Ultra Clean Holdings, Inc. (NASDAQ:UCTT) Q2 2019 Earnings Conference Call July 31, 2019 6:15 PM ET

Company Participants

Rhonda Bennetto - IR
Jim Scholhamer - CEO
Sheri Savage - CFO

Conference Call Participants

Karl Ackerman - Cowen and Company
Quinn Bolton - Needham
Dick Ryan - Dougherty
Patrick Ho - Stifel
Christian Schwab - Craig Hallum

Operator

Good afternoon, and welcome to the Ultra Clean Technology Second Quarter 2019 Earnings Conference Call and Webcast. [Operator Instructions]

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 that with Financial Review and then we'll open up the call for questions.

Today's call contain forward-looking statements that are subject to risks and uncertainties. For more information, please refer to the risk factors disclosure in our SEC public 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.

And finally, we will be participating in the D.A. Davidson Technology Conference in New York on September 4 and the Dougherty & Company Institutional Investor Conference in Minneapolis on September 5. Additional information on these conferences will be available on the Investor Events section of our website at www.uct.com.

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

Jim Scholhamer

Thank you, Rhonda, and good afternoon, everyone. Thank you for joining us for our second quarter 2019 conference call and webcast. First, I'm going to highlight a few financial results that Sheri will expand on in her commentary. I'll follow that with an update on our product and service businesses and provide our perspective on how we view the industry, both near and long term. After that, we will open up the call for questions.

I will start with our financial results for the second quarter. UCT's solid performance is a direct result of our commitment to operational efficiency and our flexibility to consistently deliver solutions to our customers during this dynamic period. Strong execution by our team resulted in higher than anticipated revenue, improved margins, robust cash generation and steady profitability.

Total revenue for the second quarter was $265.4 million, with our product business contributing $210.4 million and our services business adding another $55 million. With respect to our product business, semiconductor market conditions remained relatively unchanged from the first quarter. Ongoing adjustments and capital expenditures, excess memory inventory and slowing activity levels in China continued to weigh on the equipment market.

Geopolitical tensions and IP concerns are adding to the overall uncertainty in the near term. That aside, our product business performs better than expected, and we again executed on unexpected late-quarter customer drop-in and pull-in orders. Our team was able to flex to meet customer delivery schedules, further solidifying our strategic position as a partner and key supplier in the value chain.

While capital expenditures remain well balanced in support of rapidly advanced technology road maps, persistent elevated inventory levels led memory producers to take the additional unusual step of adjusting wafer output, something we have not seen in previous cycles.

Adjustments like this should be viewed as positive as they will help expedite the rebalancing of supply and demand in the near term and are expected to be temporary in nature. The reduction in wafer output impacted our services business in the quarter. As a brief reminder, a portion of our service revenue is derived from growth in the installed base, while the remainder is driven by wafer start.

We expect the reduction in wafer starts to continue into the third quarter, but to a lesser degree and will likely be short-lived. We anticipate returning to a more normalized run rate heading into the fourth quarter as inventory supply and demand more closely align. As demonstrated over the past several quarters, our services business has a very positive influence on UCT's financial profile.

Our worldwide footprint gives us regional flexibility, improves responsiveness, increases our competitive stance and reduces customers' total cost of ownership. Partnering with our top tier IDM customers to unlock higher productivity with our technical cleaning and analytical solution gives us great confidence that we will outperform our peers who rely solely on WFE spend.

Our results, confirmed by our peers and customers are showing strength in logic and foundry, which we anticipate will continue for the remainder of the year. This spending, driven by the initial rollout of 5G that is establishing the infrastructure for all things IoT and AI, is occurring at the leading edge. Currently, UCT derives approximately half of its revenue from foundry and logic and the remainder from memory. The memory market continues to digest the high level of capacity additions that were put in place over the past few years.

We are confident there will be a recovery, but remain uncertain about the timing and degree of the upturn. In the meantime, our integration and cost reduction initiatives remain on track. We are driving towards an improved financial model with the goal of combining growth with significant operating leverage, increasing cash generation and sustaining profitability through the cycle.

For the third quarter, we expect revenue to be down somewhat from the second quarter due to limited visibility from our customers and capital equipment demand and memory oversupply. Until we have greater clarity on the timing of any sustainable improvement in overall end demand, we are maintaining our view that our revenue will remain around these levels for the rest of the year. From our vantage point, we remain extremely confident about the long term durability of the semiconductor industry. Smarter phones, faster computing and higher content requirements will drive meaningful opportunity and result in significant growth over time.

In summary, when the industry emerges from this downturn, UCT will be a more efficient company with tremendous potential this support growth, creating long term value. I want to thank our employees and our shareholders for their continued support and I look forward to updating you on our next call.

With that, I'll turn the call over to 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. We had a solid quarter generating total revenue of $265.4 million, a 2% increase over the prior quarter. Our products division accounted for $210.4 million and our services division contributed $55 million. Late quarter drop in employment orders and our products business was offset somewhat by a decrease in our service business due to a reduction in wafer start at some of our customers fabs.

Non-semiconductor revenue, which includes display generated $17.9 million or 6.7% of revenue, up slightly from the first quarter. Total gross margin improved notably to 18.8% compared to 17.8% due to improved mix, reduced labor and material costs. SSP gross margin with 35.6% and SPS was 14.5%. As we've shared before, margins can be influenced by customer concentration, geography, product mix and volume and timing of our restructuring initiative. So you should expect to see variances quarter-to-quarter.

Operating expenses increased to $33.6 million compared to $30.3 million last quarter. As a percentage of revenue, OpEx was 12.7% versus 11.7% last quarter. The majority of the increase was associated with the acquisition of DMS, and we expect to streamline those expenses over the remainder of the year. Operating margin for the first quarter improved slightly to 6.2% from 6.1% in the prior quarter.

Margin contributed from SSB was 11% and SPS was 4.9%. Based on 39.7 million shares outstanding, earnings per share for the second quarter was $0.21, derived from net income of $8.2 million. This compares to $8.1 million or $0.21 per share last quarter. If we exclude share-based compensation and our non-GAAP reconciliation, our earnings per share would have been $0.26 for the quarter. Our tax rate for the quarter was 18.9% compared to 19.2% last quarter. Going forward, we expect our tax rate to be in the mid- to high-teens but as always you can expect to see variances quarter-to-quarter.

Turning to the balance sheet, we ended the quarter with $168.1 million in cash and cash equivalents, an increase of $13.4 million over the prior quarter, primarily due to the reduction in inventory and timing of customer payments. Cash from operations was $49.9 million compared to $18.1 million last quarter. Uses of cash included $30 million for the DMS acquisition and $14 million principal payment on our long-term debt. Our third quarter outlook assumes total revenue between $235 million and $255 million and non-GAAP EPS in the range of $0.11 to $0.21.

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

Question-and-Answer Session

Operator

[Operator Instructions] And our first question today comes from Karl Ackerman with Cowen and Company. Please go ahead.

Karl Ackerman

Hi, Jim and Sheri, I hope all is well. My first question, I want to just talk about WFE for a moment. I think the industry has revolved around WFE spending being in the low 40s, $40 billion for 2019. I guess, in the event that profitability of memory providers were to further recede and the CapEx were to get cut again, how do we think about your insulation to that? And I guess, as you think about fiscal 2020 -- or fiscal 2020 WFE.

I would think you get an incremental quarter of Quantum this year, and then an incremental quarter of DMS in 2020 so that should help a bit. But maybe just talk a little bit about the -- your core opportunities you see both from an outsourcing perspective and core growth perspective that would enable you to outgrow WFE spending next year.

Jim Scholhamer

Yeah, great. Hi, Karl. As far as -- I think your first question was around what if memory is worth. So I think as you heard, we're roughly 50% of our equipment shipments is actually in the logic and foundry space. And then if you look at the services side, obviously that has some dependence on memory as well. But obviously, that diversifies those quite a bit.

And on top of that, I think regardless of the large memory spend, I think that's very much been baked in as being more of a lot of the capital going into the shell of buildings and looking at more memory equipment going in 2020. So I think a lot of the memory downside has already kind of been baked in, and you're seeing a lot of technology moves that are happening regardless of the capacity additions.

As far as 2020, I think looking at what we'd expect to see, a rebound, obviously. When the volumes go up, the trends towards outsourcing become more important than ever. So I think we see a lot of opportunity, a lot of opportunity in that space as well as both wafer starts going up for a service business as well as an increase in outsourcing again as volumes rise.

Karl Ackerman

That's helpful. Earlier this year, you were swift to take action and reduced your cost base as demand slowed down. What are we doing now to drive continuous improvement through your own supply chain? I guess particularly outside of the services business, given not just the current tough environment but also as you contemplate your business road map in 2020 and beyond.

Jim Scholhamer

Yeah. Karl, we announced last time a pretty extensive restructuring and cost cutting as well as the integrating of the businesses that we bought DNS and Quantum. And so -- as we've been targeting $15 million to $20 million of annual cost reduction through a lot of restructuring of our footprint around the world.

Leaving the end of the year and into the first quarter, we expect annualized to achieve those kind of cost saving rates. We've done a lot along with going very well. We've closed a few factories. We've built the fuel in. We've done some reductions in force. So everything is going very well on the announced cost restructuring that we've been working on.

Karl Ackerman

Very helpful. Perhaps one last one, if I may. One of your competitors spoke about gaining some share in gas panels last quarter. I'm curious if you would comment on how you see any changes in the competitive landscape, if at all, and how you think about just the -- the overall stability of that business, perhaps in light of some of the changes within Japan and Korea trade imbalance. Thank you.

Jim Scholhamer

Yeah. The gas panel business, it's relatively stable. There are always puts and takes. I think one of the areas that both us and some of our main competitors are seeing opportunity is in the ASML space. And we have a very strong position with ASML with our long -- serving the Cymer division for them for many years and we're also seeing increased activity also with ASML as -- directly as a whole.

And so we're very comfortable with that position. So it's always a competitive environment, but the gas panels space, there are some puts and takes, but they're generally not significantly material between the suppliers. But however, there are new opportunities which I think both us and other outsourced providers are taking advantage of.

Karl Ackerman

Great. Thank you.

Operator

And our next question comes from Quinn Bolton with Needham. Please go ahead.

Quinn Bolton

Hi, guys. Congratulations on the nice margin performance. Wanted to start there and just see, you think that better margins this quarter really just a reflection of higher revenue and better absorption or are you starting to see some of the benefits of the restructuring programs and then I've got a couple of follow-ups.

Sheri Savage

Hi, Quinn. Yeah, we started seeing the initial benefit of some of the cost reductions that we're making. We're in the early stages, but we are starting to see a little bit of that come through. I think the other thing that helped in our favor this quarter was the mix of products that we ship. Sometimes we talk about that unfortunately hurting us, but this quarter it was a better situation with both geographic as well as the mix within certain sites that we have and we continue to take down our temporary labor force. We did do a reduction in force earlier this year. So it should -- it's an iterative process, but we're starting to see a little bit of benefit training that.

Quinn Bolton

Great. And then the second question is around the quantum business and sort of understand the relationship, the wafer starts. You talked about that further declining in the third quarter, but then getting back to more run rate levels in Q4. Just wondering, you've only owned that business now for just under a year or so. We don't have a lot of history. When you say run rate, should we be thinking about levels that you did in the fourth quarter and in the first quarter as kind of what you would define as run rate? Or is that too aggressive in terms of the potential snapback in that -- in the Quantum business?

Jim Scholhamer

Yeah, Quinn, no, that's correct. Typically, memory fabs operate pretty much at full capacity on a typical and even through a down cycle. So is a pretty unusual step to actually drop the capacity utilization in the wafer starts like they did. So even though we've only owned the business for a year, we obviously have historical. So that was a pretty unusual event. But the typical operation and what we expect and what our customers also expect is that the memory fabs will return back to probably full utilization where they can get the better cost points per bit.

Quinn Bolton

And that was my last question on the quantum business you've got. I think a major memory customer and a major logic customer, right? I assume the wafer start commentary is really more focused on the memory side of the business? Or did you see wafer starts decline on the -- across the logic customer base, too?

Jim Scholhamer

No the logic actually has been doing very well and actually offset a lot of the impact from the memory side, which was significant.

Quinn Bolton

Sure. And this is specifically, Jim, for the quantum business?

Jim Scholhamer

Quantum business, yes. So in the quantum business -- in the service business logic has been doing very well with that great position there. And that's been growing nicely. That offset some of the negative results that we saw from the memory. Correct memory wafer start correction that I think everybody in the industry is as aware of right now.

Quinn Bolton

Got it. Great. Thank you.

Operator

And our next question comes from Dick Ryan with Dougherty. Please go ahead.

Dick Ryan

Thank you. Hi, Jim, you mentioned drop-in and pull-ins again this quarter. Can you kind of give an order of magnitude of the degree in Q2 versus what you saw in Q1?

Jim Scholhamer

Yeah, hi, Dick. Actually it was -- I would -- what we called churn, we talk about drop-in and pull-in, but what actually is happening is drop in pull-in and push-out cancel like all both -- two arrows in and two arrows out. That was that churn was even greater than we saw in the first quarter above the net result is more coming in than going out. And that was down the order over a little bit higher than even what we saw the last quarter.

So there's a lot of very quick reaction needed by the supply chain as the end-to-end customers are making faster decisions in the lead times required as they're upgrading or adding capacity in niche areas or for basically relying on the supply chain being faster we're seeing those lead times really becoming critical, and so our ability to really react to that quickly is allowed us to really outperform in that area.

Dick Ryan

Okay. DMS has been fully integrated yet?

Jim Scholhamer

No, the integration continues. The majority of it will be done through the third quarter, but it's going very, very well.

Dick Ryan

Okay. And one last thing you mentioned, when volumes pick up increases the trend towards outsourcing. But in a pause or a trough situation, now we're in what -- what's the outsourcing sentiment out your two major customers?

Jim Scholhamer

Yeah, it's -- the two major customers act a little bit differently. One of them actually outsourcing pretty much activity is pretty much ceased or there is even sometimes a little bit of a back flow to their own factories, not a major amount, but they tend to flex in and out more of the other one is -- is kind of more of a slow plodding towards more outsourcing, regardless of where we are in the cycle.

So they behave a little bit differently. But you definitely see outsourcing. We saw tremendous acceleration in outsourcing during the last ramp and you saw us outgrow WFE by high double digits. And I would expect in the next ramp we'll see -- we'll see similar outgrowth.

Dick Ryan

Great. Thank you.

Operator

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

Patrick Ho

Thank you very much. Jim, just trying to -- I just reconcile a few things. I think it's a credit to what you guys have done in terms of reacting to the churn that you talked about. At the same time, as you're implementing some of these cost cuts that you've talked about over the past few quarters, how ready will you be when the sustained recovery hit. Are you then able to ramp up to meet potential sizable demand that comes in during a select quarter, given that you are cutting costs at the same time?

Jim Scholhamer

Yeah. The short answer is yes. A lot of the reductions in force are in the temporary workforce, which is built to -- build for fast ramp and fast scale like we did in '17. As far as the footprint changes that we're making, a lot of it is consolidating and getting scale of like products in the right spots around the globe. So actually we think at the end of the day when we're done consolidating and -- and putting the right scale to certain product lines that we do and where we do them, we actually think our capacity will be at least -- at least as good as when we started and perhaps even better.

Patrick Ho

Great. That's helpful. I guess my follow up question on DMS is still in the early stages you obviously acquired just a few months ago. How are you looking at expanding that customer base on the weldment side of things given that they're predominantly centered around one customer today? What are the efforts you're taking to look at expanding their customer base on that front?

Jim Scholhamer

Yeah, I think we don't even think of it today. The capability of DMS, the majority of the capability was pretty redundant with our overall weldment capability, where we do have a diverse customer base. So we continue to have a pretty good diverse supply, our customer base with weldment. I think one of the opportunities is some of the unique areas in the large outside diameter weldment, the bigger weldment is capability that DMS had that we didn't have in the same way they did.

So we see opportunities to bring that, especially to Asia and to be able to expand that product offering across not just their current customer led the DMS and UCT was using, but was serving, but also additional ones. So I think that it's more of a where can we expand in our product areas. We have a diverse customer base for weldment.

Patrick Ho

Great. And maybe final question then for me, Jim, in terms of capital intensity trends of your systems business some of the gas panel delivery side of things. There's a lot more talk about the increasing layers of 3D NAND, you need more etch, you need more deposition tools. Is it simply the volume of tools that will help you guys or are there more content because of some of the complexity and some of the applications such as, with more layers, high aspect ratio applications which are more intensive? Are you seeing not only a volume increase in those tools that help you, but also potentially more content within the tools themselves?

Jim Scholhamer

Yeah. That's a great question. Obviously, tools themselves going out the door is a good thing. The number of process chambers required per tool is a key indicator and is a key driver of how many gas panels are required. So absolutely, as layers get more complicated and additional steps are capping layers or stress layers of sacrificial layers are needed and more process chambers are populating each tool, that is definitely a benefit for us.

Patrick Ho

Great. Thank you.

Jim Scholhamer

Thanks, Patrick.

Operator

And our next question comes from Christian Schwab with Craig-Hallum Capital Group. Please go ahead.

Christian Schwab

Hey. Great. Actually, all my questions have been answered. Thank you.

Operator

Okay. This will conclude our question-and-answer session. I'd like to turn the conference back over to Jim Scholhamer for any closing remarks.

Jim Scholhamer

Thank you for joining us here today, and we look forward to updating you after the third quarter conference call. Thank you.

Operator

The conference has now concluded. Thank you for attending today's presentation. You may now disconnect your lines at this time and have a great day.