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Good afternoon, and welcome to the Nanometrics First Quarter Financial Results Conference Call. [Operator Instructions]. Please note that this conference call is being recorded today, May 1, 2018. At this time, I would like to turn the call over to your host, Claire McAdams. Please go ahead.
Thank you, and good afternoon, everyone. Welcome to the Nanometrics First Quarter 2018 Financial Results Conference Call. Speaking on today's call are Dr. Pierre-Yves Lesaicherre, President and Chief Executive Officer; and Jonathan Chou, Chief Financial Officer. Shortly, Pierre-Yves will provide a recap of the quarter and our perspective looking forward, then Jonathan will discuss our financial results in more detail. After which, we will open up the call for Q&A.
The press release detailing our financial results was distributed over the wire services shortly after 1:00 p.m. Pacific this afternoon. The press release and supplemental financial information are also available on our website at www.nanometrics.com.
Today's conference call contains certain forward-looking statements, including, but not limited to, financial performance and results, including revenue, margins, operating expenses, profitability and earnings per share. Such statements may be identified by the use of words like believe, expect and similar expressions that look toward future events or performance. Although Nanometrics believes that the expectations reflected in the forward-looking statements are reasonable, actual results could differ materially from the expectations due to a variety of factors, including general economic conditions, changes in timing and levels of industry spending, the adoption and competitiveness of our product, industry adoption of new technology and manufacturing processes, customer demand, shifts in timing of orders or product shipments, changes in product mix, our ability to successfully realize operating efficiencies and the additional risk factors and cautionary statements set forth in the company's Form 10-K on file for fiscal year 2017. Nanometrics disclaims any obligation to update information contained in any forward-looking statement.
During today's call, we will also refer to financial measures not calculated according to generally accepted accounting principles. Please refer to today's press release for an explanation of our reasons for using such non-GAAP measures as well as tables reconciling those measures to our GAAP results.
I will now turn over the call to Pierre-Yves.
Thank you, Claire, and good afternoon, everyone. Today, in my prepared remarks, I will briefly review our first quarter results, share our views on the current business environment and give our perspective looking forward. Jonathan will then review the financial details of our recent results before opening up the call for Q&A.
Our first quarter results were stronger than expected and set multiple new records. Revenues of $82.3 million exceeded the high-end of the range as the current ramp in NAND and DRAM investments is happening faster and even stronger than we previously forecast. In addition, our recently announced market share gains in the memory segment are having a near immediate step up in our revenue run rate and contributed to Q1 revenues exceeding our forecast and to our strengthening outlook for the full year.
First quarter revenues were 22% higher than our second half 2017 revenue run rate. At the midpoint of Q2 guidance, our first half will be about 25% stronger than the second half of last year and will be up more than 35% from the first half of last year. 2018 sales momentum is certainly off to a very strong start. Below the top line, our first quarter results also set new records for gross margin and earnings per share.
Gross margin was higher-than-expected and reflected sustainable, longer term positive trends for our business as well as favorable product mix and a favorable installation and warranty accrual adjustment. The adjustment was due to positive progress, shortening our installation cycle times and servicing our newest Atlas flagship systems in the field.
After the unique factors in Q1, the normalized gross margin for the quarter was about 56%, at the high-end of the range and within our target financial model range of this revenue volume. Record EPS of $0.67 was stronger-than-expected, primarily due to the revenue and gross margin upside. As Jonathan will discuss shortly, we also see our tax rates coming in a bit better than the 25% we guided previously.
Also, a highlight of our quarter was our free cash flow generation. We reported a record $31 million in free cash flow, or 38% of revenues for the quarter, and kept working capital flat to year-end levels in spite of the strong revenue ramp happening in the first half. The result was a $7 million increase in our cash balance since year-end, even after $23 million of stock buyback during the quarter.
Now I will turn to our outlook, looking forward for 2018 specifically. Like other industry leaders who have strong positions in memory, we are witnessing that this ramp in investment in DRAM and NAND is both faster and stronger than what we expected a quarter ago. This is culminating in an acceleration of shipments in the first half as well as the substantial improvement in the outlook for the full year. NAND was the strongest contributor to our sales in the first quarter, with DRAM stepping up sharply to the #2 position. We expect the strength in memory to continue to drive another record revenue quarter in Q2.
Our strength in full year outlook is due to a number of factors. First, in NAND, where industry expectation are for a similar year in wafer fab equipment investments compared to 2017. We announced a major customer win during Q1 for fab-wide deployment of our process control solutions at a domestic China 3D NAND manufacturer. Revenues for this win began to kick in during the first quarter and will ramp significantly during the next couple of quarters.
This incremental market share win in NAND further extends Nanometrics' leading market position in optical critical dimension, or OCD metrology, and will lead to another year of NAND revenue growth for Nanometrics in 2018, while exceeding the 10% growth forecast a quarter ago. Whereas we previously expected NAND to be evenly balanced between the first half and second half, we now see momentum building for the second half, which we expect will be even stronger than the first half of the year.
Turning to DRAM. The investments in South Korea have been ramping up at a rapid pace and we recorded nearly as much DRAM revenue in the first quarter as we did in all of last year. The incremental revenue growth forecast for our second quarter is primarily driven by an increased outlook for DRAM, including from our newest market share win in integrated metrology by leading DRAM manufacturer. Strong year-over-year spending increases in DRAM are a positive for Nanometrics, as there is a higher attach rate for our flagship Atlas systems into DRAM wafer starts versus net.
On top of this is our incremental share gain in the integrated metrology, which is a major piece of business we did not enjoy in previous DRAM cycles. While we continue to expect DRAM spending to be front-half weighted in 2018, our forecast for the second half has also improved since our last call due to all of these positive factors. We continue to expect DRAM to be our second-largest contributor to product sales for the full year.
Finally, for our foundry and IDM customers, we continue to expect revenues to be second half weighted, but represents an overall decline versus 2017 levels due to a couple of factors. First, there is a major shift in Korea-based foundry spending towards memory this year. Second, the timing of foundry and IDM investment in process control indicates increased deliveries as we exit the year. So while it would be premature to provide a formal revenue outlook for the full year, with our guidance for Q2 and current visibility for the second half, we expect the strength and outlook for NAND and DRAM will far outweigh our moderated forecast for foundry and IDM in 2018, leading to a fifth straight year of double-digit revenue growth.
With strength in DRAM primarily in the first half and a slightly back half-weighted year for NAND, the balance of revenues for the year is currently expected to be low 50s in the first half and the high 40s in the second half. With this outlook, I believe we can outperform overall industry spending in 2018 and further increase our gross margin and operating margin year-over-year. So these are the trends we are seeing for 2018, best summed up by revenue outperformance and expanding margins, but there's more to our story for this year.
Over the past few quarters you have been hearing about our progress developing an entirely new product platform for introduction in 2018. This new platform is a major development program for us, further enabled by an incremental investment in R&D, and we are targeting first installation in 2018 with a leading edge customer who's been closely collaborating with us during the development phase.
As a leading supplier of data-rich process control platform and solutions, we're in a unique position to benefit from the increased demand for data analytics needed to ramp and drive fast fab to increase profitability. We have a pipeline of new software tools and development, and expect data analytics to be an important and growing part of our business in the future. We believe that these focused investments into new technology solutions, both hardware and software based, will expand our served markets and help us achieve revenue growth well above the pace of industry investments.
Last quarter, we announced a 20% increase in our R&D investment in 2018 with a revenue and gross profit outlook increasing for the years, we may increase that plan slightly as we progress throughout the year while still delivering on improved operating profitability. We are passionate about the opportunities ahead of us to meaningfully expand our served markets, our revenues and our profitability by offering new technology solutions that solve our customers' most pressing challenges.
Since joining, I've had the opportunity to meet our key customers and I'm increasingly convinced of the strength and quality of our customer relationships. We have very close relationship with all the leading semiconductor manufacturers worldwide, which are entire technology teams that collaborate with our people to solve highly complex problems. We enjoy the same access to the technology leadership of the key customer accounts as our industry's largest suppliers, and these customers come to us to present their challenges and ask how we can help them solve these challenges.
Our R&D efforts are focused on product introductions in each of the next several years, which in turn will drive incremental revenue opportunities and enable Nanometrics to continue its revenue growth story in 2019 and beyond. I look forward to updating you on our new products as we progress through the year. As we addressed the new technologies and deliver on our R&D investments, the successful introduction of new products will drive continued growth and outperformance in the years to come.
Turning to our guidance for the second quarter. We continue to be shipping at record levels. Our Q2 guidance is for revenues of $82 million to $90 million; gross margins of approximately 56%, plus or minus 1%; operating expenses of $27 million to $28 million; and earnings per share of $0.57 to $0.74.
And in concluding, I would like to welcome Jonathan Chou to his first call for Nanometrics. Jonathan is a fantastic addition to our management team as is Jim Barnhart who recently joined as Senior Vice President of Operations. Most of them have hit the ground running and are already making contributions in support of this next phase of growth for Nanometrics.
I'll now turn the call over to Jonathan to discuss our financial results and guidance in more detail. Jonathan?
Thanks, Pierre. It's nice to be back in the U.S. after spending years in Asia and to be here for my first earnings call with Nanometrics. Before I begin my prepared remarks, I'd like to remind you that a schedule, which summarizes GAAP and non-GAAP financial results discussed on this call as well as supplemental revenue segment information by end market and geographic region, is available in the Investors section of our website.
We have made some modification to our revenue segmentation information and we'll discuss total product revenue versus service revenue as well as end market between NAND, DRAM and all foundry IDM and other device end markets. The P&L metric discussed are non-GAAP measures unless indicated as GAAP measures. These measures exclude the impact of amortization of acquired intangible assets, severance costs, executive transition search costs and discrete tax items.
As Pierre mentioned earlier, our first quarter revenue was $82.3 million, an increase of 5% from prior quarter and 39% from Q1 of 2017. Product revenue was $71 million, an increase of 5% from prior quarter and 47% year-over-year. Service revenue of $11.3 million increased 6% from prior quarter and were up 1% year-over-year and comprised 14% of total sales for the quarter.
By end market, product sales to the NAND segment continue to be the largest contributor at 50% of product revenue. DRAM sales grew significantly to comprise 39% of product sales and all foundry IDM and other device sales comprised the remaining 11% of product sales. Our 10% customers in the first quarter were Samsung, SK Hynix, Micron and Toshiba.
Our Q1 gross margin of 57.8% increased 140 basis points from prior quarter and exceeded high end of our gross margin range due to greater revenue volume, an increase contribution of high-margin upgrades as well as favorable installation and warranty accrual adjustment. The high margin for these items drove product gross margins to 59.7%, an increase of 210 basis points from prior quarter.
For the second quarter of 2018, we were guiding gross margin to 56%, plus or minus 1%. For the full year 2018, we will continue to see benefits attributed from 2017 cost improvement initiative as well as higher mix of our flagship OCD system and an increased acceptance of our software and analytic-based solutions. The combination of these items and overall growth projections gives us confidence that we will deliver gross margin within our target model ranges this year.
Operating expense of $27 million were up 9% from the prior quarter and came in higher than our guidance range, primarily due to higher variable compensation tied to our strengthening outlook for the year. As we have previously announced, our investment in R&D spending is expected to increase at least 20% over 2017. And as Pierre mentioned, we may increase these investments as we progress through 2018.
We expect our overall operating expense to average $27 million per quarter in the first half of 2018, increasing to $28.5 million a quarter in the second half due to the company's planned investment R&D, the build out of our China infrastructure and the associated variable compensation costs related to our strengthening outlook for the year. Although this is the current view, the company will continue to evaluate business outlook and adjust spending levels as necessary.
Our non-GAAP tax expense for the first quarter was $4.8 million or 22.5 of pretax income. Our tax expense on a GAAP basis includes the benefit associated to the difference between actual settlement of employee equity earnings versus the initial grant value as well as the impact of this transition tax associated with the Tax Reform Act.
On an ongoing basis in 2018, we are now expecting our non-GAAP tax rate to range between 22% and 23%. Net income for the first quarter was $16.5 million or $0.67 per share. Turning to the balance sheet. Cash and investment increased to $123.9 million or $5.19 per share based on 23.9 million basic shares outstanding at quarter-end.
In the first quarter, the company repurchased $23 million of stock or 896,000 shares at an average price of $25.65 per share. This completed, the $50 million stock buyback program as announced last November. For reference, the total number of shares repurchased was 1,962,000 at an average price of $25.48 per share.
Days sales outstanding decreased to 65 days from 72 days in the prior quarter due the timing of our shipment and collections in the quarter. Inventory increased $0.2 million to $54.6 million at the end of the first quarter. Cash flow from operation was a new record of $32.7 million and free cash flow for the quarter was also a new record of $31.4 million. This concludes our prepared remarks.
Operator, we will now be happy to take any questions.
[Operator Instructions]. And our first question comes from the line of Tom Diffely from D.A. Davidson.
So looking at the guidance for the full year, I just want to confirm, you said that your second half revenue would be above your first half revenue?
No. This is not what we said. Now we spoke specifically to the segments, DRAM, NAND and foundry IDM, but we did not speak to the -- what we did is we spoke to the strength between the first half and the second half, and we said that the first half would be -- if we divide the year in the low 50s and the second half in the high 40s.
Okay. That makes sense. So when you look at potentially relative strength in the second half of the year, is that driven by the fact that you guys are a little bit more leveraged on the DRAM side versus NAND, if NAND falls off a bit? Or is it a new customer ramp that's going to drive outperformance in the second half?
Your question was -- can you repeat your question. I'm not sure I understood exactly what you were asking for.
Yes. So whereas a lot of companies are seeing potentially a bigger drop-off in shipments in the second half of the year or revenue for the smaller companies, if you guys are in the low 50s, high 40s and if you outperform, is that outperformance can be driven by the fact that you're a little bit more leveraged to a DRAM plant versus the NAND plant with your equipment? Or potentially because your customers -- you have new customer in China ramping up through the year?
Well, we have both strengths in NAND and DRAM, but what's really driving our full year, as you can see, it's really NAND primarily because there's a larger volume of NAND being produced. Now this thing says, yes, we have this first win in China, which will be very important for us over Q2 and Q3 essentially. And the other element is we have very good visibility of what's going to happen in Q2 and Q3, but less visibility of what happens in Q4 and after. So at this point in time, this is what we're guiding to a low 50s and high 40s for the split for the year.
Okay. And then you said that your outlook for the full year has gotten up. I think, last quarter, you also said that you're expecting double-digit growth, so just stronger double-digit growth than before?
Well, we're expecting to be above 20%, actually, this year.
Okay. Great. And then just, finally, then. When you look at the new product, and you talked about the first installation in 2018. In past, you guys have talked about how you've been engaged with a few customers, wondering if you think you'll get a second customer in '18 as well or will it take a while to get to the second customer?
Well, these are complex undertakings when you're trying to introduce a completely new technology platform and we have limited bandwidth to collaborate with multiple customers. So while we have interest of multiple customers, I think, in the first stage, we're going to limit our effort to one leading customer. And as soon as we have worked some of the bugs and made sure that we have validated the concept with that customer, our expectation is we will rapidly expand to other customers, but our focus will be really on one key launch customer. In this case, focus is the friend of good execution. We don't want to be all over the place with this. There is insurance from multiple customers, if that's your question, yes.
And our next question comes from the line of Weston Twigg from KeyBank.
I wanted to ask about DRAM a little bit further. There's a big surge in activity sounds like in first half. I'm wondering why you expect that to drop-off in the back half because I would have expected maybe some expansion of DRAM activity among more customers heading into 2019. So just wondering what your visibility is on DRAM demand.
So what we said is we see that the DRAM being front half weighted, but actually strengthening in the second half. And actually, continue to strengthen in the second half and going into 2019. And that is linked to the specific customer installation. We have a very strong share. We are, we believe, one of the leaders in OCD and DRAM. And so it's just -- the timing of when each customer is making their investment and the factor is what is coming into play in our business being front half weighted versus second half weighted.
I see. But the strong trend would continue into 2019, it sounds like for DRAM. Next question, new product details that you offered. You started talking about the new products a little bit. You [indiscernible] offered too many details. Just wondering when you think that becomes a meaningful revenue contributor, is that later this year? Is it some time in 2019? Is it 2020? If you can give us a little more color on what your ramp expectations are because in the past, you kind of hinted that it could be a very large product for Nanometrics.
Yes. We're looking at now, 2019. I like that we're targeting installation this year with a lead customer, and I think there's going to be some further development efforts that we are installing at the customer and that should lead to revenue in 2019 -- revenue starting in 2019.
Okay. So a 2019 ramp-up is still probably modest revenue relative to the current top line?
Yes. Most likely, yes.
Okay. And then just, finally, on China. I was wondering if you could help quantify the China impact in Q1? You said you started shipping to this new fab, and then if you could give us any color on just China demand moving forward -- domestic China demand, because it sounds like you have pretty good traction.
Well, I think what's important is China is becoming really an ever-increasing part of our growth story. So you heard from, I believe, one of our peers recently that China fab will reach over 10% of WFE this year, wafer fab equipment, and this is both from the multinational and domestic fab customers. What we believe is we're very well positioned in China and we have a strong share with the multinationals, but also with the announced -- with the announcement that we made on the fab-wide process control market share with our 3D NAND customer. So last quarter, we said our revenue from China would double in 2018 and it's now on pace to actually exceed that growth. And beyond the -- we are ramping -- so truly the start with that 3D NAND fab in China, but the big volume for us or the big revenue for us will be really in Q2 and Q3. But beyond that win, we also have new accounts in China such as Innotron, XMC, HIDM for logics so -- as well as existing foundry customers that's making others. So we have, we believe a very strong position in China.
[Operator Instructions]. And your next question comes from the line of Patrick Ho from Stifel.
This is Brian Chin, on for Patrick. Maybe the first question, just to double back some of the commentary around NAND flash. Just curious, for the second half of the year where you're seeing uptick and strength from the last call, how much of that on relative terms is tied to expansion in the 64 layer capacity or really is more oriented to the 96 layer account NAND devices? And I ask because I know that's important in terms of the OCD capital intensity between the 2 technologies.
So it is mostly 64 at this point in time. 96 is in R&D, now so we expect that to contribute a little bit later. But the majority is 64 today, 64 layers.
Sure. That's very helpful. And kind of related to that and flipping it over back to the DRAM side, Nano has well-maintained that presentation slide that splits out the relative capital intensity for OCD by device type. And so for NAND, as I just mentioned, it shows the relative increase as the vertical layer count for 3D NAND increases. For DRAM, it shows sort of a constant intensity, but I guess I'm wondering how this is actually playing out for DRAM at the 1X and 1 nanometer nodes. So basically, is it time to maybe show DRAM increase in OCD intensity at sub 20-nanometer? It sounds like it's pretty difficult for the suppliers, perhaps that's a bit of a tailwind to what you're seeing right now in terms of your business. So just curious, do you have any thoughts about DRAM capital intensity increasing for OCD.
Yes. Okay. This is a very good question. I have with me Kevin Heidrich, Senior Vice President of Corporate Development at Nanometrics, and I'll ask him to answer this question for us as he is the most technically competent. So Kevin, please help us with this question.
Brian, I think what you're getting to on that capital intensity table is what is our opportunity look like as we're going through continued node shrinks in DRAM, is that the right understanding of the question?
Yes, exactly. If there's sort of an increasing floor and ceilings for OCD just like it is for 3D NAND.
I think in the DRAM case, our customers have a very aggressive 1 nanometer node shrink over about a 1-year pace, and their process flows are not significantly changing as they go from 19, 18, 17 to 16. So we don't see a significant way in how they're changing the process integration schemes, which is what drives the metrology. So for now, we see it moderating pretty flat. There may be a change as the big producers adopt EUV and other techniques to make changes, and we still need try to model that out and see how that plays out.
So basically, what Kevin is saying and what we're seeing is relatively confident intensity as these relatively minor changes in dimensions are happening. But what -- the other comment I want to make on DRAM is that DRAM in the past, in the last year, has not been a very significant driver for Nanometrics, but we always had a very strong market share because we have a high attach rate of our flagship, Atlas, into both technology node transitions and the capacity expansion. And what's happening this year is really capacity expansion, and that's what we're benefiting from.
Yes. That makes a lot of sense. I appreciate the color on that. Maybe one last question for the newest guy there, Jonathan. I know you haven't been in the seat for very long. But I'm curious, taking a big step back here and looking at the Nanometrics $500 million sort of longer term sales objectives and maybe that gross margin range 57% to 60%, which may not seem as big relative to what you're operating at right now. But just curious how much of that gross margin improvement is predicated on moving more of your supply chain to Asia, just if you had any -- if the team has any thoughts about that as a potential lever to create additional margin expansion longer term.
Yes. I think, right now, what's in our operating model that's in our investor relations deck is that, that model is really based on the current outlook for the team here. As a new guy here, I think I see clearly there's a lot of improvement that could be made, some are longer term, some are more shorter time. It's something that we hope we can actually further refine our planning process that we can actually identify these type of opportunities as we go. As we all know, Asia is a very important part of this industry. So the experience from what we have done in the past from our prior company, not just me alone, but also from Jim Barnhart and everyone else, clearly, can actually contribute to that planning process. So we're going to do that by looking out a little further, not just 1 year, 2 years or 3 years. So that's something that I'm hoping to do in the coming months.
[Operator Instructions]. And at this time, I'm showing no further question. I'd like to turn the call back over to Dr. Lesaicherre for any closing remarks.
Thank you. I'm very excited to be leading this team through the next phase of growth and expansion for Nanometrics. Together with the leadership team and all our employees, we remain focused on responding to the day-to-day challenges and opportunities in front of us, executing in a robust spending environment and profitably growing our business to create incremental stakeholder value. I personally look forward to updating you on our next earnings call in July. In the meantime, we will be webcasting our presentation at the Stifel conference in June. Thank you for joining our call today.
Ladies and gentlemen, thank you for your participation in today's call. This does conclude the program. You may all disconnect. Everyone, have a great day.