Keysight Technologies, Inc. (NYSE:KEYS) Q1 2024 Earnings Call Transcript

Keysight Technologies, Inc. (NYSE:KEYS) Q1 2024 Earnings Call Transcript February 20, 2024

Keysight Technologies, Inc. beats earnings expectations. Reported EPS is $1.63, expectations were $1.59. Keysight Technologies, Inc. isn’t one of the 30 most popular stocks among hedge funds at the end of the third quarter (see the details here).

Operator: Good day, ladies and gentlemen, and welcome to the Keysight Technologies Fiscal First Quarter 2024 Earnings Conference Call. My name is Joel, and I’ll be your lead operator today. [Operator Instructions] This call is being recorded today, Tuesday, February 20, 2024 at 1:30 PM Pacific Time. I would now like to hand the call over to Jason Kary, Vice President, Treasurer and Investor Relations. Please go ahead, Mr. Kary.

Jason Kary: Thank you, and welcome, everyone, to Keysight’s first quarter earnings conference call for fiscal year 2024. Joining me are Keysight’s President and CEO, Satish Dhanasekaran; and our CFO, Neil Dougherty. In the Q&A session, we’ll be joined by Chief Customer Officer, Mark Wallace. The press release and information to supplement today’s discussion are on our website at investor.keysight.com under the Financial Information and Quarterly Reports. Today’s comments will refer to non-GAAP financial measures. We will also make reference to core growth, which excludes the impact of currency movements and acquisitions or divestitures completed within the last 12 months. The most directly comparable GAAP financial metrics and reconciliations are on our website, and all comparisons are on a year-over-year basis, unless otherwise noted.

We will make forward-looking statements about the financial performance of the company on today’s call. These statements are subject to risks and uncertainties and are only valid as of today. We assume no obligation to update them and encourage you to review our recent SEC filings for a more complete view of these risks and other factors. Lastly, management is scheduled to participate in upcoming investor conferences, hosted by Susquehanna and Morgan Stanley. And now, I will turn the call over to Satish.

Satish Dhanasekaran: Good afternoon, everyone, and thank you for joining us today. My comments will focus on three key headlines: First, Keysight delivered revenue of $1.3 billion and earnings per share of $1.63, both of which exceeded the high-end of our guidance. Given the current market conditions, these results reflect the Keysight team’s strong execution and resilience of our financial model. Second, orders were $1.2 billion as the demand environment remains constrained. As certain markets continue to normalize from post-pandemic spending levels, our aerospace, defense and government, and network and data center businesses grew, highlighting the benefit of our diverse end-market exposure. Customer engagement and collaborations on next-generation themes remained strong.

The adoption of new use cases such as AI is driving new activity and investment across the ecosystem. However, we’re not factoring in a strong recovery this fiscal year. Our base-case scenario is for a modest first-half to second-half improvement in orders and revenue. Third, Keysight continues to be well-positioned for outperformance into a market recovery. We are investing to enhance our market leadership and expand our broad portfolio of leading solutions. We are also pleased to have completed the acquisition of ESI ahead of schedule and extend a warm welcome to the team. Along with our existing EDA business, the addition of ESI further expands our software solutions for simulation and emulation, a market with favorable growth attributes as the virtualization of design and prototyping increases.

Now, let’s begin with a brief overview of Keysight’s first quarter performance. Market conditions were largely unchanged from the prior quarter. Across our end markets, investment in R&D remained steady, while manufacturing and overall economic activity in Asia continued to moderate. First quarter orders were $1.2 billion, revenue $1.3 billion, and earnings per share of $1.63 were above our guidance, and we generated strong cash flow. Gross margins across the business was strong, and including ESI, we achieved a record 67%, demonstrating the differentiation of our solutions. Operating margin was 28%, reflecting expense discipline and cost actions that we have taken over the past quarter and last year. Turning to our business segments. Communications Solutions Group revenue declined relative to a strong compare last year, which was driven by robust backlog conversion.

Quarter one gross margin was a record 68%, reflecting a greater mix of software and higher-value solutions. Orders were in line with expectations with strength in aerospace, defense and government, and the wireline business, while wireless continues to normalize. Aerospace, defense and government revenue declined while orders grew year-over-year. Spending levels remain elevated, as governments around the world prioritize investments in defense modernization, space and satellite applications. We are scaling our threat emulation offerings to a broader set of customers for electromagnetic spectrum operation applications in the US and Europe, resulting in key wins at large primes. Our space and satellite solutions drove businesses this quarter for new space modules and low Earth orbit applications.

Leveraging our protocol and digital twin capabilities, we’ve partnered with Lockheed Martin and a broad set of technology leaders to successfully demonstrate a secure 5G and data link network that integrates land, air and space operations. In commercial communications, customer spending remains cautious. While we’re not seeing a market recovery yet, industry inventories are slowly returning to normalized levels. For example, smartphone sales in the fourth quarter of 2023 grew meaningfully for the first time since mid-2021. In our wireless business, customer engagements remain high, with ongoing R&D activity in advanced technologies. This results in software and service upgrades that contributed to higher gross margins in the quarter. 5G standards continue to progress and are driving a wide range of new use cases and features for ongoing network deployment.

New band combinations are expected to be added to the 3GPP standard this year, driving certification needs. This quarter, we hosted Global Certification Forum that brought together industry leaders across a broad array of sectors to collaborate on certification requirements for network and device interoperability and performance. Next week at Mobile World Congress, we will be demonstrating over a dozen solutions for 5G, Open RAN, satellite connectivity, AI and early 6G capabilities, many of which will be showcased in partnership with industry-leading customers. Moving to our wireline business, we saw order growth for our data center solutions. Orders for 400 gig and 800 gig solutions, both in R&D and manufacturing, grew double-digits. We also achieved a key milestone in partnership with Marvell by enabling test and verification of their new ultra-high-speed networking chip designed for next-generation AI-driven cloud applications.

The adoption of AI is clearly lifting activity across the entire data center ecosystem. As the industry deploys AI infrastructure at scale, we expect the demand for high-speed networking and computing capabilities to grow. Turning to the Electronic Industrial Solutions Group, revenue was down, reflecting ongoing normalization from outsized demand in the prior year. Customer spending remains cautious as market conditions, particularly in manufacturing, and regionally in China were weaker. Underneath the macro headlines, we see pockets of growth where customers are leaning in and investing to address new use cases and emerging technologies across multiple end markets. In semiconductor, the market environment is mixed. Despite the improved industry outlook for overall fab investments, foundry customers continued to push out large projects due to delays in construction and production timelines.

At the same time, we saw strong demand for Keysight’s proprietary interferometer system, driven by industry progression in EUV technology. Next-generation performance requirements for new AI-driven data center and ADAS use cases are also driving investments. And we saw some improvement this quarter in memory-related demand as well as mature process capacity in China. In automotive, the funnel of EV opportunities continues to be strong. Competition amongst OEMs, upcoming regulatory requirements and support from government subsidies are incentivizing investments in R&D for new battery technology and charging infrastructure. During the quarter, we secured a key win that marks the expansion of our European battery test footprint into France. As we have noted before, EV funnel is healthy, but the timing and the size of these system-level and longer-dated engagements are expected to vary from quarter to quarter.

In general electronics, market conditions were unchanged from last quarter. Ongoing capacity normalization and cautious spending continued to weigh on the consumer electronics and manufacturing portions of the market. We saw steady demand for our solutions in digital health, industrial automation and advanced research. This quarter, we secured key wins in digital health applications for medical imaging and scanning as well as test automation. Consistent with our software-centric solutions strategy, the value that our customers derive from software and service offerings is enabling business resilience in the current market conditions. Software and services orders and revenue continued to outperform the broader business this quarter and were greater than 35% of total Keysight even excluding ESI.

ESI further enhances our design engineering software portfolio and expands our addressable market in automotive, avionics, smart manufacturing, and human workflows. We were pleased to complete the acquisition ahead of schedule, and ESI’s results were also ahead of expectations for the quarter. In summary, our market leadership and the strength of our solutions portfolio gives us confidence in our ability to capitalize on the multiple waves of technology innovations and long-term secular growth trends of our markets. Our team’s relentless customer focus and sustained customer collaborations also position us well for long-term value creation. In addition, the strength of our financial model continues to generate healthy margins and cash flow.

With that, I will turn it over to Neil to discuss our financial performance and outlook.

Neil Dougherty: Thank you, Satish, and hello, everyone. First quarter revenue of $1.259 billion was just above the high end of our guidance range and down 9%, or 14% on a core basis. Orders of $1.220 billion declined 6%, or 12% on a core basis. We ended the quarter with $2.3 billion in backlog. Looking at our operational results for Q1, we reported record gross margin of 67%, an increase of 200 basis points year-over-year. Excluding ESI, gross margin was a near-record 66% on lower revenue, supported by a solid mix of software and higher-value solutions. In addition, software was 22% of revenue, while recurring revenue from both software and services grew 10%. Operating expenses of $491 million were flat year-over-year even with the addition of ESI, demonstrating the flexibility of our cost structure and the cost actions that we have taken.

Q1 operating margin was 28%, or 27% excluding ESI. These results demonstrate the financial flexibility and resilience of our business. We are outperforming the financial model that we put in place over a decade ago, which calls for only a 300 basis point to 400 basis point year-over-year decline in operating margin when revenue declines 10%. Turning to earnings. We achieved $286 million of net income and delivered earnings of $1.63 per share, of which ESI contributed $0.09. Our weighted average share count for the quarter was 176 million shares. Moving to the performance of our segments. Our Communications Solutions Group generated revenue of $839 million, down 11%, or 12% on a core basis. Commercial communications revenue of $544 million declined 14%, while aerospace, defense and government revenue of $295 million was down 5%.

Altogether, CSG delivered a record gross margin of 68%, and operating margin of 27%. The Electronic Industrial Solutions Group generated revenue of $420 million, down 5% or 19% on a core basis. EISG reported gross margin of 65%, and operating margin of 31%. Moving to the balance sheet and cash flow. We ended the first quarter with $1.7 billion in cash and cash equivalents, which reflects the purchase of ESI within the quarter, generating cash flow from operations of $328 million and free cash flow of $281 million. Share repurchases this quarter totaled 625,000 shares at an average price per share of approximately $149 for a total consideration of $93 million. Now, turning to our outlook. Given Q1 core orders of $1.14 billion and the typical sequential decline in ESI orders and revenue from Q1 to Q2, we expect second quarter revenue to be in the range of $1.190 billion to $1.210 billion, and Q2 earnings per share to be in the range of $1.34 to $1.40 based on a weighted diluted share count of approximately 175 million shares.

This guidance includes approximately $25 million in ESI revenue and a few cents of earnings dilution from ESI. As we look to the second half of the year and our six-month order funnel, we aren’t assuming a strong revenue recovery in Keysight’s fiscal second half, which ends in October. Our base-case scenario is that revenue is relatively flat from Q2 to Q3 and sequentially up mid-single-digits Q3 to Q4, in line with typical historical seasonality. That said, we do expect second-half orders to exceed first-half orders, which will be supportive of revenue growth in 2025. In closing, Keysight’s flexible cost structure and discipline, track record of execution and diverse end markets, give us confidence in our ability to outperform even in the current market conditions, while at the same time, investing to capitalize on the best growth opportunities as markets recover.

With that, I will now turn it back to Jason for the Q&A.

Jason Kary: Thanks, Neil. Joel, could you please give the instructions for the Q&A?

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Q&A Session

Operator: Absolutely. [Operator Instructions] The first question is from the line of Samik Chatterjee with JPMorgan. You may proceed.

Samik Chatterjee: Hi. Thanks for taking my questions. Maybe if I can start with the first one, just on the sort of what you’re implying in terms of the recovery for the back half. I mean, just looking at the 2Q guide, to me, it implies that the organically the business is — or the core business is down a bit and there is some ESI revenue sequentially declining as well. But if the core business is down sequentially, what’s driving the expectation for a recovery starting in 3Q and 4Q? I know you said you’re not baking in a recovery in relation to the macros, so is there something more customer-specific or end-market-specific that you’re seeing that’s driving that expectation? Then, I have a quick follow-up. Thank you.

Neil Dougherty: Yeah. Hi, Samik. I would just say that, as we stated in our prepared remarks, right now, we are — our base case does not include a meaningful second-half recovery. We’re really more looking at seasonal changes as you move throughout the fiscal year, so flattish Q2 to Q3, and then a typical seasonal uptick into Q4, which is typically our stronger quarter of the year. In aggregate, we do expect orders and revenue in the second half to be modestly above the first half, but we’re not baking in a recovery at this point.

Samik Chatterjee: Okay. I guess — sorry, Satish, just to clarify, I was more looking at what’s the driver there? I mean, when you call it seasonal, it’s been below seasonal for a bit. So, is it something more specific to the end markets? And I’ll ask my follow-up at same time, if you don’t mind.

Satish Dhanasekaran: Sure.

Samik Chatterjee: If you can just shed a bit more light on the order trends in relation to EISG? I know you said, largely unchanged spending, but what are you seeing in the different verticals when it comes to autos versus broader industrial because we’ve seen a lot of weaker macro data points on that front? Thank you.

Satish Dhanasekaran: Yeah. Thank you, Samik. I would say, at the highest level, the customer engagements that we have are remaining strong. And while there are signs of optimism from customers as we enter the new calendar year, we have not yet seen a progression through our pipeline. And as we said in our — in my prepared remarks, the market conditions remain largely unchanged from a quarter ago. The aerospace, defense strength that we saw last year continues on. And what we have seen incrementally is the wireline business has actually grown for the first time this quarter, and that was a function of some of the AI-related end-market inflections that are occurring. If I take a regional cut at this, I would say, our largest region, Americas, grew for the first time in four quarters, and this is driven by again the strength in aerospace, defense and the wireline business.

But Asia continues to remain weak, especially which is impacting the EISG business and some of the wireless business in that region as it continues to normalize from the peak spending levels. Again to put your question in perspective, CSG entered that normalization phase early and EISG was offset by a few quarters. And so that’s what’s currently playing out. So, given this backdrop, we think it’s prudent to think of a base-case assumption where orders and revenue would be up modestly first half to second half. But should there be a broad and stronger recovery sooner, and there may be some signs out there around SIA index where things are picking up, some of the inventory digestion that’s happening, capacity utilization, fabs, but should that occur, we will be in a good position to capitalize on that and recover quicker.

Operator: Thank you. The next question is from Mark Delaney with Goldman Sachs. Your line is open.

Mark Delaney: Yes. Good afternoon. Thanks for taking the questions. Satish, you mentioned I believe double-digit growth in orders to support data center builds for products like high-speed wireline, which you attributed to AI. Can you give us a better sense of how much of either revenue or orders may be directly or indirectly benefiting from AI at this stage, and how you see that progressing?

Satish Dhanasekaran: Yeah, that’s a really good question. It’s still an emerging opportunity for us, but what is significant this quarter is, we started to see the wireline core parts of our business inflect. And if you recall in the past earnings calls, I’ve talked about the traffic patterns caused by generative AI really impacting the whole network architecture, compute to networking and switching and silicon, and therefore, we knew that demand was coming up. And so, what we noticed this quarter is our wireline business started to inflect, driven by 400-gig and 800-gig transceiver business in manufacturing as that starts to scale, increased focus on terabit research, we announced a collaboration with Marvell in advanced technologies as well there.

So that’s the business of today. But as we start to think about the broader landscape here, I would say the memory technologies with HBM is starting to gain interest in our customers, different processor architectures, increased silicon activity enabled by AI. And then, for us, it’s very exciting because there is a lot of tools that we can deploy our IP because we have the total stack to help engineers train the AI ML models better. And so, you will see, we announced a collaboration with NVIDIA on this front as well. And there’s new interface standards. And you know our business is driven by standardization process. So, new interface standards are good for our CXL PCIe Gen-7 and the Ultra Ethernet Consortium are playing into it. Silicon photonics in quantum, while they are sort of enabling technologies, are other areas where we’ve had investment, where we’re now able to address new opportunities.

Now a lot of that is not yet baked into our forecast, but we’re continuing to action these things through the investments we’re making.

Mark Delaney: Yeah. That’s a helpful color. My second question was on margins. The company has a target for its EBIT margin to reach 31% to 32% by fiscal ’26. Maybe you can help us better understand what kind of revenue would be needed for the company to reach that kind of margin. And I think you have a 5% to 7% revenue CAGR target. I mean, should we be thinking about a couple of years of at least the high-end, if not, higher revenue relative to that targeted order to reach your margin objective? Thanks.

Satish Dhanasekaran: Thank you. It might be a little too premature to talk about the outer years, but here’s how we’re thinking about it. We’ve had — obviously, this is the second year we’re entering in where orders are declining. And every time that’s happened, we would expect a bounce back in the outer years to be stronger. So that’s still to be proven out. And you know the sort of earnings leverage that we get when we are able to grow our business above our models. So, profitability, I’m pretty encouraged by the strong gross margins we’re maintaining even on declining top-line right now, that’s a function of the software and services content, and just the discipline which we run our business. And so, I feel like getting our business back to growth is the principal driver.

And given all the trends that we see across wireless, wireline, the long-term trends we see in next-gen silicon and aerospace, defense and in semi, we believe that we can get back to this growth model that we put out at Investor Day.

Operator: Thank you. The next question is from the line of Meta Marshall with Morgan Stanley. Your line is now open.

Meta Marshall: Great. Thanks. And apologies for the background noise. Maybe just a couple of questions for me. Maybe first, and just in terms of — clearly, you guys were a little bit more cautious entering into the year. You had guided at the full year. I guess I’m just trying to get a sense of versus the environment as you saw 90 days ago, how have your expectations changed? And maybe just on the second question, just in terms of ESI and the earlier closure that we had, just any changes that you can make or able to make to that business kind of earlier than you expected? Thanks.

Satish Dhanasekaran: Yeah. I think as far as the ESI question goes, I think we’re quite positive, incrementally positive about the opportunities that we have to grow our — grow the ESI business in Keysight’s environment. We’ve long studied the system simulation/emulation marketplace. And so, having all of the capabilities is definitely a huge advantage. And for us, bringing an asset that was sort of locked-in in an European environment and exposing it with our go-to-market channel and taking that into our customer base remains an opportunity to drive growth above what they’ve been able to do. But incrementally I’m pretty bullish about the technology and the depth of simulation capabilities they bring. They also have a hybrid AI capability that is pretty unique and differentiated that we’ll look to fully leverage across the company as we go, and we’re also positive about the strong start in the first quarter for ESI.

And I’ll just hand it off to Mark to make some comments on the pipeline that he sees and how he sees that progressing.

Mark Wallace: Yeah. Thanks, Satish. Well, Meta, the pipeline that we see today really supports our base scenario that second-half orders and revenue will be modestly higher than the first half, and this is seen through some improvement in our six-month funnel that Neil mentioned in his prepared statements and we’ve called out in various other earnings calls as well. The improvement comes in the form of some funnel intake up modestly indicating that we have some green shoots and pockets of demand that are showing up. And the other area is in the funnel velocity, or in other words, how long it takes for opportunities to move through the funnel as some customers are beginning to move a bit more quickly. So, 90 days later, those are the big changes. The short-term funnel is about the same at the beginning of Q1, which still remains constrained, but we are seeing some positive pipeline dynamics as we look out six months.

Meta Marshall: Great. Thanks so much.

Satish Dhanasekaran: Thank you.

Operator: Thank you. The next question is from the line of Chris Snyder with UBS. You may proceed.

Chris Snyder: Thank you. I guess it sounds like from much of the demand end-market commentary that things are very similar in a demand sense from where they were three months ago. But I guess my question is, is there any place in the business where you see demand continuing to deteriorate on the leading edge? Because orders were down, it seems like on an organic basis, about mid-teens versus Q4, which is a bit sharper than seasonality, and the book-to-bill did step back below 1 after being above 1 last quarter. So, are there any places in the business where things are getting worse? Thank you.

Neil Dougherty: Yeah. I mean I think areas of relative weakness, Satish talked about Asia and China specifically continues to be challenging. I think manufacturing continues to be challenging. And I think we see our wireless customers that are still working through some other issues. On the positive side, wireline, driven by AI is clearly a strength point. Mark, do you want to add?

Mark Wallace: Yeah. I would just add to that, we have said that the weakness is in China for EISG businesses. As we said, if you look at China, we saw customer engagements continue. I was there in December. Our historic exposure to China has been high-teens of revenue. It was a little lower than that in Q1, and it was because of the continued headwinds incrementally worse in semi and manufacturing. But we did see sequential order growth from Q1 to Q — from Q4 to Q1 driven by this demand that we talked about earlier with growth in 400 gig and 800 gig, R&D for the data center upgrades, some demand for 5G private networks. And as a global company, we’re also exposed to some of the offshoring, that has been going on and continues as some of the multinational companies move offshore.

And the last thing I’ll say is, thinking back over the last several quarters, we vastly de-risked China from a trade perspective. It was it was meaningless in Q1, additions to the RPL have had a [variable] (ph) impact. We continue to monitor the situation very closely. So that’s where we’ve seen some of the headwinds, but even there I’ve seen some positive indicators in China as well.

Chris Snyder: Thank you. Appreciate that. And then, for my follow-up, I wanted to ask around backlog. Neil, I think you said $2.3 billion again, which is more than six months of coverage at this quarterly revenue run rate. But you guys are kind of saying that you don’t expect revenue to get better into the back half of the year. So, on this excess backlog, when does the company think it could start coming through in revenue? And is it because these big chip customers are pushing out their CapEx plans, or is it just because of the company has moved more towards a solutions-based model? Any help with that would be great. Thank you.

Neil Dougherty: Yeah. So, you’re correct. The number is $2.3 billion. And I would start by saying that we now stated a couple of quarters ago that we believe we’ve worked through the excess backlog. And so — and we did that last year when revenue outpaced orders by the tune of $275 million or something like that was when we worked through that excess backlog. I think as we look currently, we’re managing a couple of things. Obviously, by design, our recurring revenue businesses, software and services are holding up. You see that in an increasing deferred revenue balance. But in addition to this, we’re also managing this dynamic between where our — we’ve seen a pretty significant increase in these longer-dated orders, which if you remember correctly, historically been about 2% of our incoming order rate and we really didn’t talk about it as a result of that.

Last year, they were more like 8% of the incoming order rate. They were 8% again here in Q1. And as Mark talked about, we have a robust funnel of longer-dated opportunities as we look out over the course of the next six months. And so, that’s the dynamic that we’re starting to see. We are starting to see those longer-dated orders show up in revenue. We saw that beginning in Q1. And by Q4, we expect revenue from those longer-dated programs to be about 8% of that Q4 revenue.

Operator: Thank you. The next question is from Adam Thalhimer with Thompson Davis. Your line is open.

Adam Thalhimer: Hey, good afternoon, guys.

Satish Dhanasekaran: Hi, Adam.

Adam Thalhimer: I think to get to the — a question on operating margins. I think to get to the midpoint of guidance, they’re down 600 basis points, 700 basis points year-over-year. And my question is, is that what you would expect in your model? Or is there something specifically impacting margins in Q2?