Q4 2023 Onto Innovation Inc Earnings Call

Participants

Michael Sheaffer; Senior Director, IR, Corporate Communications, Market Research; Onto Innovation Inc

Michael Plisinski; CEO; Onto Innovation Inc

Mark Slicer; Chief Financial Officer; Onto Innovation Inc

Vedvati Shrotre; Analyst; Jefferies LLC

Craig Ellis; Analyst; B. Riley & Co.

Brian Chin; Analyst; Stifel

Charles Shi; Analyst; Needham & Company

David Duley; Analyst; Steelhead Securities

Mark Miller; Analyst; Benchmark Company LLC

Presentation

Operator

Good day and welcome to the Onto Innovation fourth-quarter and full-year earnings release conference call. This conference is being recorded.
At this time, I would like to turn the conference over to Mike Sheaffer, Investor Relations. Please go ahead.

Michael Sheaffer

Thank you, Rachel, and good afternoon, everyone. Onto Innovation issued its 2023 fourth-quarter and full-year financial results this afternoon, shortly after the market close. If you did not receive a copy of the release, please refer to the company's website where a copy the release is posted.
Joining us on the call today are Michael Plisinski, Chief Executive Officer; and Mark Slicer, Chief Financial Officer.
I would like to remind you that the statements made by management on this call will contain forward-looking statements within the meaning of federal securities laws. Those statements are subject to [rate] changes, risks, and uncertainties that could cause actual results to vary materially.
For more information regarding the risk factors that impact Onto Innovation's results, I would encourage you to review our earnings release and our SEC filings. Onto Innovation does not undertake any obligation to update these forward-looking statements in light of new information or future events.
Today's discussion of our financial results will be presented on a non-GAAP financial basis unless otherwise specified. As a reminder, a detailed reconciliation between GAAP and non-GAAP results can be found in today's earnings release.
I will now go ahead and turn the call over to our CEO, Mike Plisinski. Mike?

Michael Plisinski

Thank you, Mike. Good afternoon, everyone, and thank you for joining our call today. As you may have already seen, Onto Innovation had a strong end to the year with fourth-quarter revenues exceeding the high end of our guidance range. This was primarily due to stronger-than-projected demand for Dragonfly inspection systems to support packaging of memory and logic devices for AI applications. We expect this demand to continue as reflected in our increased guidance range for the first quarter.
Financially, we're starting to benefit from tighter controls and operational efficiencies, which resulted in generating over 28% of cash from operations in the quarter while still supporting the multi-quarter surge in demand for the Dragonfly systems. We expect improvements in margins will soon follow, bringing us back in line with the long-term operating model by end of the year.
So let's begin with our specialty and advanced packaging customers where the boom in AI spending lifted revenue from this market by 17% over the prior quarter and set a consecutive quarterly record. In fact, since the start of the year, quarterly revenue for the specialty device and advanced packaging markets has grown 65% while, on an annual basis, revenues have risen from $220 million in 2020 to just over $500 million in 2023.
Several markets have contributed to this growth, including power semiconductors, where demand for our solutions increased 50% this year. But the greatest and most consistent growth has come from our long-standing partnerships with the top semiconductor manufacturers and their increasing investments in advanced packaging, including chiplet and 3D memory architectures.
Over the next several years, as these architectures increasing complexity and interconnect density, we expect additional process steps to create the need for more Dragonfly inspection in new metrology applications. For example, in the fourth quarter, we shipped several of our newer front-end metrology systems, including ecofilms and [aspect] metrology to leading manufacturers and (inaudible) for emerging packaging applications.
Another highlight for the quarter was our lithography team shipping three systems as planned to two customers supporting mobile and high performance compute applications. To complement our lithography tools and provide additional technology for leading-edge panel manufacturers, we announced the availability of our latest Firefly G3 panel inspection system in the fourth quarter.
This third generation of our Firefly panel tool now includes all of the metrology capabilities of the Dragonfly G3 and shares the same high-performance optical design. This tool's inspection and metrology capability is being used to qualify glass panel substrates as well as more traditional panels. It is fully integrated with our software solutions, which we expect will help our customers accelerate their ability to reach productivity and yield targets, especially for the next generation of heterogeneous packaging technologies.
Turning briefly to the advanced notes, (inaudible) the client in the fourth quarter and we believe (inaudible) reach the bottom. Consistent with historical performance, the revenue was split nearly equally between DRAM, NAND, and logic. Although revenue was light overall, we continue to receive early orders for gate-all-around pilot lines. And in the fourth quarter, we received approximately 20 million of additional orders for Atlas scenarios systems for deliveries in the first half of 2024. We're optimistic that these placements indicate the strengthening of our position when volume ramps occur likely in early 2025.
Now I'll turn the call over to Mark to discuss our financial performance in the fourth quarter and guidance for the first quarter.

Mark Slicer

Thanks, Mike, and good afternoon, everyone. As Mike highlighted, we closed the fourth quarter with revenue of $219 million, up 6% versus the third quarter and a revenue milestone for us in 2023, exceeding our guidance range while achieving a high mark for revenue within the year. Fourth quarter EPS increased 10% sequentially to $1.06, exceeding the midpoint of our guidance, but constrained by the decline in our high-margin advanced nodes business and lower services parts revenue within the quarter.
Looking at the quarterly revenue by markets, advanced nodes, which had revenue of $18 million, declined 30% over Q3 and represented 8% of revenue. Specialty device and advanced packaging, with record revenue of $158 million, increased 17% over Q3 and represents 72 2%o f revenue. Software and services with revenue of $42 million declined 8% over Q3 will representing 20% of revenue.
Fourth-quarter operating expenses were $56 million, at the low end of our guidance range of $56 million to $58 million. We continue to actively manage costs while realizing the benefits of our cost reduction initiatives put in place earlier in the year in driving our OpEx run rate back to Q4 '21 levels.
Our operating income of $56 million was 26% of revenue for the fourth quarter compared to 24% for the third quarter. Our net income for the fourth quarter was [$52 million], 24% of revenue versus 23% for the third quarter. Both operating income and net income performance versus the third quarter (technical difficulty) highlight our improving operating leverage within the year.
(inaudible) 28% of revenue and achieving record for operating cash flow. Inventory ended the quarter at $328 million, a decrease of $18 million from Q3, representing a 14% reduction of our days inventory outstanding. Even with ramping Dragonfly production requiring us to procure long lead time items, we do expect further reduction in inventory days outstanding as inventory optimization remains a critical working capital focus area to drive consistent cash flow performance levels exceeding 20% of revenue.
Accounts receivable increased $17 million to $227 million in the quarter, and our days sales outstanding increased two days to 94 days. Now turning to our outlook for Q1.
We currently expect our revenue for the first quarter to be between $215 million in $230 million. We expect gross margins will be between 51% to 53% as we continue to experience historical lows in the advanced notes business and only the initial phases our supply chain return reductions taken hold in the quarter.
For operating expenses, we expect to be between $58 million to $60 million, higher versus Q4 primarily due to annual reset of payroll (technical difficulty) for the full year '24, I expect our tax rate to be between 14% to 16%, which does not assume any impact for potential tax legislative changes that may have occurr during the year. We expect our diluted share count for Q1 to be approximately 49.8 million shares.
Based on these assumptions, we anticipate our non-GAAP earnings for the first quarter to be between $1 per share to $1.20 per share. Looking forward to 2024, a critical focus for us continues to be our targeted programs for operating improvements necessary to return to our operating model.
And with that, I will turn it back to Mike for additional insights into Q1 of 2024. Mike?

Michael Plisinski

Thank you, Mark. Our guidance range for the first quarter reflects continued strong demand for our Dragonfly inspection systems to support increases in AI device production. By way of comparison, our inspection business in the first quarter is expected to be three times larger than Q1 of last year.
(technical difficulty) started to hit the market (technical difficulty) contrast, advanced note spending is still at historical lows, but we do expect advanced note revenue to pick up a bit in the first quarter and gain some strength through the year.
Broadly speaking, we see advanced packaging, especially for the leading edge AI devices, will be a healthy multi-year driver for our business. We're encouraged by the recent comments from TSMC (technical difficulty) seeing a 50% CAGR through (technical difficulty) for the AI application processors.
In addition, they also are forecasting we greatly increased silicon content for networking and edge devices that will begin adding neuro processing in phones and PCs. Gartner provided a similar outlook with their expectation that AI semiconductor revenues forecast to be about $140 billion by 2027, a more subdued 27% CAGD.
What we find exciting is that in addition to the growth rate for AI devices, we expect an increase in capital intensity of process control for those devices as manufacturers increase stacks of DRAM, implement denser and smaller interconnect, and include a greater number of chiplets per package. The increasing complexity will require greater emphasis on the interconnect quality and the number of steps will increase with layers and complexity.
(technical difficulty), we're developing their pace of innovation and meet production yield targets. We're only in the dawn of the AI era, and the outlook is very exciting. We expect AI packaging to be a strong driver for 2024, with our backyard backlog already extending into the second half of the year. However, the timing and magnitude of the recovery of an advanced nodes remains uncertain, even as we see tool utilizations improving and incremental technology buys increasing.
Based on the strength of our AI packaging business and gradual recovery in the advanced nodes, we project low double-digit growth for the year.
With that, Rachel, we'll open the call to your questions. Rachel?

Question and Answer Session

Operator

Thank you. (Operator Instructions) Vedvati Shrotre, Jefferies.

Vedvati Shrotre

Hi, thanks for taking my question. The first one is -- so last couple of quarters, you've talked about multiple orders, I think, going to $230 million for your packaging revenue. Could you talk about (technical difficulty) being continued as go into next quarter?

Michael Plisinski

Going into the next two -- so the backlog is there. Yeah. So going into the next two quarters, we'll be strong. And that's reflected in the increase in our guidance. Second half, as we mentioned, we've got backlog that extends all the way through the second half, not at the same level. But it's still early, and we'll see where our customers start to increase as they come out of Chinese New Year -- Lunar New Year.

Vedvati Shrotre

Right. And for my second -- if I may ask a follow-up. So you talked about the strength in metrology to starting to get used in packaging application. Could you compare and contrast what kind of use cases there are for (inaudible) tools versus waht Dragonfly did on the inspection side?

Michael Plisinski

It's different types of metrology that are more complex. So in some cases, we could be looking for voids in metals or we're looking for our metal thicknesses that the Dragonfly doesn't do as well as the Echo product line does. There's different applications for that, whether you're looking at TSVs or bump -- the creation of the -- metal stacking of bumps and bond pads, things like that. There's some other applications as well, but that gives you an idea.

Vedvati Shrotre

Okay, that's helpful. Thank you.

Operator

Craig Ellis, B. Riley Securities.

Craig Ellis

Yeah, thanks for taking the question. Mike, I want to start with some coupled with you. One, great to see the strength in advanced packaging and Dragonfly. The question is this. Given how robustly that business has ramped up 3x year over year (technical difficulty) manufacturing and [filming] issues? How are you doing on capacity? Any constraints, et cetera, as you look to meet demand that exists through your first quarter guide? And then just a further momentum in the second quarter.

Michael Plisinski

Yeah, that's a good question and it's a good concern. But I'm actually very impressed with our team. They've done a great job working with our suppliers, working internally, moving resources from one factory to another, for instance, from California to Minnesota, in oder to ensure that we're able to meet the ramp with the level of quality that customers expect from us and even increase it again.
So we talked about, at Q4, we're increasing the capacity again for the first half of the year as well. So so far, the team's done an outstanding job working through everything. And we don't see -- we're overcoming every hiccup that we see.

Craig Ellis

Yeah, got it. Okay. Good to hear. And then secondly, you did mention you expect some pretty modest advanced node pickup in the first half of the year and that to accelerate. Can you talk about which end use areas are the first to see increased tool shipment activity? And how would you agree the other end use areas to layer on as you go to the second half and into next year?

Michael Plisinski

Yeah, I think it's mostly of logic and then followed by DRAM. And again, these are incremental improvements. I think there's still a lot -- as I mentioned, still a lot of uncertainties when we'll see real volumes picking up maybe in the second half or maybe into early next year. But we're definitely seeing some incremental improvements. We've even seen some incremental improvements in NAND, but that will be a little bit further out.

Craig Ellis

Sure. And then if I could just sneak one in for Mark. Mark, nice to hear that efficiency enhancements are benefiting things like cash generation with record operating cash flow. The question is on impacted gross margin. You indicated you expect to be back in the target model by the end of the year. What's the (technical difficulty) or is it really more back-ended with a little help from advanced nodes? Thank you.

Mark Slicer

Yeah, Craig. No. Certainly, as we look at the model for the year, I mean, our goal is certainly to show quarter-over-quarter improvement in gross margin. It really comes down to just executing similar to what we did with operating expenses in working capital management, just executing what we have have in place right now for supplier management, price, commodity pricing; and executing the supply chain initiatives that we have.
It does certainly help to have advanced nodes back in the area where it was previously. I mean, that is our historically higher margin business. But again, there's a lot of things in our control from a cost perspective that we still need to get moving in the year to continue to show that improvement.

Craig Ellis

Got it. Thanks, guys.

Operator

Brian Chin, Stifel.

Brian Chin

Hi there. Good afternoon. Thanks for letting us ask a few questions. Maybe, Mike, where have you managed to keep lead times on the Dragonfly given the demand and your ability to stay in front of it? And more broadly, we've been talking to customers. What are your discussions around second-half capacity needs for AI packaging? And should we really think about second expansion being a function of expectations for growth in the market in 2025? Is that the right way to think about that?

Michael Plisinski

Yeah, Brian. So from a lead time perspective, of course, on the packaging world for forever, we had very short visibility and we would always build to a forecast or projection. So lead-time is somewhat misleading. But I would say around two quarters' lead times right now, given the high demand for the Dragonfly.
The second half expansion is a question right now. I think there's more certainty in 2025, another round of expansion. Our customers are looking at their order books and influx and seeing if the capacity they have that they're bringing online now in the last three quarters, Q4, Q1, Q2, will be enough to get them through the second half or if they need to add additional capacity.

Brian Chin

Okay.

Michael Plisinski

But we've been given more stronger indication that 2025 would be (technical difficulty)

Brian Chin

Okay, got it. I guess looking at (technical difficulty) your commentary about the full year, looks like you still have -- even though you have a harder (technical difficulty) probably not appears with maybe one of the few companies guiding for growth in first half versus second half last year. It looks like based on overall improvement in the business, you see some pickup in the second half or maybe you're tempering it at the moment.

Michael Plisinski

I'm tempering it at the moment.

Brian Chin

Okay. Fair enough. And then maybe, Mark, a question -- additional follow up on the gross margins. The from obviously advanced nodes is very cyclically depressed and your you had called for that big of a pickup in that business at the moment this year. But you do expect to be in the model on back in the target model. So it kind of suggests that when you know you just get any sort of start to pick up, not even close to sort of prior peak levels, but saw some pickup in the advanced nodes. You should be really comfortable within that target model probably even exceeding it. Tom?

Mark Slicer

Yes, absolutely. I mean that when we get those numbers back of certainly there are the things we're doing now from a cost and operational standpoint or kind of accelerate.

Brian Chin

Yes, how many points of drag on gross margins is the depressed revenue level advanced nodes right now?

Mark Slicer

Yes, I wouldn't comment specifically on that. I would just say we've always stated that advanced nodes was well above company average. And in the the inspection business was at company average.

Brian Chin

Okay, thank you.

Operator

Charles Shi, Needham.

Charles Shi

Hi, good afternoon out. The first question I might. I think one quarter ago you were expecting a I chip packaging related revenue to be up by 50% in Q4. What was the actual number has given you did beat your guidance by roughly 10 million properties, the look of over 50 would be my guess, but I really want to hear what role as an actual number.

Michael Plisinski

Yes, that's a good question, Brian. So it does, but I don't have that number in front of me. However, nearly all of the upside we saw in the quarter, not all of it was tied to the to the AI. packaging. So that basically that 10 million increase was primarily from that.

Charles Shi

Got it. The second question, I think it's interesting. You mentioned that asked that I believe Omni being adopted by packaging applications. It does one look at the aspect that it seems like the iPod POCD. systems of portfolio. And that's interesting. That's being adopted for packaging whole kind of provide a little bit Holloway exactly that used for plus some unique capabilities. Member was designed to to measure the channel holes for three demand.

Michael Plisinski

So big, big, high deep aspect ratio, metrology applications for three demand. And you can imagine that there's some I'm application similar to that in advanced packaging that the product is being applied to CSDs, for instance, and some other other things that I'm not sure how much is public from our customers, companies that are more than HBM communication hours or more of on the logic packaging side. Yes. No, I think it's more on the HBM. applications right now.

Charles Shi

Yes. Got it. Got it. Lastly, I would really thanks for the color you provided about that. But the trend in the C&I side of the business, I wanted to ask you what's the status for the HE. ON in terms of orders.

Michael Plisinski

I think when you started seeing all these orders, you started to see from one customer, primarily, right, HBM customer. And then last quarter, you're talking about a second. Hbm customer becomes Abraxas. The third was not Michael was still a little bit muted was not the same like a one quarter later. Now is the status and I wanted to thank God, they're going to pickup orders. We think the third guys picking up. So not saying who's who in the shell game of one to three would think the third is also picking up now and investing. And they have some unique technology that they think is going to help them give them some market share advantages.

Charles Shi

Thanks, Mike. You're up.

Operator

David Duley, Steelhead Securities.

David Duley

I'm sorry, I'm on mute. Yes, I'm on mute. I'm sorry. My first question is on gross margins. Just so I understand it sounds like gross margins will come because of cost reductions and what you've been focusing in on. Is that accurate? Yes, yes, great. As far as far as the AI. inspection revenue, could you help us understand whatever the growth rate you had last year was, you know, how much do you think this is driven by units and or how much do you think it's driven by much greater levels of intensity? And then as a follow-up to that, as far as onto goes, is your does your business have a which is a greater piece of this inspections and this is that high bandwidth memory or the GPU infection? Thank you.

Michael Plisinski

Thanks, Dave. So I mean a year ago a I wasn't really on the radar. So I would say, you know, the volumes are the pure number of wafers tied to a guy is not that high. So this is really about capital intensity. This is really about the complexity of these advanced architectures and how much first size metrology and inspection is required to yield these devices. So I think that's always been something we've talked about for years that on these in these really advanced applications are Dragonfly tends to to shine at Swiss Army knife containing both inspection, metrology, unique capabilities and clear sign that our customers have driven us to ever greater levels of performance. As far as the mix goes on, I think the capital intensity is higher for logic, but there are three HBM. players. So at least right now, what we've said is our backlog was roughly half-and-half, HVM ends and logic.

David Duley

Okay, thank you.

Operator

Mark Miller, Benchmark Company.

Mark Miller

Thank you for the question. You mentioned gate all around. You're getting some traction there. I'm just wondering when does that fully ramped business later this year, 2025? And also about the new fab, the funding by US and Europe and Japan for new firms, internal chip production, what does that start to route?

Michael Plisinski

Yes. So as far as when gate all around really ramps that, that's the million dollar question. We often like to know, I don't have any great clarity there. You know right now, we've bet on an early 2025. There are some signs I read recently. And two, certainly they're seeing stronger demand. So maybe that pulls in, but we're not seeing anything yet definitive one way or another where that ends up ramping. We just know our job right now is to make sure we have a strong position in gate-all-around as possible. So when it does ramp, we can benefit the most. We possibly can. As far as the fabs around the world that are being incented, whether it's Europe, Japan, US, we've already taken some some orders for at least I don't know. I don't know on memory about the European, but for sure, in Japan and in the US we've already taken orders, but these are very small and those fabs on obviously, as you know, ramping them just yet.

Mark Miller

Thank you.

Operator

(Operator Instructions) Vedvati Shrotre, Jefferies.

Vedvati Shrotre

Hi, thanks for taking my question again. As so you provided some color on the power of the specialty market. They kept growing 40% this year. Could you talk about what you're seeing out into 2020 point? Does it continue to be strong or at least turning to see weakness there?

Michael Plisinski

No, we continue to see very strong specialty device and packaging going into 2024. So well over fashion. I did mention that our piece of the power people say grow as well with our. So I know we think it could grow were more comfortable with kind of flat at this record level for To Go. We're working with customers and certain timing of of their expansions. one of the things that we benefit from being process control is our value proposition isn't just tied to expansions of these with these customers. It's tied to output and the quality of the output. So some of these fabs still have a lot of opportunity to improve yields and therefore improve output without huge capital expense. So a lot of customers we're talking to are still we're still focusing on that value proposition and seeing some traction there. Let me double-click on that.

Vedvati Shrotre

So I as far as I understand, most of your China revenues really come from the power of our revenues. So is that out, but you could you talk about the non-China versus China, Spain and how high that looking at it from me today are Al and again, different from each other in the market,

Michael Plisinski

no, I don't believe they're different. We have activity in Japan, Europe, U.S. as well as China. So it including into discussions into 2024. So so I wouldn't say there's any difference from that perspective.

Vedvati Shrotre

Thank you.

Operator

David Duley, Steelhead Securities.

David Duley

Yes. A couple of questions for me are Mike, could you talk a little bit more about the lithography tool deliveries during the quarter? I think I missed some of the detail. I think you said there was three systems to customers. I didn't catch which applications. I was wondering if you could also elaborate on these new customers or their current customers that are bringing more tools online. two questions.

Michael Plisinski

Are you pretty much got it. There are two applications, mobile and high performance compute. So those are the primary applications and their to existing customers. So buying repeat business. So repeat orders from existing customers and on, would you expect to see this customer base continues to expand or or

David Duley

as far as the growth in that segment 24, if it does grow is going to come from current customers are adding new customers? Or how should we think about that?

Michael Plisinski

While we already have a new customer adds a new customer, and we mentioned we'll be shipping that tool sometime in the summer. The maybe the but the bulk of the 2024 will be repeat business. And then I think in 2025, we'll see more of our new customers as well as some repeat business as well. Is that in place substrate customer for a logic applications, I believe so.

David Duley

Okay. Final question from me is and I'm sorry if you already mentioned that you talked about how your packaging revenue has grown dramatically. I think three times last year, what he is, what would you guess to be in the growth rate would be for that segment of your business in 2024?

Michael Plisinski

Yes, I don't know specifically because when with that comment, I was speaking about Dragonfly and Dragon supplies systems in particular is continuing to grow that much. I know how much they don't have in front of me on the whole segment, specialty devices and advanced packaging will be a pretty high double digits.

David Duley

Okay. Thank you.

Operator

Well, this concludes today's question-and-answer session. I will turn the call back to Mike Sheaffer for any additional or closing remarks.

Michael Sheaffer

Thanks again to everyone who joined us on the call today. A replay of the call will be available on our website at approximately 7:30, Eastern time, this evening. I would like to thank you for your continued interest in Onto Innovation ratio. Please conclude the call. Thank you. This concludes today's call. Thank you for your participation, and you may now disconnect. And um, thanks. Thanks. Thanks.