Ultra Clean Holdings, Inc. (NASDAQ:UCTT) Q3 2020 Earnings Conference Call October 28, 2020 4:45 PM ET

Company Participants

Rhonda Bennetto - Investor Relations
Jim Scholhamer - Chief Executive Officer
Sheri Savage - Chief Financial Officer

Conference Call Participants

Charles Shi - Needham & Company
Patrick Ho - Stifel
Tom Diffely - D.A. Davidson

Operator

Good afternoon and welcome to the Ultra Clean Third Quarter Conference Call. [Operator Instructions]. Please note, this event is being recorded.

I would like now to turn the conference over to Rhonda Bennetto, Investor Relations. Please go ahead.

Rhonda Bennetto

Thank you, operator. Good afternoon, everyone, and thank you for joining us. With me today are Jim Scholhamer, Chief Executive Officer; and Sheri Savage, Chief Financial Officer. Jim will begin with some prepared remarks about the business, and Sheri will follow with a financial review, and then we'll open up the call for questions.

Today's call contains forward-looking statements that are subject to risks and uncertainties. For more information, please refer to the risk factors disclosure in our SEC filings. All forward-looking statements are based on estimates, projections and assumptions as of today and we assume no obligation to update them after this call.

Discussion of our financial results will be presented on a non-GAAP basis. A reconciliation of GAAP to non-GAAP can be found in today's press release posted on our website.

And with that, I'd like to turn the call over to Jim. Jim?

Jim Scholhamer

Thank you, Rhonda and good afternoon, everyone. We appreciate your time today. I'm going to start with a review of our third quarter performance and then highlight a few of our recent accomplishments. I'll wrap up with our thoughts on the industry and then turn the call over to Sheri for a financial review. Then we'll open up the call for questions.

UCT delivered another solid quarter of revenue and profitability thanks to large part to the exceptional commitment and innovation of our team members around the world and ongoing strength in the semiconductor market. All our facilities are running smoothly which enabled us to again exceed customer expectations for quality and on time delivery. Our products division saw an increase in business for nearly all customers and we secured a sizable new award from one of our main customers as they continue to work with us to meet their outsourcing needs.

In addition, we were designated as an improved design and production partner for a major lithography company and continue to manufacturing awards on our next generation tools. This new designation enables UCT to add value early in the design and development process as the new systems. And a final highlight for our products business this quarter, our Singapore facility hit a new milestone reaching record revenue of $100 million.

Our service business expanded at IDMs across all device areas and we saw elevated engagement at each of our OEMs. Using the midpoint of our fourth quarter guidance, we will have increased our annual revenue by 30% this year compared to last year, significantly outperforming the overall WIB market for 2020. Our performance these past few quarters underscores the strength, flexibility and resilience of our business model to consistently gain share and deliver growth all having improved profitability and shareholder value.

In early 2016, we embarked on the plan to double our revenue and vastly improve profitability. Focusing on the semiconductor market, we pursued additional capabilities deeper within the value chain that went beyond our primary [indiscernible] business, leveraging infrastructure and vertical capabilities already in place together with a handful of strategic acquisitions. We diversified our offerings by adding multiple new equipment products into our portfolio and we added a higher margin service component to our business readily surpassing our goal.

This year we're on track to achieve annual revenue of approximately $1.4 billion. Almost three times our revenue in 2015 while maintaining our share of the gas panel business. Revenue from all other areas of our business come from almost 65% of our total revenue compared to 10% just five years ago. We continue to execute on our multi-year growth by building upon our technology leadership in key areas further strengthening our competitive advantage.

The markets we serve are being inspired by a vast set of demand drivers and UCT's diverse suite of capabilities enables us to play a large, more valuable role with our customers. By optimizing our operations, implementing new processes and procedures, maximizing utilization of our facilities and strategically expanding our global footprint. We have broadened our presence and increased our sizable lead within our served markets.

Our aspirational [ph] goals for the next three years is to become $2 billion since 2015 while the WFE market has grown less than 2x, we have more than doubled revenue from our largest customers and virtually tripled revenue from our second largest customer and gained valuable traction within our broader customer base. Another pivotal element of our growth plan is to add a third reportable customer to our products division.

This year we have accelerated our efforts and deepened our engagement with one customer in particular and expect their revenue contribution to yield reportable results within the next few years. Dynamic multi-year industry inflections are driving our business today and creating exciting new opportunities for UCT. We are confident we can maintain our sustainable growth path and outperform the industry. While we expect the fourth quarter to be somewhat flat compared to the third quarter.

We are very encouraged by the alignment of the growth drivers for the industry for 2021. Accelerating technology inflections due to the pandemic, robust mobile demand driven by 5G, new CPU architectures while are enabling higher performing servers and cloud, AI and machine learning are all driving semiconductor content enrichment. These trends will support continued demand for advance memory and logic.

Our business is well balanced and both our products and service businesses have broad exposure across all device types. In addition, we anticipate a disciplined CapEx schedule as customers build out their fabs at the leading edge as it strengthened market conditions and industry profitability next year and beyond. Before handing the call over to Sheri, I want to again thank our employees and our suppliers for their incredibly hard work ensuring our success and the success of our customers.

We remain mindful of the macro headwinds that may arise as result of the pandemic situation. But have proven we can execute at speed, innovate at scale and successfully navigate under difficult circumstances. And with that, I'll turn the call over to Sheri to review our financial performance. Sheri.

Sheri Savage

Thanks Jim and good afternoon, everyone. Thanks for joining us. In today's discussion I'll be referring to non-GAAP numbers only. Total revenue through the quarter was $363.3 million up 5.4% from the prior quarter. Our products division grew 5.9% to $294.4 million on increased demand from nearly all our customers. Our services business contributed to $68.9 million up 3% on increased activity across the board from our IBM and OEM customer base.

Total gross margin remains at the higher end of our model at 21% compared to 22% last quarter. The change was due primarily to increase the need on materials and maintenance for our services business to meet demand. Offset by favorable direct labor expenses in both businesses. Products gross margin was 17.5% compared to 17.8% last quarter. And services margin was 36% compared to 39.3% last quarter.

Margins can be influenced by customer concentration, geography, product mix and volume. So you can expect to see variances quarter-to-quarter. Operating expenses were $34.3 million down from $35.4 million last quarter. As a percentage of revenue operating expenses decreased to 9.4% compared to 10.3% in the prior quarter. Total operating margin for the quarter stayed flat at 11.6% compared to 11.7% in the second quarter.

Margins from our product division improved to 10.8% versus 10.5% in the prior quarter, above our current model of 8% to 10% due to increased volumes and lower operating expenses. Margins from our services division was 14.9% versus 17.1% in the prior quarter and remains at the high end of our current model at 12% to 15%. The change was primarily due to an increase in expenses for long [indiscernible] materials to meet demand.

Based on 41.1 million shares outstanding earnings per share for the quarter were $0.73 on net income of $29.9 million compared to $0.75 on net income of $30.5 million in the prior quarter. Our tax rate for the quarter was 18.1% compared to 18.8% last quarter. We expect our tax rate for 2020 to remain in the high-teens.

Turning to the balance sheet, our cash and cash equivalents were $176.1 million this quarter compared to $214.4 million last quarter. Cash from operations was $19.7 million up from $17.5 million in the prior quarter. In addition to our regular payment, we made an additional voluntary Term B loan payment of $7.8 million bringing our total Term B payment to $10 million for the quarter. In addition, we paid off the balance of our revolver in the amount of $40 million.

We've made significant progress paying down our Term B loan over the past couple years and continue to look at ways to ensure that our overall capital structure supports our growth objective. While demand remains steady, we continue to risk adjust our guidance to account that have numerous uncertainties surrounding COVID-19 pandemic including unexpected changes of demand, possible supply chain interruption.

We anticipate revenue for the fourth quarter to be between $345 million and $375 million and EPS in the range of $0.63 to $0.77.

And with that, I'd like to turn the call over to the operator for questions. Operator?

Question-and-Answer Session

Operator

[Operator Instructions] our first question comes from Krish Sankar with Cowen. Please go ahead.

Unidentified Participant

This is Steven [ph] calling in behalf of Krish. First question I had was regarding the guidance range. I understand that you're still providing relatively wide range given [indiscernible]. I guess looking beyond pandemic situation has the visibility or commentary from customers and OEMs has that changed at all over the last 90 days or is it still fairly comparable compared to quarter ago?

Jim Scholhamer

Hi Steven [ph], this is Jim. I think things have definitely become a bit more predictable and I think things were pretty clear in our supply chain. We had a pretty good understanding of where we would end up, what was always unclear is where our customers, other suppliers might perform. But I think we're starting to see that performance tighten as well. I think the range is now down to 30, where at one point I think we even had a $40 million range. So we're beginning to tighten up that range as well. So things are definitely smoothening out knock on wood regarding any possible second wave or any other new interruptions. We definitely see things a little bit more clearer than we did a few quarters ago.

Unidentified Participant

Got it, thanks for that. As a follow-up. I had a question related to China. As your currency opening stand, I guess how much of your sales is exposed to China domestic semiconductor companies versus through your OEM customers, just trying to understand from your guidance perspective, if still continue [indiscernible] risks related to US administration taking any actions officially against Chinese domestic companies?

Jim Scholhamer

Yes actually the actions around China trade have actually kind of played out as we predicted. The risk is mostly around the [indiscernible] foundry with its logic chips and so there's pretty much played. I mean they typically run $3 billion to $5 billion in WFP [ph]. They're running a little bit higher this year, so we do have some exposure to that. But it's relatively moderate.

Unidentified Participant

Okay, thanks Jim.

Operator

Our next question comes from Charles Shi with Needham & Company. Please go ahead.

Charles Shi

Jim and Sheri, my first question is really about the third quarter revenue. You talked the high end of the guidance and I can see that most of that is coming from the product revenue. I wondered compared to a quarter ago where do you see the scores of this significant upside from the product side of the business and is there any product revenue being pulled forward from the fourth quarter to third quarter. Thank you.

Jim Scholhamer

Yes, thanks Charles. We do not see any significant movement between the quarters and definitely nothing fourth quarter to third quarter. We've seen strength across the board. Obviously TSMC has been spending quite a bit with their successes on moving forward with 7 nanometer, Samsung has been investing very heavily in their [indiscernible] fab. So we've seen a pretty strong across the board. I wouldn't say things have changed too much in that regard.

Charles Shi

Okay, thanks. So maybe a little bit looking forward to the first quarter and actually I know you don't provide guidance. But from your conversation with the OEM customers on their view plan. What's the general feel about the first quarter next year at this moment?

Jim Scholhamer

You're right, we certainly don't give that kind of granularity. All of our customers are pretty strong in their forecast for the entire year of 2021. I think that they're all looking at around 10% growth rate and in any given quarter there can be movement around that number. So it's too early from a bonds-up forecast to really to talk about the first quarter. But there's certainly nothing to really show that there would be any significant change from the industry ramp that we're in today.

Charles Shi

Got it, thank you. So maybe the next question is little bit about the service side of the business. Definitely there's a very good nice sequential growth for the second, third quarter. I mean probably driven by slightly higher utilization rate of your IDM customers and you also mentioned some strength on the OEM customers. I wonder on the IDM side looking to the fourth quarter just a lot of concerns about whether [indiscernible] especially the memory side of the fab utilization could soften. What's your outlook there and how would that affect [indiscernible] business revenue for the fourth quarter?

Jim Scholhamer

Yes, we don't guide by division. But we don't see any weakening in the memory space on fab utilization at this point and nor do we expect it. We do are expecting kind of one quarter week utilization drop in one of the major logic foundries that are switching over from 14 nanometer and they're upgrading to 10 nanometers, so there's going to be kind of temporary one quarter drop in utilization at that rather large logic fab, where we have a very high presence. So we see a one quarter small drop there in the service business which should resume again back to full utilization in the first quarter as they finish their conversion, that's really the only change that we see in the fourth quarter for the service side or the wafer starts [indiscernible].

Charles Shi

Great, thanks so much for the color Jim and congratulations on the results. Thank you.

Operator

Our next question comes from Patrick Ho with Stifel. Please go ahead.

Patrick Ho

Jim, maybe first off on the product side of the business. Given that you've been able to deliver to your customers above expectations. You've managed the capacity well. But as business trends continue to be healthy and potentially grow as we go into 2021. One, how do you look at your current capacity situation on the products? And secondly, do you need build any inventory on your in given some of the comments by your customers that they're building inventory?

Jim Scholhamer

Thanks Patrick. The second part, most of the products we make are not really like inventory type products, they're kind of customized equipment for which are very customer specific. So I don't see a lot of that. We have the ability on the capacity part in your first question. We definitely can temporarily go up significantly capacity above the current levels. It's not sustainable to go up 20% or 30% but certainly first capacity we have that capability and we'll start to see our Malaysia facility start adding capacity in the third quarter of next year, so we're very comfortable with our ability to meet any demand increases that we expect in next year.

Patrick Ho

Great, that's helpful and maybe as my follow-up question for you, also Jim. In terms of services business and the parts cleaning side of things. As you know etch and deposition are very capital intensive in 3D NAND. They go through a lot of the parts and then probably that helps your business as utilization rates pick up. Is that something that you're monitoring closely as we go into 2021 with a potential recovery in the NAND FLASH market and how that can incrementally benefit that side of the business for you?

Jim Scholhamer

Yes Patrick, we definitely monitor all that carefully and that's really where the large footprint we have in that business, where it pays off. We're adding capacity in some of those sites to support some of those increases. [Indiscernible] our majority owned JVs and we're adding capacity in [indiscernible], right now as well as we replaced the building that burned in Korea, that building is coming online and capacity is increasing there to support Samsung and Kyontech [ph].

And in North America, we have such a broad footprint that we work with our customers to move around capacity to our fabs which have available capacity. For example, as our factories in Arizona and Oregon get closer to fall, we divert some of that to our Charleston factory, where we haven't seen the demand really there yet. So we definitely look at all those factories as we plan for capacity to meet our customer need and we're in great shape there.

Patrick Ho

Great and final question from me, maybe for Sheri in terms of the model. Actually you've done a great job in gross margin and you've managed OpEx well. But you did mention that you're adding some expenses in the near term for this business growth that you're seeing. How should we look at that full potential increase? Is it just incremental increases or is there a big step up potentially as your revenues get to higher levels?

Sheri Savage

Hi Patrick, yes for now I would say it's definitely incremental. We still feel like we'll be at the top end of our operating margin model. So it's just going to be, we're very careful obviously with OpEx to make sure that we only add incrementally and that we get the benefit of additional reverence coming through. So top end of our model still.

Patrick Ho

Right. Thank you very much.

Operator

Our next question comes from Dick Ryan [ph] from [indiscernible]. Please go ahead.

Unidentified Participant

Sheri, what Jim is mentioning of aspirational [ph] goals of $2 billion over and that's few years, is it too early to ask what you think gross margin, operating margins could go under that sort of scenario?

Sheri Savage

Yes too early Dick. I think obviously we feel very comfortable with the model range. But it also depends on where that growth of revenue is and whether it's via acquisition or organic growth. It really is dependent on many things. So it's hard to predict exactly what that margin would be at this point, but I think obviously we feel very comfortable in the model range that we're in right now.

Unidentified Participant

Okay and what sort of debt payment should we expect in Q4?

Sheri Savage

We haven't made a final decision yet. But we're continuing to look at paying down some additional debt. So I would say, we would probably see a little bit of additional payment like we did last quarter. But I don't have a specific amount at this point.

Unidentified Participant

And Jim, are we in the discussion you mentioned sizable new wins with an OEM and then some new designation with litho customers. Are you able to give us a little more color on those two items?

Jim Scholhamer

Yes on one of the our existing very high volume customers, actually they just haven't built any brick and mortar new capacity and as you can see the industry continues to push towards new highs in WFE, so outsourcing has always been part of their strategy. So it's even more important now as we continue to push to new highs in industry. So as they look to move things out of their factory, we've been bidding on some of those projects and one of the nice sizable ones have come through in the last quarter. So we were happy to report that. And obviously the litho customer we've been in a long-term engagement with them, really kicked in about a year ago, even more direct work with them and our engineers have been embedded with their engineers and we're working on a lot of the new tools that are not yet released.

So unfortunately revenue for those takes a while to go up for us because they have to release the tools and start to see volume. But it's exactly what we want to do which is get involved right into the front end of the design be involved in the whole rollout helping them get their product to the market and then becoming the high volume production house for those products as they rollout. So we're really pleased with our work there and we're starting to see that really pay off, as we won the status of being a design and a production partner for them.

Unidentified Participant

Okay, great. Thank you and congratulations on a strong quarter.

Jim Scholhamer

Thank you, Dick.

Operator

Our next question comes from Tom Diffely with D.A. Davidson. Please go ahead.

Tom Diffely

I guess first what was the timing on the litho engagement? Is that just a 2021 story?

Jim Scholhamer

Yes, I think we have current revenue going on released products with the company now especially through one of the acquisitions as they made about five or six years ago, that division of their company is been a long-time customer. So we see incremental production here and there on some of the existing tools. But definitely it's mid-to-late next year where we started to see the revenue ramp on the new products that they're rolling up, that we are engaged with them on.

Tom Diffely

Okay, great. And I was more surprised when you talked about logic conversion [indiscernible] slow things a little bit for quarter. I always thought when a company went through transition like that, with lot of annual or preventive maintenance that they would do that, would actually benefit your Cleans [ph] businesses.

Jim Scholhamer

I think obviously there's definitely some element of that offsetting the fact that the FAB will be down for the majority of the quarter. So obviously that reduces a lot of the etching and the coatings that go on that require our business to come in and clean the tools. So yes, definitely there's some offset from parts coming out to be pre-managed. But there's also obviously a lot less cleaning cycles when the FAB isn't often running.

Tom Diffely

Okay and final question on the new Malaysian facility. Obviously increases capacity nicely. But you also talked about the cost reduction. Is most of that coming from just reducing output from higher cost regions or is it more of a shipping and logistics cost savings from being closer to your customers and the suppliers?

Jim Scholhamer

Mostly it's reducing the cost of manufacturing. It is in a very great logistics place as well. But most of the logistics cost for our product, out the door are borne by our customers. So and inbound logistics is relatively straightforward. So the majority of that is products are being produced in higher cost regions will be transitioned over to Malaysia where they have a lower labor cost.

Tom Diffely

Okay, great and I appreciate your time today.

Jim Scholhamer

All right, thank you Tom.

Operator

This concludes our question-and-answer session. I would like to turn the conference back over to Jim Scholhamer for any closing remarks.

Jim Scholhamer

Thank you everyone for joining us and we look forward to speaking with you again next quarter. Thank you.

Operator

The conference is now concluded. Thank you for attending today's presentation. You may now disconnect.