there. You've had a couple of really strong quarters. What kind of line of sight do you have in that business as you look out beyond the next quarter or so? Are you seeing perhaps some signs that maybe we're in for a longer pause or do you expect that the bookings to start picking up again?
Yes. Jim, it's John. And I assume you're referring to the semiconductor market, right?
Yes. I'm referring to the flex business, John. It sounds like you've had some couple of good quarters in the year with the ESI business and I know that business can be fairly volatile quarter-to-quarter. But what are you seeing in terms of -- what are you hearing from your customers as you look at over the next couple of quarters?
Yes. I think generally as expected you have some of this discussion in Q1. You see some orders pick up and you see some delivery and then of course Q2 is the big quarter. And so I think that's what you're seeing now. I think if you kind of look at Q3, it's usually goes back down and then it's really determined by whether that smartphone cycle really picks up beyond the expectations of what our customers expect to build today. And so it can actually go back up a little bit or as we expect it will go down. That's really going to be dependent on how popular some of the new models of phones are and whether smartphones in general start picking up in the second half of the year.
Got it. And then on the advanced market side of the business looking at that business again ex the semi-piece you are expecting some recovery in the industrial. It also sounds like; we've heard this from others as well that it's been a little bit more challenging getting into some of the research and labs because of COVID. Are you anticipating that freeing up a little bit as you look out into the second half?
Yes. With respect to research we were expecting that we would have a full quarters worth of limitations on getting into research labs in Q2. And we didn't see that. We actually saw it stabilized relative to Q1 which did see kind of half a quarter's worth of those kinds of restrictions. We're kind of expecting it to be stabilized going forward. Some regions start opening up and some regions may take a little longer. So with respect to research we kind of are planning on it being stable going forward.
Our following question comes from the line of Sidney Ho with Deutsche Bank. Your line is open.
Great. Thank you very much for the questions. My first question is I see that the in terms of the revenue guidance for Q3, I see that the range of that guidance is now back to the more normal levels of $15 million. Is that an indication that you guys feel there won't be much of an impact from the disruptions from either your own operations or your supply chain? And maybe it's just related that how would you characterize your visibility versus the pre-COVID levels maybe in terms of backlog coverage or lead times or whatever metrics you want to share?
Yes. So, Sidney, so you're right we did tighten the range up this third quarter back to pre-COVID levels and you're right. That's indication we feel supply chain operations are much more certainly better shape now than entering the second quarter. So that's and that's why we overachieved in the quarter as well. So that's a true statement. Visibility, I would say it's still very similar. I mean for the semi side of the house we are a turns business so we'll book and turn a lot in the same quarter. That's true in the light and motion division as well. So I think the visibility is similar now as it was before. I think and we said just in prepared remarks in John's section. There's still with COVID-19 a level of fluidity out there that we'll have to be aware of and be cognizant of. But I would say right now nothing uniquely different. Yes, we are seeing visibility now than it wasn't a pre-COVID level.
Great. Lee, follow up to that. Do you think your shipment in Q3 is now reflecting the end consumption by your customers or does that reflect some sort of catch-up demand from the previous two quarters or maybe conversely to ask the same question do you think there may be some inventory built by a customer because last night one of the customers did talk about building some inventory to meet Q3 demand?
Yes, Sidney, it's John. I could take that. I think as we kind of front run our OEM customers so we've shipped a lot in Q2 as we're talking about today. We expect that Q3 will ship even more, slightly more. So I really can't comment on how much inventory they're building versus getting their equipment out. It certainly seems to be a strong market right now and as I said earlier as the market goes up into the right and continues there's always a little bit of inventory build, but we're still kind of in the early innings of the this cycle.
Great. That's helpful. Maybe one last one for me, maybe sticking with the semi side based in the first three quarters including your third quarter guidance. Your semi business will be up 40%-50% year-over-year versus the market is more like up 10% to 20%. I mean we've seen that kind of outperformance before in like let's say in 2017 but that's when WFE was a lot stronger especially for memory. Is there a way to parse out your growth rate this year between market growth maybe a little bit inventory stocking, maybe some market share growth and whether that's from existing product with new products that you guys talk about, the R power the ozone solutions or ALB et cetera. Just try to understand how to think about the difference between your growth and the market growth. Thanks.
Yes. Yes, I'll take a stab at that, Sydney. So you're right we are overachieving versus WFE in the year-to- date so far. And as John mentioned some of that is typically a pre-run on the inventory in a ramp environment. But over the long term we have outperformed the semi market for all the reasons you mentioned. The technology we provide is essential for next nodes and technology application. So in the long term, we do outperform the WFE estimates or actuals in the industry. Just hard to really quantify that in kind of a nine-month cut. So it's really a little bit of a build and a ramp. It's market share gains. It's growth in the power solutions business and we again the long-term outperform WFE. So there are a number of those factors in there. But it's just hard to quantify in kind of a nine-month slice what those pieces are.
Our next question comes from the line of Amanda Scarnati with Citi. Your line is open.
Hi. Good morning. The first question I have is on China and were you seeing any sort of signs of a pulling of demand ahead of these commerce department regulations taking place? I know you said you're not seeing any sort of material impact from the regulations themselves. But do you think any of your customers were kind of taking a little bit more of a cautious approach.
Yes, again it's John. Yes, we look at that all the time and there was always a little variation but we have certainly not seen any kind of a large move in that kind of direction. We talked to a lot of these customers all the time. We still think they're ordering for what they need and not trying to pull in. So that's kind of our view today for our business in China.
Great and then on the PCB side of the business, can you just help me understand the seasonality in that business? We look at sort of 3Q for smartphone suppliers for chipsets that typically tends to be a stronger seasonal quarter and we're certainly seeing that in guidance coming up this quarter. But you're calling for some seasonally down September quarter. Can you just talk about how that transition works in the PCB side of the business for you?
Yes. I think it's easy to explain. I think our customers are the people who need tools, our tools to make PCB and so of course as you pointed out the smartphone makers need their parts in that Q3 time frame, which means that the factories that make those parts have to have that equipment in kind of in the Q2 time frame. So that's really kind of how we look at that quarterized chip difference between when our PCB equipment sales goes up versus the industry-wide chip revenue for smartphones goes up. Does that make sense?
Yes. It does and then the last question I have if I could squeeze it is on the power side of the business. Are you starting to see any significant growth from logic and boundary? I know you mentioned that you are starting to get some conductor etch stuff there? Is there any growth that you're seeing from there? Is this sort of expected for maybe 2021?
As I mentioned earlier the growth and power for conductor etch I think that's your question is still mostly memory driven at this point for us.
Our next question comes from the line of Joe Quatrochi with Wells Fargo. Your line is open.
Yes. Thanks for taking the question and congrats on the solid results. Maybe first if you could kind of talk about the 10 picosecond laser wins that you've had. How should we think about the timing of a ramp of revenue for those over the next few quarters?
Yes. Joe, I'll take a crack at that. I think a lot of these design wins for lasers can turn into the volume revenue quite quickly actually. It just depends on the various customers and so it's hard to kind of expect that but it's certainly not in the kind of time frame for like semi-design wins where it could be a couple years before you see volume. These can actually turn within 6 months to 18 months. I think that's kind of the sweet spot. Some could be longer and some could be even quicker. I also wanted to clarify a little bit when we say we saw some industrial markets that were a little weak in Q2, it wasn't it the lasers. So our laser business has been actually very consistent and strong.
That's helpful. And then on the semi side, you talked about securing a number of wins around optics over the last 18-months. Can you talk about what's driving that? And just is that an area of investment going forward that maybe we should think about a larger focus on?
Yes. Joe thanks for the question. I think that is an area of focus for us. So those 18 or those design wins over the last 18-months were all, we only count the ones that we won because of the investments we made that were different from before. So we had other design wins but that was with our previous technology. So we actually invested in new technology processes, new capabilities and process engineering talents. And so they're very specific investments we made and at MKS we like to keep track of things. So that investment is really tracked towards these design wins. And so basically we're expanding our capabilities so that we could serve those customers with capability we were not able to before and so that's really exciting for us.
Our next question comes from Mark Miller with Benchmark Company. Your line is open.
Congratulations on your quarter and the guidance, it's impressive. I just wanted to talk a little about the margins. The margins came in upside to the guidance by about 180 basis points you indicated mix and volumes. In terms of mix specifically what drove the higher than expected margins? Was it power solutions?
I would say, Mark, in general the volume is a lot higher than we expected. That's the number one drive in terms of normal margins. To your point we usually see about a 50% variable gross margin and this quarter is more I think in the 80% range sequentially versus Q1. The factories are running more efficiently now because we work through a lot of supply chain constraints with COVID-19. That's a big factor and then we mentioned in the prepared remarks the E&S division the flex PCB market, those margins were north of 46% to corporate average. And so that's kind of mix we're talking about in that one example. So it's volume, it's efficiency in the factories and it's E&S division had a real strong margin quarter as well.
Just interested about the pursuing this PCB drilling strength and especially with smartphones kind of depressed. I'm just wondering where that's coming from specifically?
Yes. Mark, it's John. Even though volumes for smartphones is depressed relatively speaking the flex content some of the more advanced phones can be significantly higher per unit. And so that's kind of what's driving I think this but even though smartphone numbers are depressed. It's still large numbers and so the capacity is still needed in the industry. And so those two drivers that's content per unit as well as just the fact that it's just a lot of units even though it's less than what people had expected.
As the industry starts to transition to 5G phones, what opportunities that does that create for you?
Yes. I think we've talked about in the past. We think that in certain 5G phones the amount of flex content could be 30% more than in a 4G phone. And that's a huge amount of opportunity for us for flex PCB drilling. So that's how we look at 5G but more broadly 5G also drives more memory content both FLASH and DRAM. It certainly drives more advanced processing CPUs and so 5G and that trend towards that certainly drives our flex PCB business the E&S division; it drives our chip division in the VNA division because of those three types of chips. It also drives our light motion division because 5G phones many are going to OLED and we have a lot of laser processes that are used for manufacturing displays. We also have a lot of lasers that are used for manufacturing. Some of the very small components within the next generation smartphones that aren't just flex.
Are you starting to see some traction coming from 5G or expect more of that later this year?
That's hard to tell because when somebody's ordering a flex tool, we assume they're making some 5G phones and some non- 5G phones but we certainly don't have that visibility. We do read the industry where 5G phones might be something like 200 million units I guess this year. So that's a good hit -- tailwind for us.
Thank you. And I'm not showing any further questions at this time. I'd now like to turn the call back to John Lee for any further remarks.
Thanks everybody. So I'm very proud of the passion, dedication and resilience of our employees around the world. Needless to say 2020 has had its share of challenges thus far. But I could not be more proud and excited about the future of MKS. So thank you for joining us today and for your interest in MKS.
Ladies and gentlemen, this concludes today's conference call. Thank you for your participation. You may now disconnect.