Keysight Technologies, Inc. (NYSE:KEYS) Q4 2023 Earnings Call Transcript

Keysight Technologies, Inc. (NYSE:KEYS) Q4 2023 Earnings Call Transcript November 20, 2023

Keysight Technologies, Inc. beats earnings expectations. Reported EPS is $1.99, expectations were $1.87.

Operator: Good day, ladies and gentlemen, and welcome to the Keysight Technologies Fiscal Fourth Quarter 2023 Earnings Conference Call. My name is Sarah, and I’ll be your lead operator today. [Operator Instructions] This call is being recorded today, Monday, November 20th, 2023 at 1:30 P.M. Pacific Time. I would now like to hand the call over to Jason Kary, Vice President, Treasurer and Investor Relations. Please go ahead.

Jason Kary: Thank you, and welcome everyone to Keysight’s Fourth Quarter Earnings Conference Call for Fiscal Year 2023. 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 that 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 Wells Fargo and UBS. And now I will turn the call over to Satish.

Satish Dhanasekaran: Good afternoon, everyone, and thank you for joining us. My comments today will focus on three key headlines. First, Keysight reported solid fourth quarter results and finished the year with record revenue, gross margins and operating margin, in what remains a challenging macro environment. Fourth quarter revenue and earnings per share exceeded the high end of our guidance, as orders came in slightly ahead of expectations. For the full year, revenue grew 2% on a core basis and earnings per share increased 9%, while we generated $1.2 billion in free cash flow. Second, our customer engagement on next-generation technology teams remain strong and we continue to action opportunities, across a broad and diverse set of end markets.

Despite the mixed demand environment, as end markets normalize from post-COVID supply demand imbalances over the last two years. Third, we’re investing both organically and inorganically, to expand our addressable markets and differentiated solutions portfolio, which took other step forward this quarter with the addition of ESI. We remain confident in the long-term secular growth drivers of our business and our ability to address our customers’ most challenging and diverse innovation needs. Now let’s begin with a brief overview of Keysight’s fourth quarter and full year performance. We’re pleased with our results and execution. Fourth quarter orders were $1.3 billion, and we delivered $1.3 billion in revenue and $1.99 in earnings per share.

We also generated $340 million in free cash flow and repurchased $426 million of our shares this quarter. Full year results were strong in a year of normalizing demand. Orders of $5.2 billion were in line with our original expectations of approximately $1.3 billion per quarter this year. We delivered an all-time high of $5.5 billion in revenue and achieved record profitability with gross margins of 66% and operating margins of 30% and $8.33 in earnings per share. Moving to our markets. Overall, the demand dynamics within the quarter, were consistent with our expectations. Aerospace, Defense and Government demand increased, commercial communications was steady and as anticipated, broader manufacturing-related spending in the electronics industrial markets was incrementally softer.

Turning to our business segments. Communications Solutions Group revenue declined 10%. Aerospace, Defense and Government grew, while Commercial Communication markets are rebalancing off of last year’s record highs. On a sequential basis, orders grew across both markets. In Aerospace, Defense and Government, revenue grew 4% to an all-time high, we saw healthy order demand from the US and European primes, as well as direct government customers, driven by investments in Defense modernization, space and satellite applications. Keysight’s Leading Threat Emulation solutions capabilities drove order growth in the US, including a large US Department of Defense win for electromagnetic spectrum operation applications. We also saw demand from European primes for our Radar and phased array antenna solutions to support their delivery goals in 2024 and beyond.

The breadth and the depth of our solutions portfolio enable new customer engagements and business in satellite communications 5G and 6G and advanced quantum research, including a large order from a premier research institute contributing to the record quarter. In Commercial Communications, revenue declined 17%, reflecting ongoing customer spending constraints, as inventories in their markets normalize. Sequentially, we saw stability in wireless orders and incremental strength in demand for network and data center applications. Demand for our wireline solutions was driven by AI ML and data center expansion, as hyperscalers build infrastructure to handle increasing network and compute workloads. We expect this trend to continue into the next year and beyond.

Enterprise customer business was stable with ongoing investments in network monitoring, driven by increasing data traffic and cybersecurity compliance needs. In Wireless, the progression of standards is driving steady R&D investments in new capabilities and devices, as well as Open RAN and Release 17 features. Our R&D engagements with customers continue to expand. This quarter, we enable MediaTek to validate non-terrestrial network connectivity. In addition, Keysight was awarded two key UK government grants in partnership with universities and leading telecom operators to support Open RAN design, testing and deployment in Europe. Turning to Electronic Industrial Solutions Group. As expected, Q4 orders and revenue were both down compared to record levels of last year.

It is important to note that the EISG has shown significantly about long-term expectations with revenue increasing by 30% in 2021, 14% in 2022 and an additional 10% in 2023. This growth was driven by both our Differentiated Solutions portfolio and an outsized demand from post-COVID recovery and supply constraints. In the second half of this year, we began to see a normalization from these size as well as ongoing cautious customer spending. In semiconductor, capital spending for wafer capacity contracted in the quarter, as foundry customers pushed out their new fab investment time lines. We continue to see strong customer engagement for Keysight’s proprietary interferometer systems and differentiated R&D solutions for silicon photonics and power semiconductors, reflecting the industry’s medium to long-term recovery and growth expectations.

In automotive, customer investment in R&D for battery and charging infrastructure continues and is being fueled by increasing competition, regional legislative deadlines and government funding, particularly in Europe and Asia. The funnel of EV opportunities remain strong, while the timing and size of these systems engagements are expected to vary from a quarter-to-quarter. In General Electronics, we saw steady demand for our solutions in advanced research, industrial automation and digital health. However, and more broadly, manufacturing capacity normalization and cautious spending continued to weigh in on consumer electronics and manufacturing portions of the market. We’re watching Global PMI and other macroeconomic indicators to gauge the timing of the market recovery.

As an integral part of our solution strategy, software and services revenue growth this year continue to outpace Keysight overall. The recurring portion of software and services grew 9% this year, driving total annual recurring revenue to approximately $1.3 billion or 23% of total revenue, an increase of 200 basis points, year-over-year. In early November, ahead of schedule, we announced our acquisition of a controlling block of shares of ESI Group. The addition of ESI, further increases our software and annual recurring revenue expands our addressable markets and strengthens our strategy of moving upstream into earlier stages of our customers’ design cycles. We continue to invest prudently to capitalize on our long-term growth opportunities.

In parallel, we remain disciplined and are taking additional targeted cost actions to streamline operations and ensure strong financial performance. In wrapping up my first full year, as the CEO of Keysight, I’d like to thank our employees for their outstanding contributions, commitment and strong track record of execution in these tough market conditions. The strength of Keysight’s differentiated solutions, the diversity of our end markets and the durability of our business model, all position us well for continued market outperformance, as we enter the new fiscal year. With that, I’ll turn it over to Neil to discuss our financial performance and outlook.

Neil Dougherty: Thank you, Satish, and hello, everyone. Fourth quarter revenue of $1.311 billion was just above the high end of our guidance range and down 9% or 10%, on a core basis. Orders of $1.327 billion declined 16% on both a reported and core basis. Similar to the third quarter, demand in China was muted and accounted for roughly 1/3 of the year-over-year order decline. We ended the quarter with $2.3 billion in backlog. Looking at our operational results for Q4, we reported gross margin of 65%, an increase of 130 basis points, year-over-year and operating expenses of $474 million, resulting in operating margin of 29%. We achieved net income of $352 million and delivered earnings of $1.99 per share. Our weighted average share count for the quarter was 177 million shares.

Moving to the performance of our segments. Our Communications Solutions Group generated revenue of $891 million, down 10% on a reported and core basis. Commercial Communications revenue of $568 million, declined 17%, while Aerospace, Defense and Government revenue of $323 million was up 4%, driven by increasing defense budgets and investments in technology modernization. Altogether, CSG delivered gross margin of 68% and operating margin of 29%. The Electronic Industrial Solutions Group generated revenue of $420 million, down 7%, as reported or 8% on a core basis. EISG reported gross margin of 61% and operating margin of 30%. Turning to our full year financial performance. Keysight delivered strong results, despite demand and foreign exchange headwinds.

Full year 2023 revenue grew 1% as reported or 2% on a core basis to a record $5.464 billion. Gross margin of 66% expanded 80 basis points. We invested $842 million in R&D, while operating margin improved 90 basis points to 30%. The flexibility of our cost structure and actions that we’ve taken to further reduce costs, drove FY’23 net income to a record $1.5 billion, resulting in earnings per share of $8.33, which was up 9%. Moving to the balance sheet and cash flow. We ended the fourth quarter with $2.5 billion in cash and cash equivalents, generating cash flow from operations of $378 million and free cash flow of $340 million. Total free cash flow for the year was $1.212 billion, representing 22% of revenue and 81% of non-GAAP net income. Share repurchases this quarter totaled 3,270, 000 shares, at an average price per share of approximately $130.

For a total consideration of $426 million. This brings our total share repurchases for the year to 4.9 million shares, at an average share price of approximately $143 for a total consideration of $702 million or 58% of free cash flow. Now turning to our outlook. Looking forward to fiscal year ’24, we expect the demand environment in the first half to remain mixed, and we’ll be closely watching for signs of recovery in the second half. Going forward, we will report results including ESI, which is expected to be slightly dilutive to earnings on the full year. Given the timing of annual contract renewals, ESI typically recognizes 40% to 45% of their full year revenue in Keysight’s fiscal first quarter, with the balance recognized relatively evenly over the remainder of the year.

Also, due to GAAP accounting rules, ESI earnings recognition will be proportional to our shareholding, until all shares are acquired. With the normalization of backlog over the past year, our Q1 guidance is based on, one, existing backlog that is scheduled to ship this quarter; two, our view of incoming Q1 orders and three, our ability to turn a portion of those incoming orders into revenue within the quarter. We now expect first quarter revenue to be in the range of $1.235 billion to $1.255 billion and Q1 earnings per share in the range of $1.53 to $1.59 based on a weighted diluted share count of approximately 176 million shares. This guidance includes approximately $60 million in ESI revenue and an EPS impact of approximately $0.05 from ESI net income.

Now I would like to highlight a few modeling items for FY’24. As I just mentioned, we are modeling a significant sequential decrease in ESI revenue in Q2 and over the same period, we expect a low single-digit increase in core Keysight revenue. Excluding ESI, FY’24 operating expenses are expected to be flat to slightly down year-over-year, reflecting the structural flexibility of our business model and the cost actions we have initiated. With the addition of ESI, we expect FY’24 R&D investment to be 17% of revenue. Annual interest expense is expected to be approximately $80 million. Capital expenditures are expected to be approximately $150 million and we are modeling a 17% non-GAAP effective tax rate for FY’24. In closing, Keysight’s flexible cost structure, track record for execution, diverse end markets and long-term secular growth drivers give us confidence in our ability to outperform, even in challenging market conditions.

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

Jason Kary: Thank you, Neil. Sarah, will you please give the instructions for the Q&A?

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Q&A Session

Operator: Absolutely. [Operator Instructions] Our first question today comes from Meta Marshall with Morgan Stanley. Please proceed.

Meta Marshall: Great. Thank you. Maybe first question, you guys talked about kind of an over-performance of EISG or how well that business had done over the last couple of years. Just trying to get a sense of, is there a period, where you think kind of represents, the run rate of that business just as we think of the growth of that business going forward? And then — maybe just the second question, just on the Communications business. You guys have mentioned kind of seeing stabilization in that business. So I just wanted to kind of clarify that none of the weakness that you are seeing has kind of spread to more of the lab testing that it’s largely kind of stayed on the production side. Thank you.

Satish Dhanasekaran: Thank you, Meta. Absolutely. The EISG business, as we have said, the long-term market growth rates 4% to 6% and our goal is to beat it. And the business, obviously, has been performing significantly above that for a prolonged period of time. And that’s really a function of the differentiated positions, we have, almost unique positions in some — with some customers across these end markets that they serve. And it’s also been a focus for us to continue to diversify the company. And with regard to the Commercial comps business, we saw sequential order improvement between Q4 relative to Q3. And again, that’s stability in Wireless, continued stability now for a few quarters in Wireless, especially with 5G. And again, that is a function of the R&D holding up much better, and we’re still awaiting a recovery in manufacturing.

And then we saw some signs of recovery in our wired part of the ecosystem, again, driven by, what appears to be a sustained push to invest in AI ML/data center infrastructure by the cloud/hyperscalers.

Meta Marshall: Great. Thank you.

Satish Dhanasekaran: Thank you.

Operator: Our next question comes from Samik Chatterjee with JPMorgan. Please proceed.

Samik Chatterjee: Hi. Thanks for taking my question. I guess for my first one, so just to clarify the comments around seasonality that you had, particularly now including the acquisition. I think what you’re, I guess, guiding to is a sequential decline into the April quarter and that is the trough in terms of revenues. And when you think about the sort of back half of the year, how do you think about seasonality from 2Q onwards? Should we be thinking about sort of the typical seasonal increases that you see? Just any clarification in terms of, if I put in those comments correctly? And I have a follow-up. Thank you.

Neil Dougherty: Yes. So I do think you interpreted the comments correctly. I think as we move from Q1 to Q2, we do expect a low single-digit increase in core Keysight. But ESI, as we mentioned, because of the timing of their contract renewals, recognized as a disproportionate portion of their revenue in Keysight’s first quarter, 40% to 45% with the balance 55% to 60%, spread roughly evenly over the subsequent three quarters. So there is a significant drop off on the ESI side of things, just given the timing of those contractual renewals. I think, obviously, we’re taking this one quarter at a time, given the normalization that we’re seeing in the marketplace. I do think that over time, we expect the seasonality of the Keysight business to return more towards historic norms, than what we’ve seen over the last couple of years, as a result of the supply chain disruptions, but we’ll have to wait and see how that develops as we move forward.

Samik Chatterjee: Okay. And just in terms of the — how to think about margins for this year, just a lot of puts and takes. I know you had some comments earlier about, I think last quarter, it was about sort of a 10% revenue decline is where we should expect 200 to 250 basis points of margin deterioration in the operating margin side, but you now have the acquisition, which is probably a bit diluted, but you also have taken cost actions. So can you just give us an updated framework on how to think about margins for the year, particularly given all the puts and takes? Thank you.

Neil Dougherty: Yes. So we’ve shared the same essentially, model describing kind of demand normalization here, really since our spin. And that’s a model that says, if our revenues are down 10%, that we would expect operating margins to be down 300 to 400 basis points in that scenario. That’s obviously pre any acquisition activity. So when you think about layering in ESI, obviously, it’s a public company, you can look at their results. At this point, we only own half the shares. It’s going to take us a while to get to full ownership. So I think you can layer in ESI in the short run, much as they were — as they were running as an independent company. And once we get to full ownership, we’ll be able to really set our minds on cost reduction within that space, synergy realization.

Samik Chatterjee: Good. Thank you.

Operator: Our next question comes from Rob Mason with Baird. Please proceed.

Robert Mason: Yes, good afternoon. Last quarter, we talked about a surge in some of these longer-dated orders year-to-date. I’m just curious as you wrapped up the year where the total sum of those came in relative to last year? And then do you have any perspective on how those would start to be converted to revenue? Are those 2024 revenue events? Or are we looking more out into 2025?

Neil Dougherty: Yes. So first of all, as we said last quarter, they were about 8% of orders to date, and that’s where they finished. So Q4 was on par with the first three quarters of the year, and that compared to we’re like 2% as a historic run rate. The majority of that revenue will be in ’24, although there is a portion, a sizable portion that pushes out into ’25.