Good day, everyone, and welcome to the Entegris Third Quarter 20 16 Earnings Call. Today's call is being recorded. At this time, for opening remarks and introductions, I would like to turn the call over to Steve Kanter, Vice President of Corporate Relations. Please go ahead, sir.
Great. Thank you, and thank you all for joining our call this morning. Earlier, we announced the financial results for our third quarter ended October 1 2016. You can access a copy of our press release on our website, integrys.com. Before we begin, I'd 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.
On this call, we will also refer to non GAAP financial measures as defined by the SEC and Regulation G and you can find a reconciliation table on our website. On the call today are Bertrand Law, President and CEO and Greg Graves, CFO. Bertrand will now begin the call. Bertrand? Thank you, Steve.
I will make some general comments Greg will then provide more details on our financial results and our Q4 guidance. We'll then open the line for questions. I am pleased with the 3rd quarter results, which put us squarely on track to achieve our record year for Entegris in both sales and profit. Year to date, we have grown 6 percent organically. The performance that we believe exceeds our markets and the growth rates of most other electronic materials companies.
Our ability to outpace our markets provides evidence of the soundness of our strategies the success of our customer engagement model and the quality of our execution. For the third quarter, I want to specifically highlight a number of accomplishments. We delivered solid top and bottom line results. We generated record free cash flow We continue to pay down our debt. And finally, I want to recognize our global manufacturing teams for achieving best in class levels of quality.
Our 3rd quarter results benefited from relatively favorable trends in our markets. Wafer fab activity was better than expected relative to the seasonal softening we had anticipated. End market demand for smartphones and 3 d NAND devices remain strong. We also capitalized on the initial efforts by some of our customers to ramp their 10 nanometer nodes. Our liquid filtration business once again performed at record levels.
As we continue to capture new filtration opportunities and grow our share. The I2M facility is now fully commissioned and we are ideally positioned to address the increased cleanliness requirements for bulk photoresist manufacturing. A number of our other product platforms reported strong performance in Q3. Continued high levels of new fab construction and retrofit activity as well as new investments in 10 nanometer technology helps drive continued strength in our fluid handling and microenvironment businesses. Sales of our formulated claims in Q3 reflected the high level of fab activity and were in line with our expectations with good demand for our post CMP cleaning chemistries.
In addition, our advanced deposition business performed at near record levels driven by adoption of new materials used in advanced Cbd processes. Turning to our specialty gas product lines, strong sales of gas filters and diffusers were offset by weaker sales of some of our specialty gas solutions which were impacted by the timing of fab customer demand. 1 of the outcomes of our customer engagement model and our many customer collaborations is the clear indication of the criticality of our solutions in addressing the industries emerging process challenges across the electronics ecosystem. Our ability to leverage materials knowledge, combined with our clean and safe materials handling solutions and our contamination control expertise is resulting in unique yield enabling solutions, not only for logic, but increasingly for advanced memory devices. During our Analyst Day in July, we spoke about 5 of our top growth initiatives that demonstrate the breadth of our capabilities across all major fab processes.
Including lithography, in plant, etch, the position and CMP. These projects expand our SAM and address new applications that we have not previously served. I mentioned the bulk photoresist filtration opportunity earlier, but all five of these initiatives are progressing well. And are on track to generate I am also pleased with our operational execution, which is another very important component of our value proposition Over the past several years, through continuous investments and relentless focus, we have improved our quality from about 3.5 Sigma to levels exceeding 5 Sigma. Given that we manufactured 15,000 SKUs, across a number of manufacturing sites in the world.
This is no small feat. As pleased that I am about how far we've come, we are continuing to drive to even higher levels of excellence, excellence in our quality systems, in our technology and in everything we do. 2016 is the 50th anniversary of Entegris. We expect it to be a year of many records for us and to be the precursor of many more successful years, That optimism is based on our unique position in what is a growing and dynamic market. It is also based on our demonstrated ability by virtue of the quality of our execution, our unique value proposition and the role we play across the entire semiconductor and microelectronics ecosystem.
I will now turn the call to Greg for the financial detail.
Thank you, Bertrand. I am pleased with the results of the quarter. Our sales were at the high end of our guidance and we delivered solid net income and EPS and record cash flow. Non GAAP EPS was up currency gain we highlighted in Q3 of last year 3rd quarter sales of $297,000,000 declined modestly from Q2 reflecting normal seasonality, but were up 10% from a year ago. Foreign exchange was a 1% sequential tailwind The operating results included an impairment charge of $5,800,000 related primarily to certain 450 millimeter production sets and severance charges of $2,400,000 related to a realignment of our organization to drive greater customer focus and internal function alignment.
By segment, sales for Critical Material Handling or CMH declined 1% to $193,000,000 from Q2 and the non GAAP operating margin for CMH of 27.4% in Q3 was essentially flat with 27% in Q2. Sales for Electronic Materials or EM of $104,000,000 was 4% lower than $108,000,000 in Q2, as EM's non GAAP operating margin of 20.4% declined from 25.4% in Q2. For both CMH and EM, the non GAAP results exclude the impairment and severance charges previously mentioned. 3rd quarter non GAAP gross margin was 43.6 percent, which was below normalized levels. The lower margin was the result of lower factory utilization in one of our high margin products, which coincided with a modestly unfavorable product mix higher scrap rates and greater than expected spending on a number of one time procurement and quality initiatives We expect gross margin to be flat to up modestly in Q4 in spite of expected seasonally lower revenue levels We controlled our expenses well in the quarter, excluding amortization of $11,000,000 and the previously mentioned severance charges, Non GAAP operating expenses to be $74,000,000 to $76,000,000 in the 4th quarter.
Net interest expense was $9,300,000 in Our GAAP tax rate for The tax rate reflected a favorable geographic income mix. In line with our expectations. Adjusted EBITDA for giving us an EBITDA margin of almost and free cash flow was spending. Accounts receivable declined by $13,000,000 as DSOs improved to 52 days in Q3, compared to 54 days in Q2. Inventories increased by Inventory turns of 3.6% were consistent with Q2.
3rd quarter CapEx was 13.1 60,000,000 to 65,000,000. We grew our cash balance to 412,000,000 of which $172,000,000 was in the U. S. Total long term debt including current maturities was $608,000,000 as we continue to delever the balance sheet. We repaid $25,000,000 in Q3 and expect to repay an additional $100,000,000 over the next 12 months.
Our net leverage ratio which is consistent with what which balances debt repayment, building liquidity for potential M and Turning to our outlook for reflecting current demand trends. The 4th quarter is typically seasonally At these revenue levels, we expect non In summary, we performed well in the quarter and are on pace to achieve a record year and to outpace the industry We generated record cash strategic initiatives that position us to outperform our Operator,
you.
We will take our first question from Weston Twigg of Pacific Crest Securities. Please go ahead.
Pretty substantial drop in Q3. Mentioned some wafer scrap or not wafer, sorry, not wafer scrap. You mentioned some material scrap and mix. And I'm wondering, can you give us a little bit more color what the scrap was related to? Is that part of the driver quality?
And should we expect more moving forward? And with respect to the mix, just wondering if kind of worked throughout the startup issues in the I2M facility and if that had any relation to the lower GM?
Okay. So really 2 parts to your question, Wes. 1st of all, with regard to the gross margin in Q3, Overall, I mean, by business unit, our margins were excellent. We had 1 area where we had weakness in our gross margin due to lower volumes and lower manufacturing volumes. And that was really in our scene and phosphine product lines.
We don't expect that same thing. It was just a number of products that just did not meet our quality standards. And so we ultimately scrap them out. So as we move into Q4, we'd expect those issues to be behind us. We expect higher volumes in those gas related businesses and would expect our margins to be flat to up modestly in spite of the fact that our volumes will be down a little bit.
So the second part of the question related to the I2M center, I'm happy to say that that transition is completely behind us. I will say we spent a little bit more money in Q3 than we anticipated. But overall, our liquid filtration margins, which that business is part of, we're very strong. We're completely out of the Millipore facility. We'll have and so those recurring costs will be gone in Q4.
So overall, when I think about the margins, moving into Q4, I feel pretty good. When I think just to put it a little bit in context, I mean, if you would look at our margins over the last eight quarters, We've got a quarter where they were 41 and a quarter where they were 46, but mostly they run-in that 44, 45 range. And so while this margin was a little bit weaker than we would have liked, it certainly wasn't, it wasn't alarming to us or sort of out of the range of reason.
Okay. That's helpful. And then just as a follow-up, I think last quarter you mentioned that some of your trailing edge customers have started buying some of your leading edge products, particularly the filtration. And I was just wondering if that trend is still accelerating or is that more of a one time increase related to new product availability?
So, Wes, I think this is a trend that I hope will be continuing in the future, we have, as I mentioned before, invested a lot in increasing the level of coverage and the level of support the trading edge babs and they are constantly evaluating a number of new solutions, titration solutions but also other products and materials. And we hope that we're going to continue to capitalize on those new engagement levels. So this is a part of our business that has done well year to date. And I would expect that to continue to be a source of strength in our top line going forward.
We will take our next question from Patrick Ho of Stifel. Please go ahead.
Thank you very much. Bertrand, first in terms of some of the growth initiatives you've talked about, in terms of the different markets. What's been, I guess, the biggest surprise on the upside surprise for you has 3 d NAND helped on the deposition side of things? Where have you seen probably the fastest growth among those five market opportunities you highlighted at your Analyst Day?
So Patrick, if you recall during the Analyst Day, we We classify those 5 opportunities in, in, I would say, 3 buckets. The first two the bulk photoresist filtration solutions and the new families of boron mixtures are products that are launched, and we'll have an immediate impact to the top line. And that was the expectation. This is, in fact, what we have been experiencing since the beginning of the year. So those two products have been meaningfully contributing to our growth trajectory since the beginning of the year.
The other products are still in the early stages of development and evaluation by our customers. The progress for our new family of coatings the new deposition materials continue to be very exciting. So a lot of really good positive feedback, but still a very early stage and fairly limited impact on our top line so far this year. And then the last, is really something of a slightly different nature and that's really putting together the knowledge that we have of the CMP process, combine that with the silicon carbide and, coding technology knowledge that we have in developing a pad conditioner So this is a fairly small team, but the results are very promising. We've been primarily engaging with Logic customers so far this year, a lot of success there.
And, I think the team will start engaging with memory makers in the very near future. And next on the horizon will be the trailing edge fabs. As you know, the value proposition for that product is around increasing the life of the pad conditioners and the life of the pad themselves by a factor of 2x. And in doing so, we significantly contribute to improving the cost of ownership of our customers. So we would expect that those products would be very relevant not just for leading edge, but also for treading air.
Great. That's helpful. And maybe as a follow-up to the details you just provided there, it fair to assume that some of these new opportunities, like you mentioned, on the deposition side, the deposition materials that you mentioned, they'll start contributing to revenues in 2017?
That would be my the development of those new class of precursors really ties to the new complexity of the device architecture as the industry continues their efforts to scale up vertically. And what we're trying to do here is not only to develop the material itself, but really, to come up with the material that is pure than anything that exists in the market today. And to developed an integrated solution, including a delivery system that leverages our fluid handling knowledge, our coding capabilities, our in line monitoring technology, as well as our knowledge of gas contamination control. So this is really what we're after is really this system solution for our OEM and fab customers. And again, feedback from the market has been extremely promising But to your point, I don't expect this particular, technology in this particular platform to have any meaningful impact on our top line until later in 2017 early 2018.
Great. And final question for me, maybe for Greg in terms of the financials. As well as the way you've been able to generate cash and your balance sheet management as you get some of these new products to the marketplace, how are you managing, I guess, the supply chain to, I guess, maintain the high turns you've been able to deliver as well as this cash flow generation?
I mean, the inventory, I mean, I think you're talking specifically about inventory. I mean, inventory maintaining inventory at current levels and current turns and even looking for some modest improvement over time. Is one of our core corporate objectives. I think it's front and center with everyone in the supply chain. So I would expect you'll see continue to see inventory turns in the ranges we're at now or like I said, slightly better.
Overall, though, I would say I'm very pleased with our cash generation, I'm really pleased with the amount of cash we've been able to drive back to the United States, I think we'll continue to repatriate cash over the next year. So we've got excellent liquidity in the U. S. To reduce the debt and still have firepower for M And A.
Great. Thank you.
We will take our next question from Dick Ryan of Dougherty. Please go ahead.
Thank you. So, Greg, in your 4th quarter guidance, can you give us a sense of what you're thinking about for both the unit and the CapEx side of the businesses?
I think the downside that we're guiding down slightly and that guidance, I mean, I think that would be equal on both sides of the business.
Yes. I mean, I can help with that question. And just say that Again, right now, we are still experiencing a very healthy levels of bookings in our business, entering the quarter. But we expect the normal seasonality to set in, and the fab activity to slow down in the back end of the fourth quarter. So, as Greg mentioned, we continue to expect some very healthy industry conditions in line with a seasonal pattern.
To put that in perspective, the midpoint of our Q4 guidance represents an increase of 6% versus the same quarter last year. So I think that we're going to finish the year on a very strong note.
Okay, great. Could you give us a sense of what CapEx might look at look like for 2017 versus 2016?
No, very preliminarily, I would expect it to be in the $80,000,000 to $90,000,000 range, year. A number we came into this year talking about an $80,000,000 number. We had a number of projects because of customer ramps, a number of projects where we delayed putting capacity into place. And so those will end up happening next year.
Okay. And I think you're reviewing your
I was just going to say we'll put a finer point on that. Coming out of Q4. Sure.
I think you'll review your capital allocation strategies in the fall and I mean, great success to date and another $100,000,000 over the next year in debt paydown expectations. How do you handicap that? I mean, does debt pay down was or it seemed to be the top priority? How do you handicap that with M and A opportunities or stock buyback now?
So, Dick, you're correct. I think short term, our preference will be to pay down the debt, but, we continue to believe that M and As, our preferred capital allocation option, as we reviewed with you, we believe that the ATMI acquisition was a great success that, stayed the lowest to create significant value for all stakeholders. And frankly, that has given us confidence and hopefully credibility among the investment community that we can be an effective consolidator in our space. But the other thing that we learned with the ATMI acquisition is that we need to be disciplined. And what it means for us is that we're going to be thoughtful and potentially patient before we act.
So I would argue that right now, Again, the focus and the priority remains organic growth. We have many very exciting opportunities right in front of us And we need to execute flawlessly. And in that context, as Greg mentioned, our preference will be to pay down the debt, deliver the balance sheet, regain flexibility without compromising our dry powder. And when the time is right, you should expect us to acquire some high quality businesses at the right price.
Great. Thank you.
We will take our next question from Amanda Skarnetti of Citi. Please go ahead. Thanks for taking the question. Just kind of continuing on that
M and A question. What is the size of the acquisition that you would be considering down the road? Would it be another transformative acquisition, the size of relative size of ATMI or would it be something smaller like a $50,000,000 specialty chemical company?
Amanda, again, as you would expect, we are working on like any other company that wants to be an effective play M and A player, we are building up the pipeline of potential M and A targets. And in that pipeline, as you would expect, you would see companies of many different sizes. The question will be one of actionability and affordability. So we will continue to test all of that. And when the time is right, we will share more with you.
And Greg, what
is the percentage of cash that's currently onshore versus offshore?
There's $172,000,000 onshore out of the $412,000,000. So a little bit less than half.
And then the last question I have is just with operating margins. Are there any levers that could be used to improve operating margins into the 20% range, or is this kind of mid teen range the more appropriate range to run rate to be in for operating margin?
No, I think, I mean, our target model at 300 $1,000,000 plus is to have operating margins of 20%. And I think we're well position to deliver on that. Right at 20%, excluding some of the one time items.
We will take our next question from Tom Diffely of D. A. Davidson. Please go ahead.
Yes, good morning. So I guess I had a longer term question here on the margin front. So if you if you do get the $70 plus 1,000,000 of incremental revenue from these 5 new product lines, what is the impact to margins on a go forward basis And then similarly, what would the impact be if you got a substantial amount of growth from IoT at the trailing edge?
So from a, gross margin perspective, our new products do have higher margins. When you think about the IoT, the gross margins on those businesses would be lower, but I always the operating margin would be in line with corporate operating margin because we're while some of those products over time, we've experienced modest ASP erosion, but we're not spending much in terms of the way of ER and D because it's primarily like IoT is primarily legacy products. So lower gross, the consistent operating margins When you think about the margin long term, I mean, I've consistently said, think about this business as kind of mid-40s operating margin. And I'd like it'd be great to say that I think we'll get 47 or 48, but I don't really see that. I mean, I think at the end of the day, the customers are going to allow us to have something in the mid-40s.
Okay. And then you mentioned that the newer products or higher gross margin, are they also higher operating margin, or is there a level of R and D in there that keeps them in check?
I would say across the portfolio, the operating margins are well. I mean, if you legacy versus new, I'd say relatively consistent on an operating margin perspective.
Okay. That's helpful. And then when you look at some of the write offs, do you have any active 450 millimeter programs left? Are they at this point all shut down?
No, I mean, right now, this entire initiative is really, on ice. I mean, it's pretty clear that the industry will not be transitioning to 450,000,000 meter away for any time soon. So as a result, that's what really led us to decide to record this impairment charge in Q3. Having said that, we continue to view the transition to larger wafer as a potential growth opportunity for Entegris if and when the industry decides to migrate to 450. So again, if if and when that happens, we'll be ready to reengage.
But at this point in time, there is really no development effort within the company.
Okay. Good to know. And then finally, you talked a lot about the cash. What is the cost of repatriating your cash at this point?
We've probably got another $100,000,000 or so that we can repatriate on a highly efficient basis. We'll bring back about half of that $100,000,000 in the next 6 months and the remainder over the next 6 to 12 or I'd say 6 to 18 months. But
And that, like
I said, that'll be it won't be 0, but it'll be very close to 0. And then beyond that, it would be the delta between the rate where the cash was earned and the U. S. Rate.
Okay. And when you look at the generation of cash going forward, what percent do you think will be generated onshore versus offshore?
We're generating approximately 40% of our free cash flow in the U. S.
There are no further questions
at this time. I will now turn the call over to Steven Kanter for additional comments and closing remarks.
Before closing, I do want to note that we will be in New York for investor meetings tomorrow, and we will be participating in the Morgan Stanley Global Chemicals cup conference in November. If you want more information about those activities, you can contact me. And we look forward to updating you on our next quarterly call. Thank you and have a great day.
That concludes today's conference. Thank you for your participation. You may now disconnect.