Good afternoon, everyone. Welcome to day one of Citi Global Technology Conference. My name is Atif Malik. I cover U.S. semiconductors, semiconductor equipment, as well as communication equipment stocks here at Citi. It's my pleasure to welcome Neil Dougherty, CFO, Keysight Technologies. Also, we have Jason Kary, a VP at Treasury and IR in the audience. I'm going to kick it off with my questions first, and then we'll open up to your questions in the middle. If you have a question, please raise your hand, and the mic will come to you, and you can ask your question. Welcome, Neil.
Thank you.
Neil, I'm going to start with your commercial communication business-
Yeah
That seems to get a lot more attention from investors, primarily, you know, based on the success that you've had in terms of the 5G rollout, historically. So if you can talk about how do you see the demand profile and the recovery of your commercial communication business playing out over the near term and into next year?
Yeah. So obviously, we've seen a little bit of a disruption in demand within commercial comms brought about by the end of the supply chain disruptions of last year. A little bit of an inventory glut within the industry, which has caused, you know, some pause in investment over the first three quarters of this fiscal year. I think as the industry works through those inventory dynamics and, you know, there's investment is going to return. There's multiple Revs of the 5G standard that are still to come. Most of the deployments that are, you know, that we're all operating on today are based on Rel 15 of the standard.
But, from an R&D perspective, we're currently working on Rel 17 of the standard, things like non-terrestrial networks, Open RAN, private networks, you know, are the things that are driving investment today. And then, as we look forward to future revs of the standard, Rel 18, for example, it's gonna be, you know, how do you improve the power usage of the standard, and other things are gonna be included in that next rev. And so, you know, there's some short-term industry dynamics that are at play at the moment, but I think the long-term roadmap and the long-term need to continue to invest in R&D in 5G is there, and will return the industry back to growth.
Great. Could you delineate between wired versus wireless business, and where are you seeing investment today and going forward?
Yeah. So, I mean, I think at the margin today, the wireline side of the business is incrementally stronger than wireless. I think AI, ML, obviously, being a key driver of demand right now within the network. And so, as you think about that, you know, we are seeing the deployment of 800 gigabit, the R&D work on 1.6 terabit, and Keysight is working to enable both of those transitions. We're working with hyperscalers and those that are working on AI, ML learning models to help them optimize their network architectures so that they run more efficiently, ultimately reducing the amount of capital that needs to be invested in these networks.
And so there are a number of different plays within our network test business that are driving, you know, relatively, you know, incrementally, a strength on the wireline side. On the wireless side, we've talked about, you know, some of the dynamics there already, but again, the business predominantly focused on R&D. We're looking to those future revs of the standard, and the incremental work that is happening in standalone 5G, millimeter wave, Open RAN, to drive waves of investment moving forward. And then, of course, early 6G research has already begun, predominantly right now focused in university research labs, governments. A few leading market-leading customers have early 6G research programs underway as well.
Great. One of the reasons we like your stock is because, you know, you have a lot of stickiness in helping your customers, you know, do their R&D.
Yeah.
I think that came out in the earnings as well, that you strengthened the R&D business, held up better than manufacturing. What are some of the other areas or end markets where you're seeing you know some pull relative to other end markets in terms of helping them out on the R&D side? You mentioned 6G you know being one of them.
Yeah, we've just talked about wireless and wireline markets, and in both of those cases, obviously, we have a strong R&D bias. Moving out of the comms space, you know, the next area that comes to mind is in the auto space, where we're helping auto OEMs, Tier one suppliers to the auto industry, with both AV and EV applications. The bigger market driver today is currently EV. We're helping, essentially helping, customers build better batteries, right? How do they extend the range of an individual battery? How do they extend the life of the battery through more charge dissipation cycles? How do they improve the performance of the battery in different environmental cycles, circumstances, extreme cold, extreme heat, extreme humidity?
Those types of situations are all being worked in the industry, you know, focused on, you know, again, building better batteries. As we look forward, it's really the AV side of things, autonomous driving, that we expect to become a bigger driver of our business. How is autonomous driving gonna be achieved? It's really gonna be achieved through a convergence of multiple communications technologies, wireless standards like 4G and 5G, Wi-Fi, Bluetooth. There'll be a LAN network in the vehicle, which brings security implications into play, and then, you know, a complex network of radar and Lidar sensors, right?
These are all areas where Keysight has expertise, and so we'll be in a unique position to help that industry as they work to move towards higher levels of autonomous driving because of the breadth of our portfolio and our ability to bring multiple technologies to play.
... Great. And then, just, going back to the 6G, there's a perception among investors that, you know, 5G, you know, investment cycle has peaked, and we're coming down. But when we look at, you know, what you guys do, you guys are still quite involved in the 5G rollout. If you can help us understand which innings are we in terms of the 5G rollout, and what should investors be looking at for early signs of kind of 6G adoption? Should we be looking at white papers from Qualcomm or what should the kind of milestones we should be looking at?
Yeah, I mean, I think it's a really interesting question, and I think the important point is that these are very long cycles, right? We still have a 4G business that's measured in the $hundreds of millions, predominantly in R&D, right? And so, you know, if I was gonna put innings, I'd say we're, you're, you know, you know, mid innings, I guess I'd say in terms of of the 5G rollout. I've talked about some of the things that are currently driving R&D investments: standalone 5G, millimeter wave, private networks, non-terrestrial networks, 5G.MIL, O-RAN. There's a lot of development that still has to happen, and we're just talking about Rev 17 of the standard. You don't get to 6G, at least as currently envisioned, till Rel 21 of the standard.
There's multiple additional ways, you know, you're gonna putting it into the, into the lingo of prior, prior generations, you know, of, of, advanced 5G or, or 3.9 G, right? These, these versions of, of 5G development are still ahead of us.
Okay. Can you comment on your market share in 5G? I know, it's, you know, the market is fragmented. It's difficult to gather this data, third-party, but if you can comment on what is your share for, you know, testing of, on 5G standards, and if you're seeing any opportunities to grow that share into 6G.
Yeah, I mean, I think, you know, we've clearly have taken share, you know, during the 5G cycle relative to Keysight's performance in prior cycles. But at the same time, you know, via M&A and organic investment, we've also expanded the SAM and the portion of the market that we're going after. So while our share on one hand has increased incrementally, I think it probably undervalues our success in the marketplace because we have redefined the market that we're going after, right?
So, again, I think, we've been very successful in winning the market makers of 5G, providing that complete solution, both in the physical layer, where Keysight's historically been strong, all the way up to the protocol layers, which we accessed via our acquisition of Anite, which took place back in 2015 or 2016. That allowed us to access that portion of the market.
Okay. Neil, on your last earnings call, management commented on increasing demand for longer-term strategic customer projects. How do these commitments differ from Keysight's typical projects, and what is the advantage to the customer with these longer-term agreements?
Yeah, so I do think this is one of the things that was maybe misunderstood on the call, right? So people seem to think take away from the call that we actually had short-dated projects that were being pushed out, and that's not what we were talking about at all. We were actually taking these more complex, longer-term projects on behalf of our customers. And I think the best example would be the one that Mark Wallace tried to explain on the call itself, is in the auto space, where, in many cases, auto OEMs are actually looking to Keysight to essentially build them battery test labs, if you will.
So they would hand us an empty facility and look to Keysight to, at the end of a project, essentially hand them a lab that has been completed. A lot of that content is Keysight's, but some of it is not. But we'd come in, and we'd do all the electrical, all of the cooling that's required, put in the environmental chambers that are necessary to test these batteries under a variety of economic conditions. And these can be programs that take us, you know, well in excess of 12 months, 12-18 months to execute. So the advantage, obviously, to the customer is they have somebody who has expertise in this space that is developing the lab on their behalf.
The advantage to Keysight is that we get, you know, we build a very intimate relationship with auto OEMs around a core part of their development program, and it's the start of a long-term relationship. And just in the auto space, we have won opportunities like this with three new auto OEMs this fiscal year alone, and so we've actually seen very strong growth in this portion of our business. We do these types of long-dated projects in the semi space. We do them in the auto space, which is the example that I've just given, and also for some of our aerospace defense customers as well.
Great. There were two areas of surprises on the last earnings call, one being the deterioration of demand in China, and the other being pushouts in semis. Could you elaborate on these two areas and the change in customer behavior?
Yeah, I think the two are linked, right? I think as you think about the what changed for us in Q3 and the incremental weakness we saw in the quarter, there are two lenses that you can look through it, look at that through. The first would be a geographic lens, where that incremental weakness was largely concentrated in Asia, China specifically, but also some incremental weakness in Japan. And what we saw is, from an industry perspective, we were, you know, the delays in putting semiconductor capacity in place are in China and at other places are well established at this point.
I think as the supply chain situation has resolved itself, you know, the broader electronics supply chain, if you will, now is in a point where they're no longer adding capacity at the rate that they were last year. And so we've seen a pullback in that, you know, roughly 30% of our business that was manufacturing. It tends to be more focused in our electronic industrial businesses and tends to be, again, more focused in China. And so there's that geographic lens. I think if you look at it through a business-specific lens, it tended to be focused again on our electronic industrial business, the general electronics business, where this manufacturing pullback was realized, and of course, our semi business is managed out of electronic industrial as well.
I think there's two different lenses to which to view the same problem.
... And how do you see these two businesses kind of shape into the first half of next year?
Yeah, I think, China's a, admittedly a big unknown. I think, you know, just broadly speaking, industries were hopeful that when the zero COVID policies were lifted in China, we would see a boost, from economic activity, in the region, and actually what we've got in the short run is the opposite of that, right? There's some significant challenges right now with the China economy. So we'll be watching the actions, of the local government and that local economy, here over the short run and see whether or not that can turn and become a catalyst for growth. I think on the semi side, you know, the good news there is what you're seeing is delay in programs, but not cancellation in programs.
Most of these big fab programs are continuing to move forward. I think most in the industry are again pointing to the back half of calendar 2024 as a likely timeframe for, you know, construction and for spending to re-ramp.
Then the EV and AV, all the comments we heard at the conference, sounds like it remains a kind of a bright spot-
That's right
in terms of demand. Are you guys seeing the same thing, and how big are these areas within your EISG business?
Yeah. So, we sized our automotive business on the order line. In FY 2022, we eclipsed $500 million for the first time. Admittedly, there was, because of supply chain, there was a reasonable gap between orders and revenue. So, revenues were lower, but $500 million in orders in FY 2022, we have continued to see very nice growth in the AV and EV portions of that business. There is about 30% of our auto business that is tied to manufacturing, and what we do in the manufacturing space in automotive is actually we're testing electronic control units. It's a board test business, and so we're testing the electronics that goes into these vehicles, and that can be into an internal combustion vehicle or into an electric vehicle.
But in the R&D lab, the focus is on electrification of the drivetrain and the move towards higher levels of autonomous driving, and those areas have been quite strong this year.
Great. And then, AI has been a big topic among investors this whole year, and, can you talk about how your products can address the AI machine learning opportunity, and-
Yeah
How fast could this be a market for you guys?
Yeah, I think there's a number of different areas where we potentially will benefit from the push to AI/ML. So first of all, I would start at the beginning. You know, these complex AI chips are gonna require smaller process architectures out of the foundries, the 2- and 3-nanometer process architectures. And certainly, we're gonna participate in the build-out of that higher-end process node capacity via our semiconductor business. And then, all of that silicon is gonna need to be designed. So if you think about the folks that are designing that semiconductor content to enable AI/ML, we're a provider to them of tools as well. And then the place where we're seeing most of the investment taking place today is within the network itself.
And so again, I touched on this a little bit earlier. The question that the hyperscalers are trying to answer is: how do they make their networks as efficiently, as efficient as possible so that they can accelerate the learning of their of their learning algorithms and reduce the amount of capital that they need to invest in their networks? And Keysight, through, again, our physical layer tools and our protocol layer tools, is helping to optimize the performance of these networks.
And, Neil, we often get asked on the competitive landscape, there are and major share shifts happening, and also help us understand where, Anritsu or Rohde & Schwarz, some of these guys play and where you guys play.
Yeah. You know, I don't think there's been a real significant change to the competitive environment in this recent macroeconomic environment. I think we believe that, you know, particularly relative to the two names you just mentioned, who are big players in the commercial comm space, that we have been a net share gainer during the 5G cycle. And, you know, as we look forward to 6G, you know, Keysight is focused on making sure that we're making the investments that are necessary to sustain the leadership position that we have achieved here during this period of time. I think if you look more broadly at the competitors, you know, similarly, it gets to be fragmented after that point in time.
But generally speaking, I think if you go and you compare Keysight's results to the broader competition, we've tended to outgrow them even in this down environment.
Great. Let me pause here and see if there are any questions in the audience. If you have a question, please raise your hand.
It's all you.
All right. And in, in June, you guys announced the acquisition of ESI Group, a software prototyping company. What are some of the key highlights regarding the acquisition, and do you expect the business to accelerate Keysight's growth in auto?
... Yeah, so, you know, Keysight has had an interest in, in engineering software tools, for quite some time. This is one of the market expansion opportunities that Satish discussed at our Analyst Day back in March. And it's already a space in which we have some presence. We have an EDA, a business that's focused on the RF and microwave portions of the communications network, and have a leadership position there. And so we're looking for other opportunities for Keysight to participate in this engineering software tools market. And the thing that we liked about ESI, obviously, engineering software tools, but focused in markets where we're already where Keysight is already focused.
Their primary focus is in the automotive space, but with a secondary focus in aerospace defense, obviously, two important verticals, for us. And so, we see it as an opportunity not only to add significant software resources to our current auto product portfolio, but as you suggested, over time, we do expect that this will be accretive to growth. You know, we believe that there are opportunities within ESI's existing markets, as well as opportunities for Keysight to leverage its expansive sales force, its reach into aerospace defense, to potentially give ESI, you know, ESI product visibility that they have not been able to achieve on their own. And so, you know, we're very encouraged.
We look forward to getting the transaction closed, beginning the integration process, and beginning to drive value creation.
All right. Moving to the model, you know, when we looked at you guys during our initiation process, we were actually surprised that your gross margins are actually right behind some of the leaders in semiconductor industry like Broadcom, and so very high stickiness to what you guys do on a lab level. But if you can just kind of walk us through the disruption that the COVID and the supply chain went through over the last 2, 3 years. Are you kind of past the normalization stage from the disruption, or is there room for margins to improve as you guys kind of catch up to the normal times?
Yeah, it's, there's a lot in that question. So, obviously, Keysight's been on a pretty aggressive ramp of expanding both gross and operating margins, about adding about 1,000 basis points since our spin, you know, back in 2014. It's through a combination of, you know, increased software content, moving from selling kind of tools to our customers, to selling them complete solutions that address specific challenges that the industries that we serve are trying to solve. And through that increased value added, we've been able to increase the value delivery that we get and monetize that value. I think, you know, during COVID and the subsequent supply chain disruption, you know, there were and inflationary elements, right? I think there...
You know, we've seen input costs go up, certainly, and in the case of the supply chain disruptions, points in time where we were having to rely on third-party brokers to get key components to continue delivering to customers, sometimes at pretty extraordinary markups. I think the good news is that through that supply chain disruption, we were able to maintain gross margins at approximately 65%. I think we were able to do a very good job of getting product into the hands of our customers on a timeline that was acceptable. Did we see lead times extend? Absolutely, we did. But we saw our lead times extend weeks, not you know, six, eight weeks, not the kinds of you know, multiple-month lead times that many, many in the industry saw.
So, you know, when you're talking about a few weeks extension of lead times, that's something that your customers can plan for and respond to. I think we saw that in benefit in not only the margins that we were able to sustain, but in the customer retention that we were able to drive through that period of time. I think now that we're coming out of that, our lead times have largely normalized. At this point, I've a view with a few corner case exceptions that are still out there. The supply chain disruptions are largely behind us at this point. But we do believe that there continue to be opportunities for Keysight to continue to expand gross and operating margins.
I think we continue to grow software revenues at a rate that's above the company average. We continue to migrate more and more proportions of our portfolio to full solutions. I think where Keysight really differentiates ourselves are at the high end of technology when the problems are the hardest. And obviously, when you're solving those kinds of problems, you're bringing unique value to our customers and can monetize that value. And so we do believe that there are opportunities for us going forward, and we just need to continue to execute, continue to action on our first-to-market strategy, and enabling our customers' time to market.
What are the key drivers for the software revenue growth for you guys in the new business?
Yeah, there's no one answer because we do a number of different things in software. I think if you think, you know, historically, you know, if you go back far enough, there wasn't a lot of software attached to Keysight instrumentation. But as we've pivoted the question from kind of seeing ourselves as somebody who sold tools to trying to offer our customers more complete solutions that are addressing specific needs of the industries that we serve, much more of our software now goes out with attached software, you know, as part of the sale.
So whether that's specific applications that run on the instrument, or in the case of 5G, you know, our ability to now provide our customers with the complete 5G protocol stack, that if you're a device or a modem manufacturer, we'll emulate the network, and if you're a network equipment manufacturer, we'll emulate data traffic. And so, that portion of software is very much linked to our hardware and solution sales. I think, you know, through M&A, we've also entered into more pure software markets. The Eggplant acquisition of a couple of years back, which uses software to test software user interfaces. The recent ESI acquisition, again, doing simulations in the auto space, you know, are gonna have a different unique set of drivers because they're decoupled from Keysight hardware.
Great.
We have a question over here.
So as Satish said, you have a very enviable track record, both on execution and on margin improvement. So my question is, as I look at your business, that's funny, every time I go to your website, you have 1,000 businesses. You have, like, a lot of them are grouped together, but there's a lot of different end markets, different drivers. So it's like herding cats, like you're managing a lot of business. When I think about Keysight over the last few years, one of the hallmarks is, most of those cats are going in the right direction.
Yeah.
There's a lot of secular drivers and a lot of things were really quick. It seems like you've hit a little bit of a rough patch. Some of that is, you know, coming off a period of like, oh, you know, that long backlogs, normalizing, fine. So trying to understand the drivers to Keysight going into 2024 and 2025, can you just help. I'm trying to think of the right way to ask it. Like, if you were giving grades, like, what, what divisions are an A, a B, or a C? What needs attention to turn around versus what's just kind of, "Look, that's a cyclical thing, it'll fix itself"? So how do you-
Yeah
Catch the error?
Yeah. So, you know, I think there's really two sides to that story. There's the immediate time frame, and then there's the longer term. And I think, you know, the overarching message would, you know, there's some short-term challenges in our markets, but the long-term secular drivers across a broad range of our industries remain intact, and we remain fully very bullish around the long term. So if you think about the short term, I think, you know, our aerospace, defense, and auto markets, driven by AV and EV, have continued to be strong, whereas semi, commercial communications, and general electronics right now are experiencing a period of weakness. I think, but as you look forward, and particularly over the long term, what are the long-term secular drivers that are going to drive these industries?
As we've already talked about with regard to commercial comms, there's multiple new revs of the 5G standard that are still gonna come out, that are gonna drive waves of R&D. There's upgrades on the wireline side, from 400 gigabit to 800 gigabit to 1.6 terabit, not only driven by the traffic that comes from 5G, but driven by AI, ML. Aerospace defense budgets continue to grow, so that should, that should remain positive. On the industrial side, the semi programs are pushing out. They're not being canceled, and so the move to smaller process architectures, the need to secure semiconductor supply and re-onshore semiconductor production is going to continue.
In the automotive markets, the continued investment in electric vehicles, with the support of government regulation, driving the need to wean ourselves off of internal combustion vehicles, will be a tailwind. And then, in general electronics, you know, I think it's probably a little bit more macro-driven, where you really are looking to a broad set of industries and you're looking for, you know, macro strength to really drive a broader recovery. But within that, even within that general electronics business, there are submarkets that continue to be very strong.
IoT, advanced research in the education markets, med tech, these are all areas where we've continued to look to drive growth, albeit small, within that broader general electronic space.
Follow up, and that is, a while back, there was some talk about possibly making a large acquisition, which didn't happen. Do you now look at this opportunity, particularly in some of these more cyclical areas, where I don't, I know valuations are depressed, but it looks like they've come down. Do you think maybe this is the time that Keysight should make a move, or are valuations still considered high?
Yeah, I mean, I do think that over the last, I don't know, 6-9 months, we've seen an increased. You know, we've always had a large funnel of ideas, and I'd say it's an increasing number of those feel like they're becoming more actionable in the short to intermediate term, and I think we're gonna continue to evaluate those opportunities, right? But I think we're gonna stay disciplined with regard to our strategic and financial hurdles, make sure that, you know, we're not chasing people that have an unrealistic value expectations, and ensure that we can get a return on any investments that we make.
I just hope we can go back to the question about margins. Could you update us on what you're seeing in the pricing environment?
Yeah. So, you know, I think, the good news is the need to use third-party brokers is rapidly coming to an end, and so that has been a bit of a tailwind to margins here over the course of the last several quarters. I think, the OEM suppliers of the components that go into our instruments are continuing to raise prices. And so, you know, we want to make sure that we continue to keep pace and work to maintain margins, but we're confident in our ability to do so. We're confident in the differentiation of our portfolio. There's a question over here. Yeah.
Can you talk a little bit about the capital structure? You've got a 3x gross leverage targeting out there, which feels a little stale, with gross leverage at 1x-
Yeah
...and that cash neutral position... Maybe just how you're going to fund ESI and how we should think about that kind of pushing the leverage target going forward, maybe in the context of larger M&A deals or, you know, what you're seeing out there?
Yeah. So, we'll obviously fund ESI with cash on the balance sheet. We have the cash to do that. You know, the 2-2.25x gross leverage target is still the target, but we do think of that over time, right? And there's going to be periods of time when you're operating like we are now at a place where, you know, we're operating significantly below the leverage target. But we want to make sure that we have the strategic flexibility and dry powder to make the investments that we see fit when the opportunities present themselves. I think ESI is a great example of that.
And as we have done in the past, there have been points in time where you're overleverage target, right? When we did the Ixia acquisition, we levered up to 3.5 times and quickly brought leverage back down to the 2.25 target. So it's not the intent to always maintain leverage at 2.25 times, but that is what we think is the right operating level over time. And I think right now, particularly in this down environment, we're enjoying having a little bit of a defensive balance sheet and dry powder to make whatever strategic decisions, you know, we deem appropriate.
And then just following on shareholder returns, you know, I guess, share repurchases kind of ran here over the past couple of years. How should we think about that going forward?
Yeah, I mean, again, we have a commitment out there to at least be anti-dilutive with our buyback program. But you have seen us in the past be more aggressive with our opportunistic purchases, either as a function of dislocation in our own share price or the fact that, you know, M&A valuation expectations are out of reach, and it doesn't seem like things are actionable. I think in this current environment, you know, we clearly have ample room in our authorization. I think from a capital allocation standpoint, though, first and foremost, we want to make sure we're making the organic investments that are necessary for us to fully participate in the upturn, when it comes. And so you can expect us to keep our core R&D programs on track.
We do have a robust funnel of opportunities, you know, via M&A, and we'll evaluate them appropriately. You know, and again, if there are things that align with our strategic direction and allow us to meet our return hurdles, I don't think you'll see us hesitate to pull the trigger. But at the same time, I think there's been a dislocation in the stock price. We remain very bullish on Keysight's story over the long term. Admittedly, there are some short-term challenges, and, you know, we'll assess that appropriately when assessing our return on capital approach here over the coming quarters.
Thank you.
Neil, one final one from me. I believe you when you guys talked about your orders, you're expecting a rebound in fourth quarter. Is it that driven by seasonality? And-
Yeah.
And then I think first half comments from for next year were more muted. So help us understand how you're thinking about the orders?
Yeah. So we did say that we expect a sequential uptick from Q3 to Q4, although a smaller sequential uptick than we would typically see as driven by the current demand environment. So we are expecting things to be up sequentially. And then I think as you move into the first half of next year, I think, you know, at least, you know, we run a six-month funnel process, so I think at least through Q1, the environment is likely to be challenging. We have put a stake in the ground around our expectation that by the second half of next year, we think there are numerous things that are lining up that would suggest that, you know, a return to growth in that period of time.
I think there are scenarios where that pulls forward. I think there are scenarios where that pulls out, pushes out. But I think the main point that I'd like to leave you with is that the long-term secular drivers across our industries remain strong. And while the specific timing of a return to growth may be challenging to call, we're fully confident in Keysight's ability to fully participate in that upswing when it comes. And that we've clearly exhibited our ability to turn growth into strong profit and cash flow generation. So, we feel good about the position. Some short-term challenges, admittedly, but over the medium to long term, I think the company is very well positioned.
Great. With that, we can wrap it up. We still have a few minutes if, if you want to come up and talk to Neil on any specific questions, you can do that. But, Neil, thank you for coming to the Citi Conference.
Thank you.