Ultra Clean Holdings, Inc. (MAT) Q2 2020 Earnings Conference Call July 29, 2020 6:30 PM ET

Company Participants

Rhonda Bennetto - VP, IR
James Scholhamer - CEO & Director
Sheri Savage - SVP, Finance & CFO

Conference Call Participants

Krish Sankar - Cowen and Company
Quinn Bolton - Needham & Co.
Patrick Ho - Stifel
Christian Schwab - Craig-Hallum Capital Group
Tom Diffely - D.A. Davidson
Colin Du - MacKenzie Investments

Operator

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

I would now like 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?

James Scholhamer

Thank you, Rhonda, and good afternoon, everyone. Thank you for joining us. I want to start this call today by sincerely thanking every one of our 4,700 employees around the world for their commitment, flexibility and cooperation during this unprecedented situation. The relentless drive to succeed of our entire workforce resulted in record revenues and profitability in the second quarter clearly demonstrating the strength and resiliency of our business model.

Ongoing demand driven primarily by foundry and logic resulted in revenue from our products businesses exceeding our expectations. The recovery of wafer starts drove our service business revenue to new quarterly high. These higher volumes coupled with a focus on operational efficiencies and a favorable product mix spurred profitability to levels not previously seen.

The pandemic has prompted companies everywhere to realign how they do business and UCT has risen to the challenge across the board. I continue to be impressed by the ingenuity and innovative ways everyone pulled together to ensure business continuity while working safely and productively. Our business continuity team has done an extraordinary job and remains in a heightened state of readiness as some countries grapple with a second wave of the virus and others struggle to contain the first wave. Every safety protocol outlined in our BCP playbook remains in place at each site.

All UCT facilities remain operational and we are grateful that we have no known employee to employ transfers of the virus. We remain thankful to everyone on the front lines fighting with pandemic and look forward to a day when the virus is contained.

We are working closely with our customers to meet their needs and will continue to leverage our global footprint and optimize our supply chain to ensure our customers success.

The supply chain is a critical part of our business and operations and I would like to thank our suppliers for their diligence which enabled us to deliver on time. We are dedicated to continuous improvements in a high performance culture and have been evolving our procurement and supply chain functions.

Supply chain resiliency is about more than speed of operation and just in time delivery which is why we are proud to be partnering with applied materials in their success 2030 sustainability initiative announced during [indiscernible] last week. The 10-year program aims to optimize material and part selection, procurement, packaging, warehousing, transportation and recycling to reduce energy and emissions and conserve resources. The project also aims to promote ethics, human rights, diversity and inclusion throughout the supply chain. We recognize we have a shared responsibility as environmental stewards and we thank applied materials for leading this effort. We believe we can drive progress on social and environmental issues while improving our efficiency and effectiveness is part of our overall growth strategy.

On that note and in response to customer demand, I am excited to announce that we are extending our global footprint into Malaysia. Having operations in close proximity to our customers and suppliers in the region will help expedite our growth plans. Leasehold improvements on the 340,000 square foot state-of-the-art facility in Penang is scheduled to begin in the fourth quarter of this year with initial production slated for the second half of 2021. The facility will increase our total capacity by approximately 50%, improve our cost profile and position us well for share expansion as the industry continues to grow.

For the third quarter we expect demand to remain around the current levels as technology leaders continue to invest in no transition and leading edge capacity despite pandemic concerns. It is possible that economic fallout from the global health crisis could disrupt our end markets, our manufacturing capability or our supply chain. While we don't know exactly how things will unfold our increased diversification, strong operating fundamentals enable us to withstand uncertain periods and will serve us well as the global economy recovers.

And with that I will turn the call over to Sheri for a financial review and then open up the call for questions. Sheri?

Sheri Savage

Thanks Jim and good afternoon everyone. Thanks for joining us. In today's discussion I will be referring to non-GAAP numbers only. Ongoing industry demand drove UCT's total revenue to an another record quarter. Higher volumes, favorable mix and operational efficiencies sent profitability to new highs and increased earnings quarter-over-quarter.

Total revenue for the quarter was $344.8 million, up 7.4% from the prior quarter. Our products division grew 7.1% to $277.9 million on increased demand from our two largest customers. Our service business contributed to a record $66.9 million up 8.7% as wafer FAB utilization returned to more normalized run rates across the customer base.

Total gross margin was 22% up from 20.9% last quarter. Higher volumes from both business units, favorable mix and factory efficiencies all contributed to the increase. Product's gross margin was 17.8% compared to 17.4% of last quarter and service margin was 39.3% compared to 35.9% last quarter. Margins can be influenced by customer concentration, geography, product mix, volume and expenses related to COVID-19. So you can expect variances quarter-to-quarter.

Operating expenses were $35.4 million flat compared to the prior quarter. As a percentage of revenue operating expenses were 10.3% compared to 11% in the previous quarter. Total operating margin for the quarter improved to 11.7% from 9.9% in the first quarter. Margins from the product divisions improved to 10.5% versus 9.5% in the prior quarter due to increased volumes, improved factory efficiencies and favorable product mix.

Margins from the services division was 17.1% versus 11.9% last quarter due to increased volumes coupled by improved factory efficiencies. Based on $40.8 million shares outstanding earnings per share for the quarter rose to $0.75 on a net income of $30.5 million compared to $0.52 on net income of $21 million in the prior quarter. The increase in earnings per share resulted from higher revenues from both business units and included approximately $2 million of subsidies from the Singapore and China government primarily related to the COVID-19 situation. Our tax rate for the quarter was 18.8% compared to 18.7% last quarter. We expect our tax rate for 2020 to remain in high teens.

Turning to the balance sheet. During the June quarter we increased our cash and cash equivalents to $214.4 million up from $208.1 million. Cash from operations was $17.5 million up from $15.7 million in the prior quarter. Subsequent to end we made a $7.8 million voluntary principal prepayment on our term B facility along with our regular $2.2 million principal payment for the quarter reducing our term B loan balance by $10 million for Q3. While demand remains steady for the near term we are risk adjusting our guidance to account for the numerous uncertainties surrounding the COVID-19 pandemic including unexpected changes to demand or supply chain interruption.

We anticipate revenue for the third quarter to be between $320 million and $360 million and EPS in the range of $0.56 to $0.72.

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

Question-and-Answer Session

Operator

We will now begin the question-and-answer session. [Operator Instructions] Our first question comes from Krish Sankar of Cowen and Company. Please go ahead.

Krish Sankar

Yes. Hi. Thanks for taking my question. I have a few of them. First one I'm just trying to reconcile your guidance given the impressive numbers in June and the fact that many of your customers are guiding September up sequentially you guys are guiding roughly flat. Is that conservatism or is there something else going on in terms of the September guide? And then I had a few other questions.

James Scholhamer

Yes. Hi. Krish. This is Jim. Obviously, it's as Sheri mentioned it is somewhat risk adjusted and I think it's very difficult to bridge especially from one customer alone from quarter-to-quarter. There are definitely differences in the timing between us and our customers as well. So I think at this point our guidance is flat and that's a flattish and that's roughly where we're confident where we will be.

Krish Sankar

Got it Jim. That's helpful and then the guidance aside, do you think that given what happened in Q2 with the fact that supply was obstructed due to COVID, do you think your customers might start building inventory just to be on the safer side or have you seen any such indication yet?

A - James Scholhamer

No. We haven't. I think it's been obviously a pretty bunch of a mad scramble the last few quarters and another factor is the majority of the things that we do aren't really inventoriable if that's a word. They're not really shelf items. They're very specific modules and components which are very dependent on their particular customer as well. So typically there is not a lot of inventory between us. So we do not believe that the majority of what we are making is doing anything but continuing on to the customer.

Krish Sankar

Got it. And then just a final question on the Malaysia facility. Is that a function of the fact that your two largest customers have like a Malaysia and Singapore facility is that the reason for it or was there any other specific reason for the Malaysia plant?

James Scholhamer

Yes. Recall we have a Singapore facility as well. Yes, we are actually it turns out that our facility will be within a stone's throw of [lands] facility that was unplanned. We've been planning this for some time. There is a lot of reasons here, we see a lot of continued growth of UCT over the next several years and so we needed to add capacity. There is also, there has been an overall shift year-after-year more a higher percentage of what we're building which requires Asia pickup or an Asia destination. So we've seen a higher percentage of Asia sales versus North America as well. But and then also continues to put us in a robust, low cost supply chain and manufacturing infrastructure and a lot of other advantages as well. So I think it puts UCT in a very good cost position as well as supports our future growth as we see WFE continue to grow and our share as WFE continue to grow.

Krish Sankar

Got it. Jim, I mean if I can just squeeze in one last with the well-publicized push out of Intel 7 nanometer how does that impact your, the SSD business?

A - James Scholhamer

Yes. The push out was obviously, you're talking about the $1 billion in CapEx cuts or?

Krish Sankar

I was looking at more like the 7 nanometers pushed out by six months to a year.

James Scholhamer

Yes. I think that will impact, I think that will tend to impact maybe a delay down the road as in their expansion and in FAB's 47 nanometers. So that's something that I think we'd see maybe a two-quarter push-out of their new FAB investment. So that would be I think an impact not reducing their current spend with us. We're continuing to see that growth but maybe pushing out a few quarters that step function increase in service revenue that we would see from their new investments in 7 nanometers.

Krish Sankar

Yes. Thank you very much Jim.

James Scholhamer

Yes.

Operator

Our next question comes from Quinn Bolton of Needham & Co. please go ahead.

Quinn Bolton

Hey guys, let me offer my congratulations for the nice results. Well, I guess the first question just looking at the guidance and I know you're building some level of conservatism in here but when I look at the EPS of $0.56 to $0.72 that's down from the $0.75 you just reported. So wondering if you're anticipating any increase in OpEx or lower gross margins? Is there something that's affecting the profitability in the third quarter?

Sheri Savage

Hi Quinn, yes this is Sheri. We did see a very favorable mix come through the Q2 financials with more Weldment shipments as well as additional heater some of our higher margin products. So we're not seeing that mix right now go through our Q3 to the same level. So that's why the margins or the EPS is a little bit lower as well as we did have as we mentioned in the call $2 million subsidy from China and Singapore and we don't have that level of subsidy flowing through the P&L and Q3 as well.

Quinn Bolton

Sorry is that subsidy was that more of a cost of goods or was that an OpEx just so that we can model it appropriate?

Sheri Savage

Yes. It was in both. I can get you the specific numbers but majority of it went through cost of goods sold to deal with direct labor costs associated with the COVID situation with a small portion going through OpEx.

Quinn Bolton

Got it. Okay. And the second question just looking at the utilization you saw record service revenue. Can you give us any comments on how you've seen the utilization rates trending both on the logic and the memory side into a third quarter here?

James Scholhamer

Yes. I think logic memory foundry [wall] continued. We don't obviously have at our fingertips the exact utilization numbers but they've all continued to grow especially I think the biggest area of growth was memory utilization which it had been suppressed through ‘19 and started to recover in ‘20 and we saw that really accelerate the utilization rates and the memory really move in the last quarter.

Quinn Bolton

And then last for me just as you think about the mix shift and this may be hard for you but do you sort of expect sort of a mix shift from on a logic towards memory based on the book business you see for the second half?

James Scholhamer

Second half, I don't think the mix is going to shift that much. I think as we look into ’21, I think we see ‘21 continuing to be pretty strong and continued growth in WFE and I think that's going to be based pretty heavily on memory. I think memory is going to kind of recycling at full speed then next year and so I think that will be where we see the mix start to move. I think they'll continue to be strong investments in logic and foundry obviously logic may be pushed out a little bit but I think that mix will move more in the next year's memory really invest beyond just filling out current FABs and we started to see new FABs fill out.

Quinn Bolton

Got it. Great. Thank you very much.

James Scholhamer

Yes.

Operator

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

Patrick Ho

Thank you very much and congrats on nice quarter. Jim, maybe as a follow-up on the last question about the services business and the breakdown between foundry logic and memory, maybe as you look longer term can you discuss the growing intensity or the opportunities on the memory side, especially for your parts cleaning business? Can you detail maybe qualitatively how some of the changes on the memory side of things are driving an increase in the use of parts cleaning and the growth in that area for UCT?

James Scholhamer

Yes. We have a very strong position with Samsung and so we obviously see Samsung has started to invest quite a bit in and filling out their Pyeongtaek FAB and I think there is a new investment going into [Xian] where our joint venture, we have a position there as well. So I think we're set up pretty well in that side. I think memory overall is the, it's following the same trend obviously a little bit behind logic, foundry and logic where the cleaning intensity is going up as the dimensions get more challenging. So we're seeing, I think the requirements and I guess the cleaning value per part starting to increase in memory as well which is -- we saw that move pretty dramatically through logic over the last year to enter foundry and now we're starting to see that happen in memory as well where there is a lot of things that require pretty high level cleaning and pretty complex cleaning in the memory space that didn't require that in the past.

Patrick Ho

Right and maybe as my follow-up question on the product side of things. You obviously have the multiple business on the products but you're also seeing new applications and new processes both on the etch and deposition side where you're seeing selective etch and selective deposition. You're also seeing an increase in ALD adoption. Can you again maybe just qualitatively describe how some of the growth in those “new applications”, new processes are driving growth for your products business?

James Scholhamer

Yes. Especially the ALD application but also the depth and match some of the new products coming out, we're pretty, we're very heavily involved with our customers in those developments and so I think there is a lot of new generations of products coming out. So I think that's why we continue to see our gas panel side of our business remain very-very strong.

So we definitely even though ALD has become more productive, it's definitely an application which is very gas panel heavy versus the wafer output. So that's an application that we cheer on continued adoption in the FAB. So it's definitely a positive trend requiring more out of that section of our business in those two areas.

Patrick Ho

Great and just the final question for Sheri in terms of the prepayments and your improved cash flow generation. Should we look at additional types of pre-payments as the primary use of cash particularly in this environment when your cash flow generation is at more elevated levels?

Sheri Savage

Yes. Absolutely. We are going to continue paying down our term B debt as we move forward. So yes absolutely we do plan on doing that periodically as we move forward.

Patrick Ho

Great. Thank you very much.

James Scholhamer

Thank you, Patrick.

Operator

Our next question comes from Christian Schwab of Craig-Hallum Capital Group. Please go ahead.

Christian Schwab

Great. Congratulations guys on a great quarter and outlook. Can you walk us through what you believe your aggregate revenue capacity is today before any expansion in Malaysia?

James Scholhamer

Obviously, it's a moving target at this with the COVID we've had to spread out shifts in order to keep spacing and things like that but I think first capacity we could cover through burst capacity through extended shifts and days and depending on the different plans, we definitely can foresee covering 30% or so additional output without doing too much acrobatics and then where is always a will there is always a way. So in the short term I think we will be well set by. In the longer term by the end of next year we will have significant new capacity coming on board. So we don't see any restrictions or any ceiling that we will bump into on being able to support the industry and our customers.

Christian Schwab

Great. That leads to my follow-up. So the movement to Malaysia you talked about kind of obviously low-cost supply chain and manufacturing infrastructure, I would assume a favorable lower-cost region but when you're adding capacity in the new Malaysia facility, I guess I am trying to figure out, are you adding incrementally more capacity or will you be moving capacity from facility to facility to this lower cost? Is this, should we thinking about this is aggregate brand new capacity when it's fully built out or will there be puts and takes between the different facilities?

James Scholhamer

It's actually going to be a combination Christian. I mean they are obviously, we do need to do foresee the need of additional capacity. We see next year's WFE probably roughly 10% higher than where we currently are and every year we see one or two points of difference between North America and Asia. We see the Asia what's required to be built in Asia increase a few percent and that's been happening in a year upon year and I think those are starting to accelerate especially during the COVID crisis. I think logistics routes became kind of heightened as the supply chain got constrained. I think we all realized the extensive logistics involves and so getting closer to the end point became more important for our customers as well.

So it's really a combination of adapting the share gains, the WFE growth and the continued shift towards Asia. So there would be some reduction in capacity in North America kind of correspond with that as we go but it's also the Malaysia is also a measured addition and obviously the initial building will have a pretty high capacity roughly could overall at the end of the day increased by 50% our capacity overall but I think we're going to obviously will be a staged increase in what we add there.

Christian Schwab

Great and then lastly, I would assume it will take a modest amount of time before you would actually be producing, should we kind of be thinking kind of the fall of 2021 for that facility to be ready and ramped and ready to go? Is that the right time frame and can you just tell us what you think, I don't know if I might have missed it but what is the capital required to get that facility going?

James Scholhamer

Yes. I think the second half of ‘21 is definitely our plan and we already, we have our factory in Singapore as well, so we already have a supply chain in that region kind of established. Obviously, we're going to grow that but yes that's about the right timing for initial production and we'll be ramping over time from the initial production. The overall cost, this is a building that we're going to end up leasing. So our capital cost, our cash outlay will just be for the leasehold improvements and the equipment that we need inside that building to operate. So that's a total of around $17 million all in.

Christian Schwab

Okay. Great. All right. That's it. I have no other questions. Thanks.

James Scholhamer

Thank you Christian.

Operator

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

Unidentified Analyst

Great. Thank you and congratulations on a strong performance. So Jim with your size and global footprint were there any supply chain disruptions in the quarter that you were able to benefit from that might stick longer term?

James Scholhamer

Yes. Over the last few quarters we've had several opportunities where we were brought in as a second source where the initial suppliers were struggling. They're not dramatic changes and they tended to be some of the smaller items needed by the customer on the tool. They weren't major market shifts but yes we definitely benefited over the last few quarters as we stepped into to cover. Some of them were kind of greenfield things that we had never made before and some of them are just share shifts and we expect the majority of that to stick.

Unidentified Analyst

Okay. Great. You mentioned applied sustainability presentation and in that they talked about a more sustainable and just supply chain. What in particular if it can be defined at this early stage what does that mean for you guys?

James Scholhamer

Yes. Actually there's a lot of things that can be done that they don't necessarily, they're good things for the environment and they're also in the long run they're and even in the short run they're actually more efficient. I will give you an example. There is a tremendous amount of crates used in this industry. I mean the volume of material that we're moving around is pretty dramatic. So reusable crating and logistics supplies and packaging that's the kind of a simple one right there.

So I think there is a lot of low hanging fruit where working together on those kind of requirements we can reduce our footprint. There is things in the cleaning process where you can add, where you can re-circulate some of the chemicals rather than dumping and disposing and buying new ones. So there is certain technologies you can invest in and none of these take large capital. So there is a lot of, if you're focus, if you put a little bit of focus on these things you can save time and money and not time you can save money and the environment at the same time. So these ESG requirements are becoming obviously more important for customers, for investors and for everyone. So like I said there's a lot of low hanging fruit in this area.

Unidentified Analyst

Sure. Okay. Great. Thank you.

James Scholhamer

Yes.

Operator

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

Tom Diffely

Yes. Good afternoon and thanks for letting me ask a question. So following up on Patrick's early question when you look at the chemical cleaning market, what is the long-term growth you see there and how is that driven? Is it by chamber count or just the clean intensity going up over time that's the bigger driver?

James Scholhamer

Yes Tom, it's driven the first order of importance is wafer starts but a wafer start in the leading edge 7 nanometer processes has definitely a higher cleaning intensity or dollar value intensity than something more on the trailing edge. So I think obviously, we see that that business typically grows in the mid to high single digits year-on-year and we had a kind of an odd middle of the year last year where memory was site was utilizations dropped in the middle of the year but typically it grows with at least that wafer starts and as those FABs go more to leading edge we can expect that to even increase from there.

Tom Diffely

Okay. That helps and then I am just curious, are you seeing any activity on the flat panel side at this point?

James Scholhamer

That business for us it runs from $7 million or $8 million a quarter to $15 million. I think it was at the low end of this quarter. I think our overall non-semi was around $13 million - $14 million, so it's actually, it's still relatively quiet as I think the OLED adoption on phones has been slower than anticipated.

Tom Diffely

Yes. Are you expecting that to pick up next year or is it tough to call?

James Scholhamer

It's tough to call. You would have asked me a few years ago I would have thought the penetration rate would have been a lot higher but I think it was kind of a situation happened where China over invested in OLED and then had relatively horrible yields. So as they finally improved the yields they actually they got free capacity at the same time. So as well as the prices remain kind of high in the adoption rate and phones are made lower than expected. So I think all of that kind of put the adoption rate back a year or two but I think maybe middle or end of next year we might start to see that recover especially with the 5G handsets coming on the high-end smartphones.

Tom Diffely

Okay. I appreciate the time today.

James Scholhamer

Yes. Thank you, Tom.

Operator

Our next question comes from Colin Du of MacKenzie Investments. Please go ahead.

Colin Du

Hey guys thanks for the questions and congratulations on the quarter. Two questions from me. Could you confirm your current outstanding balance on your revolver and the [term loan]? And secondly what is the current capacity utilization?

Sheri Savage

Yes. So I can start with the revolver. It's currently at $40 million. We took that down during the Q1 time frame and we've kept it just in this current environment that we are in. So $40 million. Jim, do you want to answer the other question?

James Scholhamer

Question on capacity is the loan capacity or you mean the overall operational capacity?

Colin Du

Operational capacity.

James Scholhamer

We don't have an exact measure on that where it's not a line of widgets coming out. Obviously we're near the high end where we are, where we are at the high end of our capacity, burst capacity as I mentioned we can accommodate more and accommodate what we see coming in the next year but that's obviously one of the main drivers for us to build an additional factory in Malaysia.

Colin Du

Okay. And just again on the terminal inbound. So post the [indiscernible] and the voluntary pay down you guys would be at 290 outstanding or somewhere around?

Sheri Savage

Correct. We paid off, yes we paid off $50 million last year and then we've paid off $12.2 so far this year. So it'd be a little bit less than that but yes close to 290, 288.

Colin Du

Okay. Thank you.

Sheri Savage

Thank you.

James Scholhamer

Thanks.

Operator

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

James Scholhamer

Yes. Thank you for joining us today. We look forward to speaking to you next quarter.

Operator

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