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Good afternoon and welcome to the Nanometrics Third Quarter Financial Results Conference Call. [Operator Instructions] A Q&A session will be held at the end of the call. Until that time, all participants will be in a listen-only mode. Please note that this conference call is being recorded today, October 30, 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 third quarter 2018 financial results conference call. Speaking on today's call are Dr. Pierre-Yves Lesaicherre, President and Chief Executive Officer; and Greg Swyt, VP of Finance and our Principal Financial Officer. Shortly, Pierre-Yves will provide a recap of the quarter and our perspective looking forward, then Greg 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 PM Pacific this afternoon. The press release and supplemental financial information are also available on our web-site 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, earnings per share, and the benefits that Nanometrics expects that will realize from its acquisition of 4D Technology Corporation. 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 products, 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 these measures to our GAAP results.
I will now turn over the call to Pierre-Yves.
Thank you, Claire, and good afternoon everyone. Our third quarter results were at the upper end of our forecast, due to a modest amount of customer pull-ins from the fourth [ph] quarter. Revenues of $76.6 million were 14% lower than our record setting second quarter and were up 35% from the same period last year.
Memory continued to be our primary revenue driver at 80% of product revenue for the quarter, but foundry, IDM, and all other devices rebounded sharply from the second quarter to contribute to the other 20%. Both growth margin and OpEx were closely aligned to our forecast and earnings were $0.47 per share.
For the first nine months of 2018 in total, $248 million in revenue is an increase of 37% over the same period last year, while gross profits are up 53%, operating profits are up 130%, and earnings per share are up 163% over the same period. Growing profits faster than revenues is a key aspect of our strategy to deliver value to our shareholders, both during this period as well as in the future growth trajectory of the company.
We continue to deliver strong free cash flow generation in the quarter, adding $24 million in cash to the balance sheet to a record $173 million at quarter-end. Year to date, we have generated over $80 million in free cash flow and added $56 million in net cash and investments to the balance sheet, reflecting the $23 million used to complete our stock buyback program earlier this year.
Since our last earnings call, while we saw some modest shifts in customer demand between device types and between the third and fourth quarters, our outlook for the full year is relatively unchanged. To sum up, our outlook for 2018 is aligned with every key attribute we’ve outline in our earnings calls earlier this year. Revenue growth exceeding 20%, outperforming overall industry spending with expanding growth and operating margins, and delivering record earnings and cash flow.
Prudent and strategic deployment of the company’s capital is the key aspect of the strategies we’ve put in place to increase shareholder value. Earlier this year, we communicated the investments we are making in R&D and to our global service and sales infrastructure to support continued expansion of our business above these unprecedented levels for us as a company.
We have also stepped up our capital expenditures this year, again in support of growth towards our $500 million revenue plan. Year-to-date, capital spending is up 27% from the same period last year, and we expect capital expenditures will increase again in the forth coming quarters as we continue to upgrade our manufacturing environment and other critical facilities, while investing in incremental technology to enable us to scale to a much higher revenue level.
Further, we completed a $50 million stock repurchase plan earlier this year, reducing our share count by about 2 million shares. Today, we are very pleased to spend some time discussing the fourth key aspect of our capital deployment strategy, which is making accretive and complementary acquisitions, which also support that $500 million revenue plan.
Yesterday, we announced the $40 million acquisition of 4D Technology and we expect to close the transaction in the current quarter. 4D Technology is a leading supplier of high-performance interferometric measurement and inspection systems, primarily to the industrial aerospace and scientific research markets.
With an annual revenue run rate currently in the $15 million to $20 million range, 4D provides Nanometrics with both an ongoing business and revenue stream outside of the semiconductor industry, but also key technologies, which we believe will enable next-generation metrology and inspection solutions for the most advanced semiconductor device applications.
4G Technology pioneered Dynamic Interferometry, which enables unique applications at unmatched performance for high-precision surface shape and profile measurements. Located in Tucson, Arizona 4D brings to the Nanometrics team 57 employees and fantastic opportunities for growth.
4D's margin profile and financial model is aligned with our own performance and targets. Given that the transaction has not that closed, our fourth-quarter guidance does not include the impact of the 4D acquisition. We expect the acquisition to be accretive to our earnings per share during its first or second full quarter after closing.
To summarize, our capital deployment strategies and priority, first, we have been investing in R&D and our worldwide sales organization to enable continued growth and outperformance. Second, we targeted increases in capital expenditures in support of that growth. Third, we’ve made opportunistic stock repurchases. And fourth, acquisitions, and we are very excited to be closing the 4D Transaction later this quarter.
Turning now to the current business environment. This year has developed almost exactly the way we expected, certainly with some shifts along the way between various in markets and among our key customers. We have some modest pull-ins of business occur in September, which means our third quarter was at the upper end of our forecast, while Q4 most likely will be down slightly from Q3.
Business from the entire second half of 2018 is consistent with our prior expectations and for the full-year that equates to revenue growth in excess of 20% year-over-year. As expected, our memory business is weighted towards the front half of the year, about 60/40 percentage-wise, reflecting the strong ramp in investments in both NAND and DRAM technology and capacity that began earlier this year.
For the full-year, our strong growth and memory revenues is also indicative of our market share gains in both NAND and DRAM. We reported on push-outs and DRAM capacity expansions on our last earnings call. Since then, these have been further pushed to 2019. For Nanometrics, this latest DRAM push-out was offset by an increase in second half spending plan by the two of our NAND customers. In total, our memory outlook is consistent with our last earnings call.
Our forecast for foundry, IDM, and all other devices is also consistent from last quarter for a significantly second half weighted year, and in the third quarter as expected, we saw a sharp rebound in sales of a small base in the first half. Looking at the full year, 2018 will clearly be a record year for our memory business, which is seeing growth well outpacing the growth in memory spending.
Our sales to the foundry, IDM, and other device markets is down a bit from a very strong 2017, primarily due to the shift of Korea-based foundry spending towards memory this year. As we look into the beginning of next year, we see these dynamic shifting. With our current visibility, we are expecting foundry, logic, and other devices to be stronger in the first half of 2019 than the second half of 2018.
We also see a stronger environment for DRAM spending in early 2019. At the same time, we expect total memory sales would be lower for the same comparable period, due to reduced spending forecast for NAND. Whereas on our previous call, we had expected first half 2019 revenues to be somewhat stronger than the second half of 2018. We now expect the first half will be similar to the second half of this year.
The primary reason for the change is that we now see fewer customers adding NAND capacity in the first half of 2019, compared to the current spending environment. This being said, there has been more semiconductor capital investment volatility most upside and downside in recent quarters, compared to years prior, and our outlook has been dynamic to say the least.
Given our positions with each of the top six spenders in the semiconductor industry, the PCs are in place for stronger second half 2019, but with our current visibility and the sheer number of moving PCs, it’s too early to provide an outlook as to how much the second half could increase over the first half.
So, during this near-term downtick in industry capital spending, we are feeling better than most in the industry. The second half of 2018 and the first half of 2019 run rate are looking to be down around 15% from the record levels witnessed in the first half of this year. Of course, this outlook relates to where Nanometrics business is today, before the acquisition of 4D Technology.
We remain uniquely positioned to outperform the overall industry through all of the strategies outlined earlier, enabled our position in optical critical dimension process control metrology and bolstered by strategic M&A. We have annually outperformed the process control and wafer fab equipment markets over the last five years, and our objective is to do the same again for the next five years.
So, as we recap 2018, we expect this to be a record year for both our automated and integrated metrology platforms. A record year for software and analytics sales. A record year for optical critical dimension solutions. A record year for our thin film business. A record year for service business. And a year in which we returned to record levels for our materials characterization products as well.
Finally, I will summarize the call with some of the positive indicators for 2019 and beyond. First, the DRAM push-outs referenced earlier are still expected to become 2019 revenue event. Second, while there may be pauses along the way, we expect a positive spending environment from memory will continue.
Third, we expect our foundry and IDM revenues will go year-over-year in 2019, due to the timing of project spend on 10 nanometer and below devices. Fourth, we have a growing pipeline of new products and new customers that are incremental to our current level of business. Fifth, we’re excited about the addition of 4D Technology, and the additional growth opportunities ahead of us with their products and technology.
And finally, we see opportunities for additional market share gains and further growth in our software and service businesses. So, regardless of fluctuations and forecast for wafer fab equipment spending in 2019, we remain steadfast in our objective to outperform the overall industry.
We expect to complement these future revenue growth drivers with continued strong operational execution with expanding margins and strong cash flows, and we’re firmly committed to creating shareholder value as we drive towards our revenue growth and profitability targets.
Turning to our guidance for the fourth quarter. Our outlook for the entire second half is consistent with our last conference call. With the modest amounts of pull-ins into Q3 referenced earlier, our Q4 guidance is for revenues of $69 million to $75 million, gross margin of approximately 56.5%, plus or minus 1%; operating expenses of approximately $29 million, plus or minus $0.5 million; and earnings per share of $0.33 to $0.45.
I'll now turn the call over to Greg to discuss our financial results and guidance in more detail. Greg?
Thank you, Pierre-Yves. 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 conference call, as well as supplemental revenue segment information by end market and geographic region is available in the investors section of our website. The P&L metrics discussed are non-GAAP measures, unless I identify the measure as GAAP-based. These measures exclude the impact of amortization of acquired intangible assets, severance costs, cost related to executive transition and search costs, as well as discrete tax items.
As Pierre-Yves mentioned earlier, our third quarter revenues were $76.6 million, 14% lower than our record second quarter, and 35% higher than Q3 of 2017. Product revenues were $63.8 million, a decrease of 17% from the prior quarter and an increase of 40% year-over-year. Record service revenues of $12.8 million increased 8% from the prior quarter and were up 50% year-over-year and were 17% of total sales for the quarter.
By end market, product sales to the NAND segment contributed 58% of product revenues, DRAM was 22% of product revenues, and all foundry, IDM, and other device sales comprised the remaining 20% of product revenues. Our 10% customers in the third quarter, included Samsung, SK Hynix, Toshiba, and YMTC.
Our Q3 gross margin of 57% was in-line with our Q3 forecast and was 50 basis points lower than the previous quarter. Product gross margins increased 60 basis points from the second quarter to 59.9%. Service gross margins of 42.7% was below our target model for the service business largely attributed to a higher mix of lower margin service contracts and utilization of levels of recently hired field service engineers to support our growing installed base.
For the fourth quarter, we are guiding gross margin to 56.5%, plus or minus 1 percentage point. With this projection, we expect to deliver gross margins at the high-end of our financial model targets for the year. Operating expenses of $29.1 million were aligned with our earlier forecast and we expect our fourth-quarter operating expenses to be $29 million plus or minus $500,000.
Our non-GAAP tax expense for the third quarter was $3.4 million or 22.8% of pretax income. Our tax expense on a GAAP basis includes the benefit associated with the non-GAAP expenses, previously mentioned, as well as the benefit associated with the difference between the actual settlement of employee equity earnings, versus the initial grant value.
Our non-GAAP tax rate is forecasted to be 20% to 21% for Q4 and for 2019. Net income for the third quarter was $11.4 million or $0.47 per share, based on a 24.5 million weighted average diluted shares.
Now turning to the balance sheet. Cash and investments increased to a record $172.9 million or $7.14 per share, based on 24.2 million basic shares outstanding at quarter-end. Days sales outstanding increased to 59 days from 55 days in the prior quarter, due to the timing of our shipments and collections within the quarter. Inventory increased $4.6 million to $60.7 million at the end of the third quarter.
The increase is related to the timing of inventory that is expected to ship in the early part of Q4 and accordingly we are projecting inventory to decline as we exit the year. Cash flow from operations was $24.4 million, and free cash flow for the quarter was $23.3 million, and 29% of revenue. As included in our earnings release, year-to-date capital expenditures were $3 million.
As part of our long-term investment strategy, CapEx will increase in the fourth quarter and will continue for several quarters in fiscal 2019 as we complete our plans to upgrade our manufacturing environment, and other critical facilities improve the utilization of our global office space and upgrade our global information technology environment. All of this will enable us to scale up our operations to support a much higher level of revenue. This concludes our prepared remarks.
Operator, we will now be happy to take any questions.
Thank you. [Operator Instructions] Our first question comes from Weston Twigg from KeyBanc Capital Markets. Your line is open.
Hi. Thanks for taking my question. I was hoping to ask two actually. First, you actually sound pretty optimistic on the 2019 outlook in general and I'm wondering if you could give us some color on just customer feedback and behavior, do you see any increased risk of those push-outs that landed in 2019, if maybe, [indiscernible] in the back half of 2019 or you have been pushing out a little further?
Well. Right now, the best view we have is, where we’ve communicated. We’re seeing – from plants for logic and foundry, that’s very clear. I think the DRAM push-outs that happened between the quarters now seems to be consolidated into the first half. The most difficult part to predict is really NAND, and we really don't know how firm and when that’s going to happen.
Okay. So, it sounds like your… go ahead.
There’s still a lot of uncertainty with NAND, but the rest seems pretty firm.
Okay. That’s helpful. The other question I had was on the acquisition. The 4D acquisition which I know it’s isn’t closed yet, but I think you said that revenue is tracking 15 million to 20 million a year, what’s the growth rate on that revenue? Is that something that should grow nicely in 2019 and beyond or is that kind of a flat line number that maybe you could expand upon?
So, the company has been growing over the last 3, 4 years and we expect to continue that growth with potentially doubling the revenue over the next three years.
Okay. That’s very helpful. Alright, thank you.
Thank you. Our next question comes from Patrick Ho from Stifel. Your line is open.
Thank you very much and congrats on a nice quarter. Pierre, maybe first if you could add a little bit of color or just give little more details about process control, and how much it leads process tools because directionally you’re talking about very similar things about the first half of 2019, versus second half of 2018, you're not seeing it go down, you’re saying flat, but can you just give a little color of process control and how that may lead the rest of the capacity by a quarter or two?
Well typically, we know that that process control and in-particular metrology, which is really the technology used to help ramp up fab it is front loaded, so it is ahead of other capital equipment, but today there are so many fab additions, line additions, line extensions that is a bit difficult for us to figure out really what’s happening fully everywhere.
So, I wouldn't think that we are much different than the rest of the industry, and by that, I mean deposition and etch. We tend to be more front-end loaded as I said, but as the fab continues expanding than they had the others guys, so, there is – the combination of new fabs and existing fab expanding means they’re going to spend relatively similar amounts between metrology and deposition and etch, we believe. So, we don't see a huge differentiation of our results, compared to the non-process control if that was your question.
Yes, that was the question. So, it was very helpful. Thank you. And my follow-up question, in terms of 4D Technology and the acquisition and some of the capabilities that you detailed in your press release and on the conference call, I guess now that they’re going to be part of the company, how fast do you believe you can integrate some of those capabilities into your current product portfolio? And is this something that we could expect new products as soon as 2020 with their capabilities, I guess integrated into your current product portfolio?
We have been partnering with them for technology development for few years. So, we would expect new products, incorporating their technologies to be part of our portfolio in 2019, a bit earlier than what you expect.
Great. Thank you very much.
You're welcome.
Thank you. Our next question comes from Tom Diffely from D.A. Davidson. Your line is open.
Yes, good afternoon. So, just following up on Patrick's question for 4D, are they a municipal supplier at this point, and is that – the revenue that you talked about, is that – does a chunk of that come from you?
So, they are not a supplier in the sense that we're not buying their equipment or technology to sell one of our products. As I said, they are a technology partner. We have worked with them on new development. What they do is, they offer complementary technology with multiple potential application in the semiconductor industry. So, we expect to have it incorporated in our future products as I said, but we will not specify, which one at this point in time.
Okay. And are those future products for the semiconductor industry or would they go into other industrial industries?
Well, the part that we will incorporate will be fort the semiconductor industry, but they have – the company already has existing sales into the industrial market, the aerospace, they sell equipment for inspection of telescope lenses, there is some activities towards automotive. So, there is a lot of other markets being served by their products, then we're going to continue that and try to expand it beyond integrating their products into a more automated tool, which is a type of tool that Nanometrics has been doing historically.
Okay. And maybe just a question on the NAND side of the business, you talked about how that’s the toughest peace to forecast for next year, but it was still close to 60% of your business in the quarter, how much do you think that falls off in the next few quarters before it starts to recover?
That’s a very good question, and I’m looking at the numbers as we speak. It was pretty good this quarter because as we mentioned in the call, we had some pull-ins at two of our customers and we expect that it will come down in Q1, that’s really what the – in Q1, in the first half I mean, and then it should go up after that in the second half, but by how much is very hard to tell.
Okay.
We’re not expecting the same levels of NAND spending in 2019 as we have seen in 2018.
Okay. But would you say significantly higher in the second half of the year?
Hard to tell at this point in time.
Just one last question, obviously a nice slug of business from a Chinese NAND producer, middle of this year, does the announcement we heard yesterday, how about another potential customer being put in the penalty box here, does that change your view on the Chinese market in those customers?
We had, and I think you’re talking about Fujian Jinhua IC Corporation. We did not have a significant business with them and it was not in our forecast at any significant level. So, that particular action of the Department of Commerce against that company does not impact us. We are expecting our business in China to grow with other domestic China customers, especially strong growth next year.
So, we’re monitoring now all of the actions of the U.S. government towards Chinese company. My view, my personal view is that the Fujian Jinhua case was a bit particular because of the IT dispute with micron. We don't see that happening with our other customers, YMTC and all the other China domestic customers. So, at this point in time, we expect this to be limited to the FJHICC, but who knows.
Okay. That was great color. Appreciate your time today.
Thank you.
Thank you. [Operator Instructions] And our next question comes from Mark Miller from Benchmark. Your line is open.
You mentioned 4D had sales outside of the semiconductor space, I don't believe aerospace, I was just wondering what percent of the sales from 4D were non-semiconductor and also what about the margins from these other areas? Are they similar to semiconductor margins?
So, the 4D sales to the semiconductor market are less than 10%. So, the majority of their sales is non-semiconductor. As we said, industrial, aerospace, and scientific instruments, majority of it, more than 90%. And their margin profile, and profitability is very similar to ours, so by integrating the company that does not change our model, our target model.
What technology specifically could be levered from them and vice versa from you in their new products in terms of synergies or technologies that might be attracted to improve your products or their products?
So, what they do is, they are really a leader in Dynamic Interferometry and they do these Fizeau Interferometers, so we – and they tend to do standalone tools that are not for the semiconductor industry. So, when you are trying to apply these technologies for the semiconductor industry, you can imagine that now you have to have wafer handling, you need a stage, you need precise positioning, you need a front-end module to move the wafers in and out, you need a control environment.
So, the idea is, on one hand to take their technology, their core technology, and put it in a automated large system that we can sell to the semiconductor industry for some applications and vice versa it is taking some of our spectroscopy or reflectrometry technology and sell it into the industry and other markets.
You mentioned, you had some pull-ins this quarter, do you know what prompted the pull-ins, was it straining capacity or just curious or people waiting for new programs?
It was adding incremental capacity. So, these particular customers, two of them in the NAND market, we’re adding incremental capacity and they needed these equipment’s, these pull-ins.
Thank you.
You're welcome.
Thank you. And I am showing no further questions from our phone line. I would now like to turn the conference back over to Dr. Lesaicherre for any closing remarks.
Well, thank you for joining our call today. Together with our leadership team and all our employees, we remain steadfast in addressing the challenges and opportunities in front of us, and profitably growing our business to create incremental shareholder value. I would also like to take this opportunity to thank our employees for their amazing efforts towards growing the company in excess of 20% this year.
Finally, I look forward to welcoming the 4D team to Nanometrics later this quarter and pursuing the many growth opportunities ahead of us. Our next earnings call is scheduled for February, and in the meantime, we have plans to attend the New York City Summit on December 11, and look forward to seeing many of you there. And that concludes our call for today. So long.
Ladies and gentlemen, thank you for participating in today's conference. This does conclude the program. You may all disconnect. Everyone, have a wonderful day.