Good day everyone. Welcome to the Entegris first quarter 2019 earnings call with analysts. Today's call is being recorded. If you would like to ask a question on today's call, please press star one to be entered into the queue. At this time, for opening remarks and introductions, I would like to turn the call over to Bill Seymour, Entegris VP of Investor Relations. Please go ahead, sir.
Good morning, everyone. Earlier today, we announced the financial results for our first quarter of 2019. Before we begin, I would like to remind listeners that our comments today will include some forward-looking statements. These statements involve a number of risks and uncertainties, which are outlined in detail in our reports and filings with the SEC. Please refer to the information on the disclaimer slide in the presentation. On this call, we will also refer to non-GAAP financial measures as defined by the SEC and Regulation G. You can find a reconciliation table on today's press release, as well as on our website. Before I hand the call over to Bertrand, I'd like to point out a change we've made to our accounting treatment of inter-segment product sales, which started in the first quarter of this year.
Our new practice recognizes the revenue and profit associated with products and components produced in one segment and supplied to another before being sold to the ultimate end customer. Our old practice was to transfer the products and components at cost. This change does not impact our consolidated financials, but it does impact the segment financials. The segment with the most impact is AMH. AMH segment sales are $6.9 million higher, and margins are $2.9 million higher in Q1 with the new practice. Of course, the complementary adjustments were made in the other two segments. You can find restated segment financials for the prior year and sequential quarters in today's earnings release, and we've also provided all of 2018 and 2017 quarterly segment financial restatements in our earnings slide deck. On the call today are Bertrand Loy, our CEO, and Greg Graves, our CFO. I'll hand over to Bertrand.
Thank you, Bill. I will make some comments on our first quarter performance, how we see the industry environment and our expectations for the rest of the year. Greg will follow with more details on our financial results and provide guidance for the second quarter of 2019. We will open the line for questions. Before I get started, I would like to address the termination of the Versum transaction. While we are disappointed that the merger did not happen, nothing changes for Entegris. We feel very confident in our competitive position, world-class technical capabilities, operational excellence, and overall growth prospects. It is also worth repeating that we believe the secular semiconductor demand will continue to be attractive. Enabled by technologies like IoT, 5G, and AI, our society will continue to need more and better chips.
Greater materials intensity and greater materials purity will be the two defining factors of the next generation of semiconductor performance. As you all well know, Entegris operates at the crossroads of materials intensity and materials purity. In other words, our solution set is increasingly critical for our customers to achieve higher yields and targeted levels of chip performance and reliability. In addition to executing on our strategic plan and growing our core business, we continue to focus on a broad array of capital allocation options that will lead to additional long-term value creation for our shareholders. We will provide more details on that shortly. For now, let me cover Q1. During the first quarter, we delivered solid results that were essentially in line with our guidance. I am particularly pleased with this performance in light of the incremental softness that impacted the industry in the quarter.
Our first quarter results demonstrated the strength of our execution as well as the resilience of the Entegris platform. We grew our sales 6% year-over-year in the first quarter, once again outpacing our markets. Sequentially, sales were down modestly, reflecting the impact of the softer industry environment. In spite of this, our operating margins were flat sequentially, and we generated $109 million of EBITDA, demonstrating the organization's strong execution and ongoing focus on cost control and productivity enhancements. In addition, non-GAAP EPS was up 6% both year-over-year and sequentially. Finally, in March, we acquired Digital Specialty Chemicals. I will now provide some color on the market and how it impacted us in the first quarter. As I said, the market was softer than expected in the quarter.
This was particularly true in memory-related wafer production, where customers lowered utilization rates and focused on working down inventory levels. As a result, our sales to memory customers were down significantly in the first quarter. In contrast, in logic and foundry, despite the soft end market, our sales grew both year-over-year and sequentially. As we started to benefit from a number of new node transitions. At wafer growers and chemical customers, Entegris sales were up significantly year-over-year and up modestly sequentially. Finally, as you would expect, our sales to equipment customers, which is more tied to industry CapEx, was down in the quarter both year-over-year and sequentially. In mid-March, we acquired Digital Specialty Chemicals, or DSC, a provider of advanced materials to the semiconductor, specialty chemical, and pharmaceutical industries. In semiconductor manufacturing, increasing complexity of device architectures in leading-edge nodes requires more advanced and highly engineered materials.
DSC is a market leader in designing and synthesizing these new generations of films and deposition materials. DSC chemical synthesis capabilities expands our ability to serve our customers and complements our own existing capabilities. This addition will accelerate our time to market between $15 million and $20 million in sales for the full year of 2019, and be essentially neutral to earnings this year. DSC will be part of our SCEM business. Let me just say that we are very excited to have DSC join the Entegris team. Looking ahead at the rest of 2019, let me first comment on the market. As I just referenced, memory-related wafer starts declined during the first quarter as the memory makers confronted high inventory levels. We expect this softness to extend into the second quarter as customers continue to lower their inventory levels.
However, looking to the second half, there are reasons to be cautiously optimistic as we see some positive indicators for both the broader industry and our business. In particular, we are expecting a recovery in leading-edge logic in the later part of the year. However, I want to be clear that we are not counting on any meaningful recovery in industry CapEx for the balance of the year. As it relates to our own business in 2019, we remain very confident. On a macro level, we expect to benefit from technology node transitions at a number of foundry, logic, and memory customers. Several new products will benefit from these advanced node transitions, including in our Microcontamination division, the Torrento X wet etchant clean filter, and our SAES bulk gas purification systems.
In our AMH division, our EUV reticle pods and high-purity drums, and finally, in SCEM, a number of new deposition materials, advanced coatings, and selective etch chemistries. In addition, we continue to look at ways to use our balance sheet and deploy our capital to create value for shareholders. Historically, M&A has been a very effective way to create shareholder value. As an aside, the acquisitions completed in 2018, namely PSS, Flex Concepts, and SAES, are performing well above our expectation in spite of the soft industry environment. Looking forward, expect us to be focused on additional M&A in the areas of high-performance materials, filtration, and purifications. SAES and DSC are perfect examples of the type of businesses we are targeting. Putting it all together, we expect 2019 to be another record year for Entegris.
We expect our sales in 2019 to be approximately $1.6 billion, and we expect our non-GAAP EPS to exceed $1.90. I will now turn the call to Greg for the financial detail. Greg?
Thank you, Bertrand. As Bertrand said, our first quarter performance and execution was solid, especially in light of the industry environment. Q1 sales of $391 million grew 6% from a year ago. Sales were down 2.6% sequentially, driven primarily by the slower wafer starts that Bertrand referenced. Q1 GAAP diluted earnings per share was $0.24. On a non-GAAP basis, EPS was $0.50, up 6% from Q1 of 2018. Moving on to gross margins. GAAP gross margins of 45.4% included the negative impact of an approximately $2 million inventory write-up associated with the SAES Pure Gas and DSC acquisitions. Our non-GAAP gross margins of 46% were flat sequentially. The year-on-year decline in gross margin was driven primarily, as expected, by the addition of SAES Pure Gas to the portfolio. We expect gross margin to be approximately 46% on a non-GAAP basis in Q2.
GAAP operating expenses of $130 million included approximately $19 million of deal-related costs associated with the Versum transaction, $19 million of amortization of intangible assets, $3 million of integration costs, and $2 million in severance. Non-GAAP operating expenses in Q1 were $88 million, below our guidance, reflecting effective cost control. We expect non-GAAP operating expenses to be $89 million-$91 million in the second quarter. Non-GAAP operating income was $92.2 million or 23.6% of revenue, in line with our target model. Our GAAP tax rate was 14.2% for the quarter and included a 3% discrete benefit related to stock-based compensation. Our non-GAAP tax rate was 18.4% and included the same discrete benefit. For 2019, we continue to expect our full-year non-GAAP tax rate to be approximately 21%. Adjusted EBITDA for the quarter was $109 million or 28% of revenue. Turning to our performance by division.
Q1 sales of $124 million for Specialty Chemicals and Engineered Materials, or SCEM, declined 5% from a year ago. As a reminder, our SCEM business is the most exposed to the memory decline and the decrease in wafer starts. Adjusted operating margin for SCEM was 20.1%, down over 300 basis points from the same period last year. The decline in operating margin was driven primarily by lower sales volume and investments in manufacturing capacity in anticipation of future growth. Q1 sales of $158 million for Microcontamination Control, or MC, were up 33% from last year. The strong growth in the quarter was driven by the addition of SAES Pure Gas and a record quarter in liquid filtration. Adjusted operating margin for MC of 31.8% was down over 200 basis points from last year but was flat sequentially.
The decline from last year was primarily due to the addition of SAES to the portfolio. We expect that MC margins will benefit as SAES synergies are more fully realized in the back half of 2019. Q1 sales for Advanced Materials Handling, or AMH, of $116 million was down 6% from last year. The year-over-year decline in sales was driven by softness in capital-driven businesses and the impact from the Q3 divestiture of a small non-core cleaning services business. Adjusted operating margin for AMH of 19.8% was down year-over-year, but up almost 300 basis points sequentially. AMH margins benefited from cost reductions, favorable product mix, and other margin enhancement programs implemented in Q4 of last year. Cash flow from operations for the first quarter was a negative $3 million, and free cash flow was a negative $37 million.
As a reminder, Q1 typically has the lowest cash flow of the year, primarily due to the variable compensation payment that is made during the first quarter. It is worth noting that shortly after quarter end, we collected the $140 million termination fee from the Versum transaction, and we received a $31 million tax refund. Uses of cash during the quarter included $50 million for the purchase of DSC. CapEx in the first quarter totaled $34 million. We expect to spend approximately $110 million on CapEx in 2019 to support our new product introductions, improve technical capabilities, and growth in filtration and liquid packaging. Consistent with our capital allocation strategy, we used $9.5 million for our quarterly dividend. For share repurchases in the fourth quarter and through the end of January, we repurchased a total of 6.6 million shares for approximately $179 million at an average price of approximately $27.
This includes 1 million shares purchased in January prior to the announcement of the MOE transaction. We expect our share count to be approximately 137 million diluted shares for Q2. Turning to our outlook for Q2, we expect sales to range from $375 million-$390 million, and we expect non-GAAP EPS to be $0.40-$0.55. We expect Q2 to be the trough for the year, with revenue improving in the back half. In summary, we are pleased with our operating and financial performance in the first quarter. We once again demonstrated the resilience of our model, with revenue declining modestly sequentially, despite softness in wafer starts and a weak CapEx environment. Even with the modest decline in revenue, we delivered an operating profit in line with our expectations and the target model. We continue to be active with respect to strategic acquisitions.
Finally, we positioned our company to achieve a higher level of earnings in 2019. Operator, we will now take questions.
Thank you. If you would like to ask a question, please signal by pressing *1 on your telephone keypad. If you are using a speakerphone, please make sure your mute function is turned off to allow your signal to reach our equipment. Again, that is *1 to ask a question. And we will take our first question from Sidney Ho from Deutsche Bank. Please go ahead.
Good morning, and thanks for taking my question. My first question is on Bertrand, you made a comment that you are starting to see some positive indicators. I was just hoping that you can expand that a little bit more. Is that mostly related just to leading-edge logic, or is it some signs on the memory side as well? And in terms of timing, how are those positive indicators going to play out?
Sidney, I think that the second quarter industry environment will remain challenging. We expect to see low level of utilization rates at both our memory and mainstream fab customers. We expect those utilization rates for those customers to improve in the back end of the year. That's really what led us to be more optimistic for the back end of the year. That's on the one hand. The other factor is indeed the number of node transition and the intensity of those node transitions in the back end of the year, both in logic and in memory. As you know, that should benefit both our filtration and our SCEM business in the back end of the year.
Okay, great. Maybe a question on the Versum merger. Clearly, it's a different outcome that you would prefer. Curious on the revenue synergy side that you guys identified during the process. I think you mentioned $50 million of EBITDA, and if you assume EBITDA margin is 30%, it implies revenue somewhere in a $200 million range. How much of that do you think you can actually recognize in the future, something you can achieve by going alone? Or is it just a matter of time, how long it takes to get those kind of revenue for yourself?
Look, I think that the Versum merger is now old history for us. I don't want to spend too much time talking about that. Instead, what I would say is that we have the opportunity to selectively grab technologies that could be enhancing our portfolio in such a way that we could be in a position to unlock some of those positive revenue synergies. DSC is a good example of that. DSC gives us access to new synthesis capabilities that we did not have at Entegris, something that we were hoping to get as part of a combination with Versum. Ultimately, we didn't get it, but I'm glad that we found it through the acquisition of DSC. DSC gives us access to a number of new materials like cobalt precursor, high-K dielectric materials, hard mask materials.
Also allows us to expand our serve market into pharmaceutical applications and other industrial applications. Again, we will find other ways to create positive revenue synergies as we continue to be active on our acquisition strategies.
Maybe one last one for me. I'll hop back in the queue. I know the management team has been very focused on getting to this $3 EPS target for Or it could be just a run rate basis exiting next year. Given the current market conditions, is that still a target we should think about, and how much are we relying on M&A versus share repurchases there? Thanks.
Sidney, it's fair to say that the current industry environment is a bit of a setback for us. There were a number of industry growth assumptions, obviously, built into that model. Having said that, given where we stand today and with the acquisition of DSC, we believe that we should be able to reach close to $2.50 on an organic basis. That's a number that, again, remember that the $3 number was a run rate number as we exit 2020. We expect that we would be in a position to improve that number further as we continue to be active on the acquisition front and depending on a number of capital allocation decisions that we may make over the next 18 months.
Great. Thank you very much.
Thank you.
We'll take our next question from Patrick Ho from Stifel. Please go ahead.
Thank you very much. Maybe Bertrand first, in terms of the market environment, can you give us your updated view of the MSI or the industry wafer starts data and where you think that's tracking to for 2019? Maybe as a follow-up to that, obviously you're getting feedback from your memory customers regarding a potential second half recovery. We've heard comments from Hynix and Micron about that recovery. What gives you confidence that, I guess, that recovery will ensue given a lot of the mixed data points that are out there?
Patrick, for MSI, we expect MSI to be flat year-on-year. I think MSI is a misleading indicator in 2019, simply because, as you know, a lot of the wafer growers instituted take-or-pay contracts in the past few years. Instead, what we've been trying to do is to really assess what wafer starts truly was, which is really the primary driver for our business. Wafer starts, you can infer wafer starts based on utilization rates and levels of inventory. As we know, our customers have been working their inventory levels down in Q1. We expect that to continue to be the case in the second quarter as well. We expect inventory levels to be at sound levels as we exit Q2, that's really the reason why we believe utilization rate would start increasing after that at most of our customers.
Great. Maybe as a follow-up question for Greg, in terms of the execution, you did execute quite well, despite the soft industry environment and the lower revenues. Can you just give us a little bit of color in terms of where the key levers are? I mean, gross margins came in at 46% despite the lower revenue. Are you getting more leverage and I guess, more ability to make, I guess, flexible moves on the gross margin line? Or are additional moves necessary on the OpEx line to keep the operating margins at these relatively elevated levels?
Hi, Patrick. I would say two things. One is on the gross margin line, I would just say we continue to execute quite well on the operation/manufacturing side, and I've said it before, we continue to mature as an organization and get better there. As things slow down, that team is managing their variable costs very well. It used to be from time to time, we'd see surprises on the op side. We see a lot less of that today. I would just say a lot more consistency and a lot more discipline on the gross margin side of the house, and specifically the manufacturing and supply chain organizations. With regard to OpEx, I mean, as we came into the quarter, we saw the softness coming. We're committed to making our target model.
We really just asked people to sort of tighten their belts, and we trimmed where we could. We did. I noted that we had a couple million dollars of severance in the quarter, we did make some headcount reductions in the quarter that'll result in annualized savings of approximately $5 million. You saw part of that in Q1. You see part of that with the good expense control we talked about for Q2.
Great. Thank you very much.
We'll take our next question from Toshiya Hari from Goldman Sachs. Please go ahead.
Hey, guys. Good morning. I had a couple of questions. Bertrand, I was hoping you could provide a little bit more color on your CapEx business. We know AMH, there's a significant CapEx component, and I think within MC as well, especially post the SAES acquisition, a meaningful part of your business is tied to CapEx. How meaningful was the decline in your overall CapEx business in Q1 on a sequential or year-over-year basis? Is it fair to say that business has troughed, or is there further downside into Q2 in the second half, in your view?
The unit CapEx ratio was 70/30 in Q1. That was essentially the same ratio as last quarter. In other words, the decline in unit or CapEx was about the same in that 2%-3% range for us. The way to think about it is that, overall, we're very pleased obviously with the performance of our CapEx business, especially in the context of a declining industry CapEx. The way to think about it is we have been taking share on a number of new fab projects in advanced logic and advanced memory, and that was really a nice offset to the otherwise industry-wide decline in new investment. Two examples of that would be the steadiness of our gas purification business, which continues to grow, and we expect that business to actually grow year-on-year this year.
Another example of that would be the continued success of our fluid handling business, which is a business unit residing in our AMH platform. That business actually grew sequentially. Those products are increasingly becoming the industry standards for advanced memory and advanced logic fabs. Those fabs require very pure valves and tubes and sub fabs that can withstand higher temperatures and very harsh chemistries. We've been actually picking up share for those new fabs and those applications. That part of the business actually behaved well. As you would expect, the sales of our on-tool solutions, so products like gas filters, dispense pumps, liquid flow controllers, so the products that we sell to the equipment makers, those product lines were down sequentially, in line with the decline that we experienced as an industry in wafer fab equipment.
Great. Thanks so much for the color. Greg, on operating margins for the individual segments, I apologize if I missed some of your prepared remarks, but for SCEM, I think this was the third consecutive quarter of margin declines. Can you talk about that? What's driven that, what's the go forward within SCEM? MC, you talked about some of the synergies with SAES materializing in the back half. Are the synergies on track, or are you tracking ahead of plan? Finally, AMH. You had a nice sequential uptick in margins. Is there more on the come in terms of some of the benefits, post your restructuring there?
Yeah. Let's start with SCEM, as you point out, down pretty significantly year-over-year, then sequentially down again. A couple of things. One is, in the quarter, you really had three things going on. One, you had a relatively weak product mix. We had higher, or abnormally high logistics costs. Then the thing that is impacting that business from a trend perspective is we've invested very heavily in deposition materials as well as engineered materials, i.e., graphite. The capacity in those two areas, and we're starting to depreciate that capacity and pay for it, but the volumes have not increased to the level to absorb that. That business is a little bit capacity-laden at this point.
We do expect, I mean, in both cases, we expect improvement in essentially the absorption and the volumes in deposition materials and engineered materials, which should help the overall margins in SCEM as we move through the year. AMH is, as you pointed out, relatively. Excuse me. Up sequentially, pretty good performance. That business is a business where we've made lots of change from a cost structure perspective. We've done a number of things to improve the margin around, I'll call it product mix/pricing, which have had a favorable impact. That business, it continues to be our lumpiest business because of the capital nature of it.
If I said, "Overall, how do I feel about the margin trends?" I feel we should have an upward bias, but I would say I expect there to be some lumpiness as we go forward until we see improvement in the capital cycle. Then MC, we expect the margins to improve as we move through the year, primarily driven by improvements in [business mix space] .
Okay. Got it.
As we start to realize more of the synergies, and frankly, we have a better backlog today than we had a year ago in terms of the quality of the backlog from a margin perspective.
Okay, got it. Then one housekeeping question, if I could. For DSC, what sort of revenue and potentially EBITDA contribution are you assuming for Q2 and the full year? Thank you.
That business is order of magnitude $15 million-$20 million. The EBITDA contribution this year is, I'll just say low single digits. We said it's essentially earnings neutral this year. As we move out, it'll be accretive next year, and as we get into 2020 and 2021, it'll start to see accretion levels in kind of the $0.04 range.
Yeah, if I could add to that, I would say, this is a business that we expect to grow at 10%-15% CAGR for the next five years. As Greg mentioned, we expect EBITDA margins to become pretty much in line with the SCEM margins over time. Not a meaningful contributor this year by any stretch. As we get into late 2020, 2021, the contribution of that business will start actually to show very nicely to the P&L.
Great. Thanks so much.
We'll take our next question from Paretosh Misra from Berenberg Bank. Please go ahead.
Great. Thank you. My first question is on your mix, the units-driven versus CapEx-driven. When it comes to M&A, are you pleased with where your mix is currently, or maybe you could use the M&A to move it a bit more towards units-driven business?
Yeah, I mean, that's not necessarily a major criteria for selection. I mean, recall, for instance, that we acquired a pure equipment business when we acquired SAES Pure Gas last year. This was a very high-quality business, a CapEx business that is really not behaving the way your usual CapEx business would. Again, it's not necessarily a criteria for selection. Having said all of that, if I look forward, and if I look at our M&A pipeline, I indeed see mostly unit-driven businesses in the pipeline. Assuming success on the M&A front, you should expect that ratio to trend more towards units going forward.
Got it. Very clear. Then second one, just if you could please remind me, how are you impacted by the US-China trade issues? In other words, if you have given any dollar impact for 2019 due to tariffs.
Right. We have always cited the US-China tariff tensions as relatively immaterial to our business. Now that we have actually a few quarters of actual experience behind us, the numbers are confirming the range that we gave externally, which is an impact of less than $1 million annually. Actually, the actual impact is significantly below that.
Got it. Thanks, guys.
We'll take our next question from Christian Schwab from Craig-Hallum Capital Group. Please go ahead.
Hey, good morning, guys. I understand the memory weakness that you're seeing today. I just want an update from when you guys reported the last quarter. We've taken MSI from being up modestly to flat now. When you guys talked about the second half being greater than the first half last quarter, you said it would be driven by CapEx improvement and memory, as well as foundry and logic, only due to node transitions at the NAND level at 64 and 96, and then the 10/7nm node transitions. You thought that the company was in position to outgrow the wafer front-end market in 2019, which it seems you still believe will be down mid to high teens. Is that still accurate as we look to the second half, or has anything changed regarding that as well?
Yeah. Christian, this is a very difficult environment to predict, indeed, and I think that that's what you're saying in your long question. Having said that, we believe that 2019 will be a great opportunity for us to demonstrate the resilience of our model. That's what we're suggesting in our annual guidance of $1.6 billion. If I want to deconstruct that guidance for you, I would say that we expect the industry to be down 5%-6%. How do we get to that number? That's CapEx down in the mid-teens. Wafer starts, not MSI, wafer starts down in the low single digits. We expect our organic revenue to be flat in 2019.
How do we get there, where we capitalize on improving utilization rates, we capitalized on new node transitions, both in logic and memory in the back end of the year. We capitalize on access to new graphite capacity. As Greg was mentioning, we have invested a lot in new capacity. That capacity is going to come online at the end of Q2, so no impact to Q2, but we expect a $4 million-$5 million positive impact quarterly in the back end of the year. That capacity is already totally committed, we should see a nice pickup from there. The additional revenue on top of that organic performance is really the net effect of the recent acquisition, minus the divestiture of the cleaning business that we had in France last year. Does that help you?
That's extremely helpful. Thank you. I don't have any other questions. Thank you.
Sure.
We'll take our last question from Chris Kapsch from Loop Capital Markets. Please go ahead.
Good morning. I just had a question about your geographic mix as depicted on, I guess, slide seven. Clearly, the strength in Taiwan and softness in Korea is consistent with your narrative around foundry logic and memory, and markets specifically. Could you just elaborate on the trends in Japan, what's driving that, and how you see that playing out over, I guess, the balance of 2019 to the extent you have visibility? Thanks.
Japan, we suffered from continuous decline in our OEM business. Sales to the equipment makers in Japan was down significantly, sequentially. Then we also saw some negative impact from the soft economic environment in Japan that led most of our fab customers to operate at fairly low levels of utilization in Japan. That's why we saw a sequential decline of about 9% in Japan.
We have no further questions.
Do you have a follow-up? I think that's all for the call, operator. Thank you again for joining the call, have a great day.
That concludes today's presentation. Thank you for your participation. You may now disconnect.