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Intrinsic Value is all-important and is the only logical way to evaluate the relative attractiveness of investments and businesses.
Ladies and gentlemen, thank you for standing by. Welcome to the Nova Measuring Instruments Ltd. Second Quarter 2018 Results Conference Call. Today's conference is being recorded.
At this time, I would like to turn the conference over to Miri Segal of MS-IR.
Thank you, operator, and good day to everybody. I would like to welcome all of you to Nova Measuring Instruments' second quarter 2018 financial results conference call. With us on the line today are Mr. Eitan Oppenhaim, President and CEO and Mr. Dror David, CFO.
Before we begin, may I remind our listeners, that certain information provided on this call may contain forward-looking statements, and the Safe Harbor statements outlined in today's earnings release also pertains to this call. If you have not received a copy of the release, please view it in the Investor Relations of the Company's Web site.
Eitan will begin the call with a business update, followed by Dror, with an overview of the financials. We will then open the call for the question-and-answer session.
I'll now hand over the call to Mr. Eitan Oppenhaim, Nova's President and CEO. Eitan, please go ahead.
Thank you, Miri. I'd like to thank you all for joining our second quarter 2018 financial results conference call. I'll start the call today by speaking briefly about our second quarter results and performance highlights. I'll then conclude by providing guidance for the third quarter of 2018. Following my commentary, Dror will review the quarter's financial results in detail.
We are very pleased with the second quarter results which reinforce our continuous efforts to execute on our strategic growth plan, diversify our customer base, and technology offering. Revenue for the quarter were at the higher end of our guidance with GAAP and non-GAAP profits exceeding our guidance. This result highlight the progress we are making with our dimensional and material metrology solutions across the different semiconductor fabrication segment with notable strength in memory.
Our growing value creation, specifically in light of the current business environment, is emphasized by our increasing position in the front end semiconductor supply chain. Our effort to expose the company to the main robust industry growth engine are well reflected in our quarterly results with solid achievements in memory, China, advanced 5 and 7-nanometer Logic, and new emerging process control applications.
As a result of our performance in the second quarter, our revenues for the first half of 2018 represent approximately 13% growth year-over-year and in line with our target to continue our annual growth trajectory in 2018 as well. As we detailed in length, during our Investor Day last month, we continue to effectively materialize our strategic vision to expand our markets, customers and technology. This is reflected in our balanced revenue mix, which was driven by significant inroads we are making in the memory space.
Memory customers contributed approximately 50% to our overall product revenue. Our relentless efforts to enhance our partnership with leading customers, in the five large customers this quarter, three of which are leading memory providers in Korea and China. This unique mix expand our opportunity base for 2019 when both sectors should return to expected spending levels.
We are very encouraged by this progress as the company continues to achieve solid results, despite the current business environment. Notably, in 2014 the company's revenue from foundry customers accounted for more than 80% versus 65% in 2017 and forecasted of 65% this year.
Besides our growing penetration to all six memory customers, our biggest achievement is the ability to take share in the most complicated application, which currently can't be sold just with the traditional OCD, which was the common solution. We could do that only by introducing unique coupled hardware and software solutions as well as combination of X-ray and optical technologies. Our benefits here is that while metrology, intensity and memories increased, it's not necessarily implied for increased available market for the traditional methods and the in-depth environment we prevail.
Additionally, our expectation for increased foundry spending in the next six months for the most advanced Logic node below 7-nanometer are starting to come through with initial orders that are in outcome of a selection process that took place recently for all our materials and dimensional newly introduced models. We expect, we could start generating growing revenues in Q4 and onwards.
Our strategic plan to diversify our source of revenue beyond device type is also evident by the continuous change in the geographical revenue mix. China continue to contribute around 40% of overall product revenue this quarter with significant wins in two domestic leading foundry and 3D NAND customers. In our view, although we may see a transition period, while local Greenfield establishment move from R&D stage to high-volume production, we still envision China as a significant sustained driver for our long-term growth.
In addition to our efforts to widen our customer base, we're encouraged by the market reception of our new technological innovation. We see growing adoption of our newly launched metrology solutions where all of our recently launched products, the i550 integrated metrology, T600 NMSR standalone, VeraFlex III plus XPS and the Nova Fleet software engines are all generating revenues and creating value in a growing number of applications.
In that respect, and in light of our elevated R&D spending, we are also satisfied by the growing anticipation and the initial reaction to our next-generation products. We believe that the combination of the broader customer base along with a differentiated technology will present a larger market for us to pursue as early as 2019. One of the major goals of our $300 million strategic plan is to continue maintaining our efficient and controlled financial model, which can accommodate elevated investment in R&D and still support our long-term profitability targets.
As previously discussed in both our Q1 earnings call and the Investor Day, we intend to increase our R&D spending this year to accelerate our innovation and introduce new breakthrough technologies in 2019. Our expected R&D spending support our long-term growth vision by investing in our core differentiators which allow us to bring unique and competitive solutions to the market.
Our product rollout is on track and expect -- expected to expand our available market in approximately $150 million to $200 million starting from 2019. Since the acquisition of ReVera in 2015, the company changed its value proposition to deliver a holistic solution to its customers, combining both materials and dimensional metrology solution.
We believe then that in order to improve the vast performance, materials engineering will become one of the toughest challenges in the most advanced nodes. To continue improving semiconductors, scaling and architectural changes would not be sufficient and introduction of new materials would be unavoidable. This shift would require more control than move new metrology methods from the lab into the production environment.
Analyzing our performance in this area reveals continuous growth in our materials metrology revenue year-over-year. As a result of this infliction point, semiconductor manufacturers introduced new materials and new combinations of Nova materials which are essential to improve performance in IN [ph] logic and memory devices. This growing trend along with continued growth in revenue contributions from our materials portfolio, we affirm our vision that advanced metrology used to control materials performance will continue to be a significant growth engine in the coming years.
To support this anticipated growth, our materials metrology solution has been installed in all major memory and logic customers. This advanced solution control material variation along the publication process measuring in line and in dye structure through the production step. As a result of this trend, we believe that the materials metrology overall available market will double itself in the next 3 to 5 years. In this growing market, we are adding application on a daily basis with some of them can be sold only by our XPS solution, which is the most advanced productive X-ray solution in the production line to date.
An additional notable achievement this quarter is the growth in our service revenue, which reached a record high and contributed 26% to overall revenue. Our continuous investment in enhancing our install base is bearing fruit with various solutions that enable better productivity, higher utilization, and improved metrology capabilities in previous models.
Our continued growth is mainly fuelled by increased revenue from proactive software and hardware packages we developed to improve our install base. Our goal is that at least 30% of the revenue generated in the service segment will come from new products on top of the regular services to our customers. In summary, and in spite of the extreme investment challenges, we expect the long-term industry momentum to continue while the market benefits from multiple solid catalysts. This trend fuelled the demand for silicon and require continuous technical improvement across all devices.
Our widened exposure to multiple customers and the traction that our differentiated portfolio is creating in the market position us to benefit from this long-term growth potential. Despite the backdrop of the industry and the peer group earnings, I would like to share with you our third quarter guidance range, which reflects the higher potential versus the second quarter guidance. Revenue in the range of $58 million to $64 million, diluted EPS on a GAAP basis in the range of $0.32 to $0.44 per share and non-GAAP basis diluted EPS in the range of $0.37 to $0.49 per share.
Now let me hand the call over to Dror to review our financial results in detail. Dror?
Thanks, Eitan, and good day, everyone. In my following prepared remarks, I will refer to both GAAP and non-GAAP results. You can find a detailed reconciliation between GAAP and non-GAAP results per item at the end of the earnings press release.
Total revenues in the second quarter of 2018 were $61.9 million, reflecting a 10% increase year-over-year. Product revenues for the quarter were $45.8 million, approximately 50% from the foundry sector and 50% from the memory sector. During the quarter, Huali, YMTC, Hynix, Samsug and TSMC, each exceeded 10% of product revenues.
On a regional basis, this list includes two Chinese customers, two Korean customers, and one Taiwanese customer. Broken down by segment, it includes three memory customers, two of which are the leading memory manufacturers and two foundry customers, one of which is the leading foundry manufacturer. We believe this leads and it spread reflect the diversification of the company revenue sources across regions, segments, and technology nodes.
Service revenues grew 30% quarter-over-quarter as a result of several install base upgrade projects. Blended gross margin in the second quarter came in at 58% and included an impact of the opening of the new [indiscernible] facility in Israel. Product gross margins came in at 61%, lower than the previous quarter due to a product mix which included less software revenues and the new [indiscernible] facility impact. Services gross margins came in at 49%, very high result as a result of the steep increase in revenues during the quarter.
Operating expenses for the quarter totaled $22.1 million on a GAAP basis and $20.6 million on a non-GAAP basis, an increase of approximately $1.6 million over the previous quarter. This increase reflected the company's continued efforts to execute its plan to introduce new technology and products within the next 12 months and the regional distribution of the company revenues from China which include higher sales channel costs.
Operating margin in the quarter was 22% on a GAAP basis and 25% on a non-GAAP basis, while the effective tax rate of the company was approximately 16%. GAAP EPS in the quarter was $0.41 per diluted share and non-GAAP EPS was $0.46 per diluted share slightly higher than the company guidance for the second quarter.
Regarding the company guidance for the third quarter, revenues are expected to be between $58 million and $64 million. This revenue guidance assume a return of service revenues to a normalized level of approximately $14.5 million in the quarter. At the midpoint of this revenue guidance, we expect the following: blended gross margin is expected to be approximately 57%, operating expenses are expected to be approximately $21.5 million on a GAAP basis and approximately $20 million on a non-GAAP basis. This is slightly lower than the previous quarter and reflects an expected reduction in sales and marketing expenses, which will be partially offset by an expected increase in research and developing expenses.
Effective tax rate is expected to be between 17% and 18%. Regarding the target long-term financial model of the company, at a $300 million revenue level, we continue to target gross margins between 56% and 59%, operating expenses which are approximately 30% of revenue and operating margin between 26% and 29%.
With that, I will turn the call back to Eitan.
Thank you, Dror. With that, we are pleased to take your questions. Operator?
Thank you. [Operator Instructions] We will take a question from Edwin Mok with Needham & Company.
Good morning, guys. Congrats for the great quarter. So, my first question is on, I guess second half outlook, I think, firstly, Eitan you talk about second-half roughly flattish to first-half. With the kind of recent update on market, do you have any update on that and I will -- if I assume flat through the first half and midpoint of the guidance that will imply fourth quarter will grow from the third quarter level? Is that correct or can you give some color on that?
So, I think, Edwin, we stay with the same statement that we gave before. Although we are not yet seeing the full fourth quarter, the visibility right now to our largest foundry customer is clearer than months ago. So if am looking right now on the fourth quarter revenues, I am more optimistic on that part. The big question is timing. So we're not clear yet on the exact timing between the end of the fourth quarter and the first quarter in regard to capacity. So therefore we stay with the same statement as we’ve said before. Nevertheless, there are few upside that can materialize.
I see. Okay, great. And then, I know that many you guys have talked about two new platform that you guys plan to launch. Can you provide us any update on that where you stand on that? Do you still expect this part shifting them? I think previously you guys said shipping late this year and potentially start seeing revenue in '19. Can you give some color on that?
Yes. So the -- we talked about two new technologies. I will not give the details about exactly where they go into sub [ph] and exactly which application they’re going to sold. Its different technology that we did before. The two new systems are -- or the two new technologies are going to start back somewhere in Q3, Q4. And therefore we are very optimistic on getting the revenue on both of them in 2019.
I see. So shipment is for the new plan. Yes, [indiscernible] inventory plan and you guys accepted that. Okay, great.
That’s a better [indiscernible].
Yes, go ahead.
Edwin, better agreement and [indiscernible] to our clients and the customers are refined as well. So we know exactly where we shipped it.
Okay, great. Great. Thanks for clarifying that. And then, I guess, my last question is on this memory improvement mix where I think you guys [indiscernible] memory and now it's 50%, right. How much of that is driven by the new software that is enabling customer to do a new type of metrology they’ve done before? And then is that kind of talk about how much is that tied to NAND versus DRAM, and do you expect this 50% range to be sustainable?
Edwin, if you right now on the expected revenue for memory customers in 2018, we are going actually to double the amount from 2017. So it's an tremendous amount of system that we are shipping right now to memory and a significant growth which are actually outperforming the memory growth this year in the market. So definitely most of the translation that we had in a very dense competitive environment is coming from our ability in some cases to come as a third vendor and to increase our market position and market share. And we could succeed in doing it and coming and solving the most complex solution that could not be sold up to that moment. And this ticket to get into those sophisticated memory customers came from two main capabilities beside the measurement itself. One is the combination of the hardware and software. We are growing a lot today into more mathematical statistical virtual metrology stuff, which assist the hardware measurement. This is one. And second is the ability to combine the XPS or the X-ray measurement together with the optical measurement. We see today there is a shift in cross application that today if you have the reference coming from one -- one of the two, the other technology can perform much better. So if you look right now on a company that has only one of those technologies, they cannot actually sold the same application as we are because we have the three and fourth measurement data, so we can tighten the measurement much better. And it allow us to get in to bring something else to those customers and actually sold the application that we are not sold before. Basically some of those application either went through TAM or went to other process control tools, which currently we can do on our portfolio. Those were the key.
Edwin, if you want to translate all these successes into the numbers, so when we look at the first half of the year, 50% of the revenues of the company came from the memory segment. And the guidance for the third quarter also assumes around 50% of the revenues coming from the memory segment. And because we also believe the memory strength will continue into Q4 for us. Looking year-over-year, we are lucky we had only 35% of our revenues coming from memory. We should see this year an increase in memory revenues year-over-year of approximately 40% to 50%. And we believe this is actually double than the peer group or the growth in memory investments in the industry as a whole.
[Indiscernible] helpful color. Thank you.
Thanks, Edwin.
Thank you. Our next question comes from Jaeson Schmidt with Lake Street Capital Markets.
Hey, guys. Thanks for taking my question. Just the first one, wondering if you could comment on the order and linearity you saw in the quarter?
So in general, we're not giving -- the company is not giving booking numbers or book-to-bill, but we can say that bookings in the second quarter were higher than the previous one.
Okay. That's helpful. And then, curious if you could comment on what percentage of the revenue came from trailing nodes in Q2?
So, it's approximately 60% from trailing nodes and 40% from high-end nodes.
Okay, perfect. And the last one for me and I will jump back into queue. How should we think about the service business growing longer term. Obviously, its dependent on the growing install base, but what’s sort of kind of long-term growth rate should we look for that business to generate?
So, Jaeson, I will answer this question from the segmentation in the service revenue and then Dror can talk about the financials. I want to emphasize one thing about the service revenue. So, our long-term target is to be at around 25% of the overall revenue. But one of the things that I emphasized in my prepared remark is that we look on the install base not only as an install base to service and then get some money for contract and timing material. Actually 30% out of the service revenue coming from proactive packages that we develop, specifically to this install base. So we are looking on the install base like in other market for Nova to sell products to and it's accounted in the service. But that's where we try to increase this number beyond the growing install base that we have every year.
So, in terms of the numbers, so our strategic plan assumes between 10% and 15% increase in service revenues every year, which relates to the increase in the install base. And as Eitan mentioned, specifically for 2018 we might see a high growth rate in 2018, because of these upgrade projects and strategic plan.
All right. That's very helpful. Thanks, guys.
Our next question will come from Patrick Ho with Stifel.
Thank you very much. Eitan, maybe as a follow-up to some of the commentary you gave on the memory side of things. 3D NAND has obviously been a key driver for increasing OCD metrology used and you have benefited from some of the share gains with your customers. Can you talk a little bit about the opportunities in DRAM and where you see both OCD as well as X-ray metrology potential uses for DRAM relative to 3D NAND?
Sure. I think that if we are looking right now on DRAM, it's more similar to foundry than its to the VNAND. So therefore we see actually two segments of measurement or two segments of metrology. One of them is the geometrical or the architectural change when the customers going below 20-nanometer, the one YXZ where they start to [indiscernible] the gates in silicon and therefore the application or the complexity of measuring both materials and dimensions actually are increasing. So if we're looking right now on the intensity in the last quarter and DRAM spending actually is going higher than we have experienced before. We see both the X-ray and the OCD growing. So the intensity grows and I think that most of the growth coming from the changes in the technological and architectural structure of the device.
Great. That's really helpful. And maybe as a follow-up on the foundry side of things, obviously you have a very strong position with the leading player in Taiwan as they're moving to both 7-nanometers and beginning some of their 5-nanometer pilot line. Where do you see, I guess, greater activity right now? Is it partly with the 7-nanometer capacity build or are you seeing some of the 5-nanometer pilot line activity that your customer has talked about?
So, I didn’t talk about 7-nanometer because it's ongoing expansion where we see capacity added on a small amount in the last two quarters. What I referred specifically is the anticipated 5-nanometer that everybody waited for the orders to be released. I think that when we are looking right now, if it will happen at the end of the year or it will happen at the beginning of next year, it is a timing issue, but we do see a clearer picture on that. I think that delays or push outs came in light of bit -- in my mind in light of the business environment. We are extending because of the EOV [ph] was so high where the cost was an issue, how you start building this far, but I think that most of it was cleared out. And I think that we will start to see more orders coming in the next couple of weeks to start shipment of stores in Q4. This was the main remark that I gave. It's important for us because it might be an upside.
Right. And maybe a final question for me, maybe for Dror, in terms of gross margins and services business. Actually your services gross margin were very strong and I think you’ve noticed some of the drivers there. As we look at services going forward, particularly with the growth rates you talked about, I guess what are some of the levers on the services side where you can maintain the gross margins in that, I guess 56% to 59% target model that you're looking for. What are some of the levers on the services side to help, I guess not dilute the gross margin levels?
So, in our model for gross margins of 50 -- blended gross margins of 56% to 59%, assume services gross margins of between 35% and 40%, and product gross margins which are north of 60%. We do believe that given the increase in service revenues, which a significant portion of that is related to time and material, rather to contract, which are heavy on headcount costs and fixed costs. Therefore there is some upside there for services gross margins to continue and be at the high-end of this range of 35% to 40%, more on the 40% side. And as you mentioned, support the overall gross margin, blended margins of the company.
Great. Thank you very much.
Thank you. We will now hear from Mark Miller with the Benchmark Company.
You indicated memory is going to be strong in third quarter and also in fourth quarter, that's one of your competitors is talking about the impact of push outs into 2019. Is that just because you're serving different customers? Why you have a different outlook for memory in the second half?
So, I think, Mark, from what we see the -- we are looking on the overall demand and we are looking on the market share. So, you know that sometimes when the demand goes up and you stay on the current level which means that you get more market share than you’re getting into more penetrations into the memory. This is what we see in the third quarter and also the fourth quarter. We definitely see that the majority of the penetration that we had will dematerialize in the third and the fourth quarter, therefore we are -- we think that Russia will stay roughly on the same level.
And again the implication of that is that year-over-year we expect 40% to 50% increase in memory revenues for the company, which we believe is almost double than the average growth in memory investments between the two years.
And that's for 2017 to 2018?
Right.
What about Logic? Do you see Logic -- I think you said Logic was strengthening as we go out of 2018. Do you think that continues to strengthen in 2019?
So we think that definitely at the beginning of 2019 we will see the -- we will see some 7-nanometer expansion as well as the start of the N5 extended pilot line. So definitely we are expecting the first half '19 to be weighted towards foundry.
Right. Thank you.
Thank you. We will go to David Wu with Indaba Global Research.
Yes, good afternoon. I want a clarification, if I may, on the memory side and a question on the Logic foundry side. The memory side, your pattern is very different from both KLA and nano metrics, as well as the LAM research that reported. Is it the function of your different stage of penetration into the memory market or a different customer mix, which makes your pattern much more level in the second half and many of those competitors that have a dip in Q3 and a rebound in Q4.
Well, these companies that you're referring to, obviously have a wide exposure to the memory market across all the customers as we do. However, the fact that the company is able to show stable revenues from the memory segment going into the second half, despite the reduction that other providers see in the market, mean that we are able to win market share as a result of the applications that Eitan mentioned before.
Okay. Do you see a widening of 7-nanometer spending in foundries in the first half of calendar '19, besides TSMC?
So, Mark, it's very difficult to say from now. We know that at least two other customers and TSMC are spending time and efforts to qualify their 7-nanometer. And it's hard for me to say right now if it will expand more in the first half. So it definitely depends on the number of customer that they will acquire.
Okay. Thank you.
Thank you. With no additional questions, I will turn the floor back over to Mr. Oppenhaim for any additional or closing remarks.
Thank you, operator, and thank you all for joining our call today. With that, we conclude our Q2 2018 earnings conference call. Thank you.
Thank you. Ladies and gentlemen, again that does conclude today's conference. Thank you all again for your participation. You may now disconnect.