Good day, and welcome to the Nova Measuring Instruments Ltd. Third Quarter 2020 Results Conference Call. Today's conference is being recorded. At this time, I would like to turn the conference over to Miri Segal. MS-IR, please go ahead.
Thank you, operator, and good day to everybody. I would like to welcome all of you to Nova's Third Quarter 2020 Financial Results Conference Call. With us on the line today are Mr. Eitan Oppenheim, President and CEO, and Mr. Dror David, CFO. Before we begin, may I remind our listeners that certain information provided on this call may contain forward-looking statements, and the safe harbor statement outlined in today's earnings release also pertains to this call. If you have not received a copy of the release, please view it in the investor relations section of the company's website. Eitan will begin the call with a business update, followed by Dror with an overview of the financials. We will open the call for the question and answer session. I'll now hand over the call to Mr. Eitan Oppenheim, Nova's President and CEO. Eitan, please go ahead.
Thank you, Miri, and welcome everyone to our third quarter financial results conference call. I will start the call today by speaking about our quarterly results and performance highlights. Following my commentary, Dror will review the quarterly financial results in detail, including the guidance for the fourth quarter of fiscal year 2020. Our outstanding results for the third quarter exceeded the company's previous expectations and guidance. Despite the market dynamics, we continued to demonstrate strong financial performance, solid cash flow generation, and sound execution against our long-term strategic targets. Along with our guidance for the fourth quarter, we are currently forecasting 2020 to be a growth year for Nova, while we outperformed the industry growth rate projection year to date. We remain confident in our strategy and the long-term value we bring to our customers as they progress to their next-generation devices across all technologies and segments.
Although the industry is experiencing various demand shifts during this disruptive year, our technical value continues to resonate with the market, demonstrated by several customer wins in the third quarter, including selections for our traditional and newly introduced technologies. Our well-executed plan is strongly reflected in our financial results for the third quarter, where both our revenue and EPS exceeded our previously announced guidance. Moreover, both our product revenue, optical CD standalone, and software sales reached record highs. This is a result of continued demand for our products by our customers, outstanding execution by our global and local teams, and the resiliency of our operating model. Turning now to the business performance highlights for the quarter. Our quarterly revenue included a diversified customer and territory mix, which was primarily made up of four large customers, two global memory providers, and two logic foundry manufacturers.
As expected, demand from foundry for both advanced and trailing nodes remained strong this quarter. Exiting 2020, we expect the healthy revenue stream from foundry customers to continue in 2021 as well, as they prepare for growing demand in several key applications and manage structural changes in manufacturing dynamics across customers and territories. Although this quarter was weighted towards logic, we continue to see high utilization in the memory sites and expect recovery in 2021. The relative softness in memory during 2020 allowed us to further penetrate this segment and enabled us to continue the proliferation of our new and existing products in this segment. One indication of our growing market share is our recent announcement that a top memory customer selected Nova Prism for its most advanced memory fabrication sites. Following the selection, the company expects to deliver multiple tools to multiple sites throughout 2021.
Based on our long-term trajectory, which combines both organic and inorganic growth drivers, we have decided also to raise capital to support our next level of expansion. In October, we completed a successful private convertible note offering of $200 million. We initially announced an offering of $150 million, but upsized it due to a strong demand. The offer was closed at attractive conditions of 0% interest on a conversion premium of approximately 27.5%. The fact that over 100 institutions applied to participate in the offering was a very positive indicator to us, with interest extending beyond U.S. borders, including Europe and Israel. Beyond the fact that this recent move creates a favorable position for us to leverage our company assets for inorganic expansion. It is a broad vote of confidence in Nova's business trajectory.
Following the transaction, we will continue to seek investment in disruptive new technologies, pursue attractive merger and acquisition opportunities, and enhance shareholder value. During the last quarter, we remained focused on realizing our strategy to build Nova's growth engine by constructing a disruptive portfolio in both dimensional and materials metrology solutions. Our goal is to continuously develop and introduce disruptive solutions to the market that set us apart from the competition, and allow our customers to overcome new emerging challenges. As part of this strategy, we enhanced all our traditional product lines with new generation platforms to continue supporting our customers' future complex challenges across all semiconductor segments.
The new set of platforms that were introduced in the last 12 months, including the Nova Prism OCD standalone, VeraFlex III X-ray platform, Nova i570 and Nova ASTERA integrated metrology tools, and our new Deep Tech software and machine learning engines are all generating strong customer traction with multiple orders and installations. Additionally, a fundamental part of our 2020 strategy was to develop a pipeline of new technologies that will expand our total available market and gain us share in non-traditional metrology steps. These disruptive technologies aim to create new application space in the inline in-die production environment in order to shorten time to market in the most advanced nodes. By introducing these new platforms, we are working with customers to fundamentally change their process control scheme to overcome new challenges that are not met today by traditional OCD or IR systems that have existed in the market for decades.
Although our plans met some challenges due to the COVID-19 spread, we are back on track with multiple installations in leading customer sites. We still expect initial acceptances to happen in 2020. It is worth mentioning that according to our procedure and cautious approach, we only announce new products after they reach a certain level of maturity, typically following multiple installations and receiving actual purchase orders. Following the quarterly highlights, I would like to spend a few minutes and explain our long-term hardware technology in more detail. Since the semiconductor market is very aggressive in moving to the next generation chip technology, our product portfolio is always built to meet the future technology trends of our industry. In our view, the industry is undergoing a major revolution where critical dimension-driven scaling can no longer be the sole process used to deliver improvement in performance.
Along with traditional scaling, one of the main avenues of advancement is the introduction of new materials, compounds, and alloys in the most advanced process steps, including litho, etch, and deposition. As a result, the surge in complexity also raised the bar for material metrology platforms, creating a strong need for novel solution capable of measuring and controlling materials properties such as ultra-thin films, composition, stress, strain, surface properties, and more. Customer requirements already span multiple performance factors for such advanced tools, including high productivity and extremely accurate non-destructive material property analysis. Nova's non-destructive VeraFlex X-ray solution is the industry standard for inline compositional and ultra-thin films analysis with dozens of distinct use cases in each major segment. It has the unique ability to measure in-die, in production, on patterned wafer with sensitivity for films below 100 angstrom, where most of the critical composition control happens.
While Nova continuously evolves its X-ray performance, we are also developing new materials analysis technologies, including optical and other spectrometry methods capable of extending to new application space and addressing critical units. In a dimensional metrology space led by the optical CD solution, the growth in complexity driven by continued 3D scaling and higher aspect ratio devices produces new metrology challenges. While in the past, there was a clear distinction between optical metrology used to measure critical dimension and X-ray used to measure materials, our portfolio vision aims to converge the technologies where X-ray metrology will address in-die dimensional application as well. The new directions of X-ray metrology are non-destructive methods and will solve applications that optical methods cannot solve physically today in the future.
We definitely expect our CD portfolio to be driven in the future by a combination of optical CD and X-ray capabilities, which will complement each other with extra sensitivity. Let me turn now to the company operational status. In terms of our growing efforts to overcome the COVID-19 pandemic, we are very pleased with the comprehensive actions we take to strengthen our global operational infrastructure in the last three quarters. We proactively manage supply chain disruptions and successfully executed high volume manufacturing while maintaining the health and safety of our global workforce. As a result of our employees' dedication and outstanding efforts, we quickly ramped up our production lines and development capabilities to peak levels.
Since we expect the virus to remain a global concern during 2021 as well, we have fundamentally changed our working procedures and implemented them as the new normal environment for at least the next 12 months. As we continue to assure our business continuity, our go-forward focus is on strengthening our local entities in order to maintain top-quality service for our global customers and engage in various emerging opportunities with the reliance on remote capabilities and a minimal headquarter support. The confidence we have in our new product portfolio and our ability to transform short-term pipelines into long-term growth engines dictates our operational goals currently despite the interim disruption. A significant step towards our long-term goals is the recently announced construction of the new large clean room in Israel, planned for manufacturing Nova's most advanced platform by utilizing state-of-the-art production and Industry 4.0 methods.
The new facility will allow for flexible capacity changes to facilitate shift work for better social distancing and swift adjustment of production line focus, and will ensure our long-term agility and business continuity in various recovery scenarios. Looking forward, despite the several disruptions we had this year, Nova is well-positioned for a strong finish to the year, outperforming the industry's latest growth projections of wafer fab equipment spending. To conclude, we delivered strong results in the first three quarter of the year. Our guidance for the fourth quarter assumes similar level of performance. Exiting 2020, our outlook is positive in term of overall market growth and Nova expansion. Coupled with our diverse customer base and product offering, we are well-positioned to deliver on our long-term strategic goals. Now, let me hand over the call to Dror to review the financial results in detail. Dror?
Thanks, Eitan. Good day, everyone. In the third quarter of 2020, the company continued to perform well and the financial results exceeded the initial expectations and guidance. Total revenues in the third quarter of 2020 were $69.5 million, all-time record quarterly revenues, 32% higher than the third quarter of 2019. Product revenue distribution was approximately 65% from logic and foundry and approximately 35% from memory. Geographically, China, Taiwan, and the U.S. each contributed more than 20% to our product revenues. The higher than usual contribution from the U.S. was related to a recent penetration to a new customer in that region and to the adoption of the Nova Prism by another U.S. based customer. On a per customer basis, four major customers contributed 10% or more to the company product revenues, including two foundry customers and two memory customers.
Blended gross margin came in at 57% on a GAAP basis and 58% on a non-GAAP basis within the company target model of 56%-59% on a non-GAAP basis. Operating expenses in the third quarter of 2020 increased to $24 million on a GAAP basis and $22 million on a non-GAAP basis. These incremental increases are across all company operational activities and are aimed at aligning the company resources and redundancies to the growing business levels and the COVID-19 environment. Operating margins in the third quarter of 2020 increased to 22% on a GAAP basis and to 26% on a non-GAAP basis. Effective tax rate in the quarter came in at approximately 15% on a GAAP basis.
Earnings per share in the quarter increased to $0.48 per diluted share on a GAAP basis and $0.57 per diluted share on a non-GAAP basis. Moving to the main balance sheet items, trade accounts receivables further decreased by approximately $3 million as a result of effective collection during the third quarter, and days sales out came in at 55 days. As expected, the company inventory levels continued to increase due to the higher business volumes and due to business continuity measures taken as a result of the COVID-19 pandemic. We expect to continue to gradually increase the company's supply chain commitments and related inventories in order to secure the production and delivery of products and services as much as possible across the different locations and territories. Inventories at the end of the third quarter accumulated to $62 million, with inventory turns of two times a year.
During the third quarter, the company generated approximately $22 million of operating cash flow, accumulating to approximately $54 million of positive operating cash flow in the first three quarters of 2020. As a result, overall cash reserves at the end of the third quarter increased to $238 million. In parallel, in October 2020, the company successfully concluded a 0% interest convertible bond offering in the amount of $200 million. The company used $10 million of these proceeds to buy back shares during the offering process. The company guidance for the fourth quarter is already taking into consideration the accounting impact of the convertible debt issuance on the company GAAP results. We expect to charge approximately $1 million in amortization of debt discount and issuance costs for GAAP purposes on a quarterly basis.
This amortization is expected to be presented as financial expense in the company's consolidated statements of operations on a GAAP basis starting the fourth quarter of 2020. The company intends to adjust these amortization costs for non-GAAP purposes, and investors can view the specific breakdown and reconciliation of GAAP to non-GAAP results as it relates to the fourth quarter guidance at the end of the quarterly press release. The convertible debt is due in five years, and the company has the intention and is expected to have the ability to redeem the par value of the convertible debt in cash at the maturity date. As a result, for purposes of diluted earnings per share, the underlying shares related to the convertible debt are not expected to impact the share count of the company in the near future.
Such impact may occur partially or fully if Nova share price is higher than the conversion price or when the company adopts new accounting standards which relate to the convertible debt. Moving into the details of the company outlook for the fourth quarter of 2020, we expect the following. Revenues are expected to be between $66 million to $73 million. GAAP earnings per diluted share between $0.32 and $0.43. Non-GAAP earnings per diluted share between $0.45 and $0.56. At the midpoint of the fourth quarter guidance, we expect the following. Blend ed gross margins are expected to be approximately 57%. Given the COVID-19 situation, the company continues to build backup resources across its global workforce. In parallel, we continue to focus on introducing and proliferating new products globally.
In that respect, operating expenses are expected to increase to approximately $26 million on a GAAP basis and to increase to approximately $23 million on a non-GAAP basis. Most of this increase is expected in R&D expenses. Effective tax rates are expected to slightly increase in the fourth quarter as a result of annual provisions and tax closing processes. As we conclude 2020, which is expected to be a year of record revenues for the company, gross overall cash reserves are expected to accumulate to more than $400 million. We believe this level will enable the company to explore different business opportunities during and after the COVID-19 global pandemic crisis. With that, I will turn the call back to Eitan. Eitan?
Thank you, Dror. With that, we will begin to take your questions. Operator?
Thank you. If you would like to ask a question, please signal by pressing star one on your telephone keypad. If you're using a speakerphone, please make sure your mute function is turned off to allow your signal to reach our equipment. Again, press star one to ask a question. We will take our first question from Quinn Bolton with Needham & Company.
Hey, guys. Thanks. Nice job on the third quarter results and the fourth quarter outlook. I wanted to start first with your outlook for the specialty foundry segment of the market. Obviously, the U.S. Commerce Department actions on SMIC will result in U.S. companies needing export licenses. Wondering if that's having any impact on your shipments to SMIC? I don't believe your OCD business requires an export license. Just wondering if you've seen any change in demand from that customer? As a result of export control, then I've got a couple of follow-up questions.
Sorry, Quinn, thank you for the question. It's Eitan here. Most of the demand in SMIC for our tools came for the OCD tools that are coming from Israel. Therefore, we don't see any shifts in demand. We do see pull-in of part of the tools as an overall phenomenon of SMIC trying to pull in tools from the rest of the vendors. We see it as well. We don't see a reduction in capacity nor the demand.
Okay, great. For the comments you made, the U.S. was more than 20% of revenue in the third quarter. I believe you said that reflected the Prism win at a large logic manufacturer. I think you may have said that you also shipped Prism to a second customer in the U.S. I wanted to make sure I heard that right. If I did, could you provide any more color, whether that's Prism for logic or memory, any more detail would be helpful.
Yeah. What I said in the prepared remarks is that the increase in U.S. product revenues in the third quarter was related to the win that we announced earlier this year for a U.S. based customer and to another U.S. based customer, which was in the logic area, which adopted the Nova Prism as well.
Great. All right. Just Dror, a couple of quick clarifications. On the revenue guidance of $66 million to $73 million, you mentioned in the script that you still expect rev rec on a new tool. I'm wondering if the $66 million to $73 million includes rev rec or to the extent you do rev rec a new tool, whether that would be additional to that $66 million to $73 million.
As Eitan mentioned, we do expect initial acceptances from the new technologies in the 4th quarter already in 2020. The range of the guidance reflects all the elements related to our projections for that quarter, including the new technologies.
Got it. Great. Just lastly on the inventory. I know you said that you increased the inventory, one, for business continuity reasons, but also to support higher levels of demand. Wondering also is there an increase in terms of sell units included in that inventory figure, either for Prism at new customers or for some of the new technologies? Thank you.
Yes, the increase in inventory, not necessarily in the third quarter, but across 2020 also relates to new evaluations of the new products.
Great. Thank you.
We will take our next question from Jaeson Schmidt with Lake Street.
Hey, guys. Thanks for taking my questions. I think your previous expectation for Q4 was for logic and memory to be a bit more even here. Is that still the assumption?
If we're looking right now on the fourth quarter, we still expect that foundry will be a bit stronger, although we do expect that memory will come up. It will not be the same allocation as we see right now, around 70/30, but definitely in a more equal way. Nevertheless, the foundry will still be stronger in Q4.
Okay, that's helpful. Just curious if you're seeing any supply constraints at all across the channel?
No, in general, we do not see any significant disruption. Obviously, some of the suppliers have some difficulties during these times, but nothing which is of significant. As mentioned before, we are securing the supply chain with both orders, inventory at hand, and also inventory at supply facilities. We do not have disruptions to date.
Okay. Then just the last one from me, and I'll jump back in a queue. Obviously, the service revenue is a bit more macro sensitive. How should we think about that rebounding going forward? Do you think Q3 was the bottom? I think at one point, the goal was to grow that line above 10% on an annual basis. Is that still the target even with all the uncertainty out there?
Yes. As we discussed before, the growth of the service business is highly correlated with the increase in the install base. Generally, this increase is between 5% and 10% a year, maybe 5%-8%, and we still expect such growth rate in the future.
Okay. Thanks a lot, guys.
Thank you.
We will take our next question from Patrick Ho with Stifel.
Thank you very much, and congrats on the nice quarter and outlook. Eitan, maybe first off, aside from the SMIC situation, can you give a little bit of color of the traction you're seeing on the trailing edge foundry logic end at this time? It looks like that business segment is picking up. OCD metrology fits in well with some of the product markets that are at the trailing edge. Can you give a little bit of color on what you're seeing out there, broadly speaking?
Yeah. When we're looking right now on the demand and the foundry drivers across advanced nodes and trailing nodes, we roughly see a solid distribution over the year of around 70% coming from advanced nodes and around 30% coming from trailing nodes. The 30% that are coming from trailing nodes are divided between Taiwan and China, where we see a growing demand coming from China along the quarter, where we definitely see at least the next two quarters growing from this foundry demand from trailing nodes, trailing edge in China.
There are two major foundry providers in China, both of them actually grow significantly this year. Unless something is changing in the U.S. China trade war next year, we expect that definitely one of them will continue growing. If I need to expect what will come in 2021, it's the same distribution of around 70%, 30%, where we have this leading foundry that will increase capacity, and also the trailing edge nodes that will keep modestly growing next year as well.
Great. That's really helpful, Eitan. Maybe as my follow-up question, obviously, OCD metrology has been a beneficiary out of the industry shift to 3D NAND and the growth of wafer starts capacity in that marketplace. Can you give your thoughts on the DRAM space, both from a market perspective and what you think may occur? Secondly, the capital intensity trends, particularly as they go to 1Z and 1-alpha, the need for more OCD metrology, and possibly X-ray as well for those most advanced nodes.
All right. I need to divide it between the X-ray capabilities and the materials shipments versus the OCD and the traditional dimensional demand. If we're looking right now on OCD, currently the most dense sites are the foundry logic one. Every new node that is coming in, the intensity of the demand is growing per 1,000 wafers. After that, it's the V-NAND that once you increase the cells or the number of cells, you increase the layers, but you also increase the stacks from one stack to two stacks, which increase the number of layers that require OCD. The third one is the DRAM. Even scaling DRAM from 1X, 1Y, 1Z, and even further, actually increase a bit the intensity, but it's not large as the NAND and the foundry, and logic.
If I'm going into the memory, I think that in the first place is the memory, including V-NAND and DRAM, and the second place is foundry. This is the way it goes, and the scale is the same, which means every new node that is coming in, the attach rate for X-ray tools, the XPSs, are actually increasing. Every new node that's introduced in memory is having more attach rate than foundry.
Great. Thank you very much.
Thanks, Patrick.
As a reminder, if you would like to ask a question, please press star one. We will take our next question from Mark Miller with Benchmark Company.
Eitan, on the quarter and your outlook, just was wondering, you indicated two new customers in China. Were you shipping in the third quarter to these customers?
Yes.
You anticipate shipping in the fourth quarter also?
Yes.
You mentioned a higher attach rate for X-ray. Just was wondering, next year, do you see X-ray and software being a greater % of your sales or similar to what you had this year?
I referred to part of it in my script when I said that we would like to converge X-ray to be a dimensional tool as well. If I'm looking right now on next year, I'm looking right now on the X-ray tools to be driven by demands of both dimensional end materials. We definitely see the X-ray tools demand growing next year. Okay? It's growing from attach rate perspective, it's growing from new customers.
It's growing from the fact that it's going inline, and it's worth mentioning that our X-ray is non-destructive, very fast inline tool. It's growing with capacity, and therefore, we're definitely looking on X-ray growing next year. Regarding software, our long-term model is talking about staying at around 10% of our product revenue. If the product revenue will grow next year, the software revenue will grow as well. We're not taking it outside of the metrology space. As we look on that, we would like to stick to the 10% number.
With the X-ray growing next year, what is the impact on margins? Will that be a slight improvement or stay the same?
More or less the same.
Thank you.
Thanks, Mark.
It appears there are no further questions at this time. I would like to turn the conference back to Mr. Oppenheim for any additional or closing remarks.
Thank you, operator, and thank you all for joining our call today. Thank you.
That concludes today's presentation. Thank you for your participation. You may now disconnect.