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Good day, and welcome to the Nova Measuring Instruments Second Quarter 2019 Results Conference Call. Today's conference is being recorded.
At this time, I'd like to turn the conference over to Miri Segal of MS-IR. Please go ahead.
Thank you, Operator, and good day to everybody. I would like to welcome all of you to Nova's Second Quarter 2019 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 statement 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 section of the company's website. Eitan will begin the call with the 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, and thank you all for joining our second quarter financial results conference call. I will start the call today by speaking about our quarterly results and performance highlights and conclude by providing guidance for the third quarter of 2019. Following my commentary, Dror will review the quarter's financial results in detail. In the second quarter, Nova delivered results towards the high end of the guidance range, reflecting our focused efforts to execute our plan in a volatile semiconductor environment. We were able to deliver these results due to the efforts we are making to strengthen our position with leading customers while efficiently leveraging the operation model we have built to keep firm focus on technical innovation even in a challenging business environment. We remained committed to the development of our new growth engine, which will continue differentiating our offering, expanding our addressable market and enabling our long-term growth. The results for this quarter are also evidence of the progress we have made in diversifying our exposure to different semiconductor segment, multiple customers and new evolving applications in both materials and dimensional process control.
From a business perspective, our performance was highlighted by a balanced customer mix, which included 4 large customers that contributed more than 10% each to our product revenue. I would like to emphasize 2 major achievements which are embedded in this outstanding mix. Firstly, the major inroads we are making with a large global Memory customer in both NAND and DRAM. And second, a major win in one of the biggest foundries in China. Both milestones reflect the traction our unique portfolio is gaining in the market due to the synergy we have built between the different technologies we offer to our customers.
Following the press release in April, when we announced the selection of Nova's VeraFlex inline materials metrology solution by a global leading Memory customer, we are pleased to announce that this win contributes and continues to generate revenue and was proliferate to 2 other global sites for both DRAM and VNAND applications. This milestone is further evidence of our successful progress in expanding our reach into the growing materials engineering space, which is experiencing fundamental changes that creates many publication challenges. We intend to further increase our efforts in this area as we strongly believe that materials control will become increasingly important as new generation devices are developed.
Looking at all recent technical inflection point, be it DRAM 1Z or 1A or Foundry nanowires or multi [indiscernible] VNAND, they all represent a growing opportunity for new materials control scheme. The need for tighter materials control drives faster transition from lab slow process control into fast inline production step. Like we did with the X-ray contrition, we intend to bring other methods from lab environment into the production environment, which will assist our customers to reduce cost and improve yields.
An additional business highlight was the selection of our dimensional OCD metrology by an additional Memory manufacturer in China. This competitive selection emphasize our unique offering, which interlaces hardware sensitivity with advanced machine learning and deep training engines to solve challenging Memory application that can't be solved with traditional techniques.
In addition, and following the growing demand for logic devices for emerging solutions like 5G and AI, we've begun to receive orders from the world's leading Foundry for 7- and 5-nanometer expedited ramp-up. As previously discussed, Nova's application footprint has expanded in this node to include both front-end and back-end solutions in multiple steps.
Turning now to our product development and the challenges ahead of us, we believe that there are 3 major technology inflections for us to address as part of our roadmap. They include 3D scaling in all semiconductor segments, device shrinkage while improving performance and Nova materials introduction to support architectural limitations. In order to meet our customers' requirement, as a result of these challenges, we are building innovative capabilities in both our traditional OCD and X-ray portfolios as well as in new technology directions that provide new insights into the publication process.
In order to deliver sophisticated solutions that will improve yield and cost of ownership, we have established the following fundamentals in our roadmap: First, interlacing hardware sensitivity with software machine learning solutions to improve learning and prediction. Second, investing aggressively to lead the material process control market that is evolving into one of the major transition this year as customers are moving to complex devices. Third, developing new metrology methods that will enable inline production measurement instead of slow and expensive laboratory measurements. The harbinger of our new portfolio is the recent launch of the PRIZM. This newly designed tool is positioned to solve critical application in the most advanced manufacturing processes. PRIZM is the first of its kind metrology platform that combines traditional optical spectroscopy technology with interferometry technology. The technology is an optical method that is currently widely used for imaging and topography measurement. This new technology is capable of extracting unique physical information from the measured device that is inaccessible by either electrometry or reflectometry. Combined with interpretation algorithm embedded in our Nova MARS and Nova Fleet machine learning solution, PRIZM provides superior sensitivity and measurement accuracy for the most complex logic and Memory device structure. We have already shipped several tools to multiple customers and are receiving excellent feedback on the value it bring.
In addition to this exciting product launch, we continue productizing additional platform. We are on track with multiple evaluations and still expect initial revenue in 2019. These technologies reveal unique metrology capabilities for multiple wafer fabrication process steps.
Before I conclude my prepared remarks, I would like to address the market conditions and how they relate to Nova performance. From an overall industry perspective, we strongly believe in the semiconductor fundamental drivers as well as new drivers, which will continue fueling the market beyond the interim challenging conditions. The combination of demand for new computing architectures as well as advanced memories beyond traditional scaling will create more opportunities for us that is our customers improve device performance and cost while trying to meet their own customers' demand and specification.
As discussed in the previous earning call, we are aligned with the market expectation for a soft 2019. In our view, the spending environment is largely influenced by a decline in Memory spending in both DRAM and NAND. We expect that the current soft demand will be better optimized through 2020 when Memory prices and inventory levels will improve. While this remark is consistent with our first quarter comments, we see an improvement in demand for advanced logic devices in Foundry. Though this will not necessarily offset the Memory decline, we are prepared to increase shipments for 7- and 5-nanometer in the fourth quarter.
Overall, we believe that 2019 is shaping up to be a transition year in several aspects, which will generate more opportunities for Nova to improve its position. We are making significant inroads into major customers, remain focused on delivering our new products and our managing expenses cautiously. We also believe that our widened exposure to multiple segments, customers and geographies, combined with the traction our differentiated portfolio is creating in the market, has positioned us well to benefit from the long-term growth potential as the market recovers.
As for the third quarter of 2019 guidance, we expect revenues in the range of $46 million to $54 million, diluted EPS on a GAAP basis in the range of $0.11 to $0.24 per share and non-GAAP basis diluted EPS in the range of $0.20 to $0.34 per share.
Now let me hand over the call to Dror to review our financial results in detail. Dror?
Thanks, Eitan. Good day, everyone. In my following prepared remarks, I will refer to both GAAP and non-GAAP results. You can find a detailed reconciliation per item at the end of the earnings press release. Total revenues in the second quarter of 2019 were $51.1 million at the high end of the company quarterly guidance. Of the company's product revenues, approximately 65% came from Memory and approximately 35% came from Foundry. The increase in the Memory portion of product revenues was also driven by the adoption of the company solutions for high-end applications as a global Memory customer. Blended gross margin in the second quarter was 55% on a GAAP basis and 56% on a non-GAAP basis within the company target model of 56% to 59% on a non-GAAP basis.
Operating expenses in the quarter totaled $21.3 million on a GAAP basis and $19.3 million on a non-GAAP basis. On a non-GAAP basis, this is 8% reduction or a $1.6 million reduction relative to the previous quarter. The reduction was across all expense items, reflecting management efforts to contain operating expenses.
Looking forward, during this interim volatile period, we plan to continue our efforts to contain expense levels. In parallel, the company continues its full force, its focus on continued customer penetration and new product development as was evident by the recent new tool of record wins and the recent introduction of a new optical CD platform.
Operating margin in the quarter was 13% on a GAAP basis and 18% on a non-GAAP basis. The effective tax rate of the company in the quarter was approximately 15%. Earnings per share in the quarter were $0.23 per diluted share on a GAAP basis and $0.32 per diluted share on a non-GAAP basis at the high end of the company guidance for the second quarter.
As previously communicated, the company is transitioning its main offices in Israel and the U.S. to new locations. As a result, during the office transition period, the company is bearing duplicate office lease cost. In the second quarter of 2019, lease cost amounted to USD 827,000 and were adjusted for non-GAAP presentation purposes, under the items facilities transition cost. The distribution of these costs across the company expense items in the profit and loss statement is detailed at the end of the company's quarterly press release. We expect similar field facility transition cost of approximately USD 800,000 in the third quarter of the year, which will mark the finalization of the company's facility transition prospect.
On the cash flow front, across the first half of 2019, the company generated $16.5 million from operating activities and invested $7.7 million in property and equipment, mainly in the new facility. In parallel, the company continued to execute its previously announced share repurchase plan and concluded the second quarter of 2019 with approximately $180 million in cash reserves, slightly higher than the beginning of the year.
Regarding the company outlook for the third quarter of 2019, at the midpoint of the company guidance, we expect the following: Blended gross margin is expected to be approximately 54%. This result is lower than the previous quarter and the company target model due to a combination of factors, including an unfavorable product mix, the sale of newly introduced products which bear higher costs during the initial adoption cycle, the lower general business volume and costs related to the new facility.
Operating expenses are expected to be approximately $22 million on a GAAP basis and approximately $19.8 million on a non-GAAP basis. On the tax front, we expect the effective tax rate in the third quarter to decrease to approximately 5% due to the finalization of tax reporting processes and a different distribution of profits between the different territory. Effective tax rate in the fourth quarter of 2019, and in future years, is expected to normalize at 15%.
With that, I will turn the call back to Eitan.
Thank you, Dror. And with that, operator, we'll take the questions.
[Operator Instructions]. And we will take our first question from Quinn Bolton with Needham & Company.
I wanted to start with the new PRIZM tool and the new technologies. Your comments around gross margin, talked about some new products, wondering if the third quarter guidance includes any revenue from new technologies or the PRIZM tool that might in part be driving that lower gross margin for the third quarter?
Quinn, actually, not particularly the comments which related to new products related to products which we announced earlier and are already in, I would say, extensive process of adoption in the market. So it does not include these new products and the PRIZM.
Okay. Second question, you talked about the sort of Foundry strength acceleration at 5 and 7 nanometer. Can you talk at all directionally about how you see that strength continuing in the 2020? I think your largest customer seems to be on a pretty aggressive build of their 5-nanometer plans and has holding to 7-nanometer. Do you think that strength continues into the first half of 2020?
Quinn, thanks for the question. It's Eitan. So the way that I look at that and I view it couple of times that the way that this customer is build the capacity usually they have it by phases. The first phase took place in the first quarter of 2019 -- actually, started in the fourth quarter of 2018 and continued to 2019. And what we look right now on the expedite ramp is for the second phase that's supposed to start somewhere towards the end of the third quarter. And in the way that I look on the capacity and the amount of capacity, it will continue at least towards the first quarter of 2020.
Okay. Great. And then just lastly, over the last quarter it seems like the Memory outlook has continued to deteriorate the Logic/Foundry business has upticked. How do you see your mix between Memory and Foundry trending in the third quarter from that 65-35 split in Q2?
So while we still expect Memory to be relatively strong in the third quarter, but evidently given the extensive ramp-up of 5-nanometer the significant customer in the fourth quarter, in the end of the year, there will be transitioned towards Foundry.
Memory more than half...
Quinn, it's Eitan here. I think that the mix in the third quarter will stay around 60% Memory. I think that besides the fact that the traditional Memory providers are seeing some decline in their revenue and as well they are reducing the CapEx. But if you're looking right now on the macroeconomic situation, we do see some increase in Memory in China. As I said in my remarks, there's a big win for us in the Memory. And there are couple of customers that are building faster the VNAND capabilities as well as the DRAM. So if you look right now on the mix, I think that it will be less of the Korean providers, but it will be more in the Chinese Memory customer. But the mix will stay 60-40 roughly.
We will take our next question from Patrick Ho with Stifel.
Eitan, maybe as a follow-up to some of your prepared regarding China and especially Foundry business over there. Are you seeing increased, I guess, demand and interest in your product portfolio for some of the trailing edge given that there are several nodes behind or are they evaluating a lot of the work as they are very leading edge?
So I think that when I'm looking right now on China in the last two quarters and I think that it's aligned with other companies with report, we see that yielded global economy situation. We see increased growth in the Foundry as well as in the metro. And when we're looking right now on those customers, there is one leading NAND provider that is not so behind the Korean and the others. And he actually expedites capacity on the VNAND side. Regarding DRAM, there's one customer that is building very aggressively the capacity and it's been expedited a bit in the last few quarters. Regarding foundries, we have two local Chinese manufacturers that we see also some expansion in the trailing nodes. So without getting into the details, if you have those four customers investing, two in Memory and two in Foundry, we obviously enjoy those expansions.
Great. That's helpful. And maybe a question also for -- the advanced Foundry [indiscernible]. Not a surprise given some of the commentary, customers like [indiscernible] have said on their earnings call. How do you see metro intensity trend rising potentially as the industry goes 5- to 3-nanometer as we saw quite a bit of the jump when we went from 16, 14 and to the current 7 and 5, to see the evaluation what you're doing at 3 nanometers helping Nova from a capacity standpoint?
So if I concentrate only on the logic side, if we're looking right now on the transition from 16 to 10, 7, 7-plus and then 5, all of them will be on scaling FinFET devices. So even if you're looking right now on 5-nanometer in -- by the way, not only in TSM, but in others it's publicly they announced that is going to be FinFET and it's just scaling down. If you're going beyond that, there are a couple of architectural changes that probably they will have to make and choose if it's going to be a regular dimensional FinFET device or it's going to be changed to something else. One of the major discussion in the industry is the move from FinFET devices into a Nanosheet or nanowires, it can be vertical, it can be horizontal. But looking on 3-nanometer, we think that it's a major inflection point. You can't just scale. You need to change materials in order to keep the performance. You need to move to a different dimensional shape because otherwise the performance will go down. And therefore, we do see that moving from 5 to 3, it will be a major inflection point technology wise. And therefore, if we have a combination in the Foundry where both the dimension and the materials are keep on changing, it -- the combination itself is very good to the mix that we're offering to those customers.
We'll take our next question from Jaeson Schmidt with Lake Street.
Just curious if -- how we should think about the service revenue growth this year? I think last time you still expected that to grow 10% in 2019. Is that still the case?
So I think that, in general, what we experienced in the recent months is that given the situation in the high-volume manufacturing of DRAM and also some NAND, VNAND, some customers are actually idling portions of the fab or the tool. So we have more challenge in that front. But we do expect to see service revenues grow quarter-over-quarter across the coming quarters.
Okay. That's helpful. And then I understand the headwinds to gross margin here in Q3. When should we expect that to alleviate? Is that more of a first half 2020 story or Q4 of this year?
So obviously, this depends, I would say, mainly on the level of business volumes. And I think that under the assumption that there is a stronger quarter looking beyond Q3, then gross margin should return to the normal level.
We will take our next question from Mark Miller with The Benchmark Company.
I was just wondering if you could provide a little more color on what's your X-ray business?
Mark, can you repeat? Please.
Well, I was wondering if you could just give us a little more color on the -- what's going on with the X-ray, in terms of orders and sales?
Okay. So as you know, we don't break down the revenues between the optical and x-ray since both can measure dimensional and materials. So therefore, it's an information that we don't give from competitive reasons. Nevertheless, I can tell you that today, if I'm looking right now on the progress which we did in the last 3 years on bringing the x-ray from lab to that used to be very slow and measure only a few applications. Today, we can say probably that most of the customers that are buying these tools buying it for production and some of them for [indiscernible] and inline. The reason, by the way, is following the prepared remarks that I made or commented that there's no way to continue scaling devices in semiconductor without referring into materials as a major element or major drivers to improve performance.
And if you're looking right now, those on DRAM ongoing to 1Z, 1A, you're looking on VNAND multi-stock and the next embedded memory. And you look even for Foundry or Logic going to 5-nanometer and 3-nanometer, changing the device itself from architectural point of view or dimensional point of view will not give the fine results. And therefore, if you look right now on the amount of materials that is being used in a device is actually doubled itself in the last few years and it will continue to be evolving in the next coming years. Combined with making the films even [indiscernible] from what they used to be, the combination of that film structure as well as an extra or Nova materials that are being introduced is presenting a big opportunity for Nova, and we were able to materialize that in the last two years. The business of the X-ray is continue growing in the last few years, and we assume it will continue growing in the next coming year as well.
That was helpful. That was my point for the question. Could you provide breakdown -- sales breakdown by region?
Yes. So in general, I would say the following: China was around 25% of the revenues, Korea was around 30% of the revenues and the rest will split mainly between U.S., Japan and Taiwan.
This concludes our question-and-answer session. I would now like to turn the call back over to Eitan Oppenhaim, President and CEO.
Thank you, operator, and thank you all for joining our call today. By that, we conclude our second quarter 2019 earnings conference call.
This concludes today's call. Thank you for your participation. You may now disconnect.