Good day, ladies and gentlemen, and welcome to the Photronics Q1 FY2019 Earnings Call. At this time, all participants are in a listen-only mode. Later, we will conduct a question-and-answer session, and instructions for how to participate will follow at that time. During the conference, if anyone should require assistance, please press star or the number zero on your touch-tone telephone. As a reminder, this conference call is being recorded on February 21, 2019. I would now like to introduce your host for today's conference, Mr. Troy Dewar, Head of Investor Relations. Sir, you may begin.
Thank you, Jimmy. Good morning, everyone. Welcome to our review of Photronics 2019 first quarter financial results. Joining me this morning are Dr. Peter Kirlin, Chief Executive Officer, John Jordan, Senior Vice President, Chief Financial Officer, and Dr. Christopher Progler, Vice President, Chief Technology Officer and Strategic Planning. The press release we issued earlier this morning, along with the presentation material which accompanies our remarks, is available on the Investor Relations section of our webpage. Comments made by any participants on today's call may include forward-looking statements that include such words as anticipate, believe, estimate, expect, forecast. These forward-looking statements are based upon a number of risks, uncertainties, and other factors that are difficult to predict. Actual results may differ materially from those expressed or implied, and we assume no obligation to update any forward-looking information. During the course of our discussion, we will refer to certain non-GAAP financial metrics.
These numbers are useful for analysts, investors, and management to evaluate our ongoing performance. Reconciliation of these metrics to GAAP financial results is provided in our presentation materials. At this time, I will turn the call over to Peter.
Thank you, Troy, and good morning, everyone. Revenue for the first quarter of 2019 was mostly in line with expectations, reaching year-over-year growth despite fewer days this quarter, as an increase in high-end was somewhat offset by weaker mainstream. On a sequential basis, revenue was down 14% due to seasonal weakness, a shorter quarter, and macro-industry headwinds. Within IC, high-end grew while mainstream was down compared with last year. On a sequential basis, both high-end and mainstream declined due to seasonality and uncertainty related to industry, economic, and geopolitical concerns delaying order activity. We saw weaker high-end memory demand, although we believe this was mostly related to order timing and not end-market-driven. High-end logic remained soft. Looking into the second quarter, we expect to see a pickup in memory, though the outlook in logic is less clear.
Regarding the latter, we don't expect to see material deterioration, but recovery may be beyond the second quarter. While we experienced lower demand across many parts of our business, high-end FPD was a notable exception. Our FPD business is in a very strong competitive position with the industry's leading technology and our technology lineup anchored by a P-800, which offers superior resolution to all the tools. Once again, AMOLED revenues were up sequentially to the extent that they now represent approximately half of our total FPD revenue and more than doubled compared to last year. Mainstream FPD revenue was down as we devoted more mainstream capacity to building the non-critical layers of the AMOLED mask sets and experienced competitive pressures associated with an oversupplied market. FPD production capacity was sold out throughout the first quarter.
Looking forward into the second quarter, we expect our FPD business to grow, driven primarily by mobile display, with additional capacity coming online as we bring up production in China in the latter half of the second quarter. Shifting to profitability, we saw a decrease compared with the fourth quarter, resulting from lower revenue and higher costs in China. Below the line, we incurred some pluses and minuses, with the net result being earnings of $0.08 per share. Overall, I believe we performed well in what was a very challenging environment, in line with our expectations. Operating cash flow for the quarter was negative, also in line with our expectations, due in large part to temporary factors such as the timing of receivables and the payment of value-added taxes on tools delivered into China. We expect to see operating cash flow improve moving forward.
Our China investments are peaking, and with CapEx of $107 million, our cash balance dropped to $232 million at the end of the quarter. Even with this, we are in a great spot financially, which enabled us to repurchase 1.1 million shares during the quarter, and we expect to begin rapidly rebuilding our cash balance as our new facilities in China ramp. As you know, we have placed a high strategic priority on developing the China business and have already seen tremendous success. The customers are a combination of China headquartered companies and multinational companies that invested in the country in order to avail themselves of the growing semiconductor and flat panel display demand. Revenue to China in the first quarter improved 55% year-over-year, with a solid 50/50 balance between IC and FPD.
To put our performance in a broader context, our revenue to China over the last 12 months was approximately $109 million. In 2017, it was $43 million. In other words, our business in China is over two and a half times larger than it was just a little over one year ago. When we announced the first China investment in August of 2016, we said that one of the reasons we were confident in our ability to generate necessary returns on this investment was the fact that we already had developed a customer base in China. At that time, China represented approximately 5% of our revenue. In this quarter, China was 22% of our revenue. This gives us an extraordinarily strong foundation even before we manufacture the first IC or G10.5+ photomask in China.
In addition to our already mature and growing China revenue stream, our investment risk management includes customer contractual commitments, investment incentives, and the extension of our IC joint venture with DNP to help us more effectively compete in China. These factors give us confidence that the investment return in China will be significantly better than historical return on invested capital. The Made in China 2025 goals for IC production are ambitious, and semiconductor manufacturers there are making progress against industry objectives for domestic-produced chips. The stated target is to achieve 40% self-sufficiency by the end of the year 2020. According to recent projections provided by IC Insights, they will only be at 20% by 2023. This implies that there is much more investment needed to hit the targets. If those investments occur, then they will need many more photomasks to ramp production at those facilities.
While there is noticeable short-term softness in the China economy, the long-term trend for the semiconductor industry looks robust. Technology trends are also positive. Leading Chinese logic companies are moving into production at 28 nanometers, with early-stage development commencing at 14. For Chinese memory manufacturers, we are starting to see both 1x DRAM and 32-layer 3D NAND flash in production, with development beginning at the 1x DRAM and 96-layer flash nodes, respectively. For FPD, G10.5 Plus and AMOLED are becoming important technologies for the country. Adoption of AMOLED displays for mobile application continues as more smartphone manufacturers are using this superior component. On the supply side, we continue to partner with more panel producers that are developing this technology. As competition increases, we will likely see a reduction in panel prices, which accelerates adoption rates. Increasing the total available market has more smartphone makers shift from LCD.
In addition, other applications should also become more widely adopted, such as laptop displays, providing additional growth drivers. We are the clear technology leader in this space and have supplied photomasks to each and every one of the AMOLED panel producers. Without a doubt, we should continue to grow as this market accelerates. The introduction of G10.5 Plus is already having a noticeable impact on the ultra-large screen TV panel market. And to date, there is just one fab in China operating with this technology. We anticipate five more will move to production in the next two to three years. This will be a disruptive shift in the industry. To align with this inflection point, we have equipped our Hefei plant to produce G10.5 Plus masks.
We believe that local production, coupled with our long history of supplying high-end reticles to the industry's leading panel producers, will provide us with a competitive advantage sufficient to attain market leadership. Our investments in China to expand our geographic footprint, with the addition of two new manufacturing facilities, are going well. Both buildings are complete, and tools are currently being installed and ready for production. Our FPD factory is proceeding to our original plan. We have largely completed the recruitment and hiring of key personnel, and we expect to ship our first revenue-generating photomask by the end of this quarter. As a reminder, our primary focus is G10.5 Plus photomasks for ultra-large screen TVs, but we will also have the ability to make AMOLED mask sets. In contrast to FPD, which is sold out despite market headwinds, our IC business is being negatively impacted by the semiconductor industry downturn.
Furthermore, the majority of the Chinese business is logic, which, as you heard earlier, is the most affected. As a result, we have delayed the ramp of our IC factory by one quarter, which is reflected in the actual CapEx spend of $107 million, which is approximately $70 million less than the guidance given in the last earnings call. As a reminder, qualification cycles for high-end IC are 9-12 months, and the reason for the delay is to ensure that we are beyond the current downturn and ramping volume production into a strong market. This three-month delay does not indicate a damping of our enthusiasm for the China IC mass market, but instead reflects our operating methodology of always doing our best to align investment timing with business growth. As we expected, 2019 is starting out with a number of challenges across our industry.
However, we are performing well and see a pathway to growing sequentially throughout the remainder of this year. Moreover, our two new facilities in China are nearly ready for production, and we anticipate a strong FPD revenue ramp in the second half of 2019. At this time, I will turn the call over to John to provide commentary on our performance and outlook. John?
Thank you, Peter. Good morning, everyone. Revenue of $124.7 million in the fourth quarter was a 1% improvement over the same quarter last year, as high-end growth more than offset weakness in mainstream products. Sequentially, revenue declined 14%, reflecting our anticipated combination of seasonal softness after a record quarter and in the face of macroeconomic headwinds. There were also six fewer days in the first quarter than in the fourth quarter due to adoption of October 31 as the fiscal year-end.
High-end IC improved 4% year-over-year, primarily due to increased market share in a weaker market. IC revenue overall decreased 14% from the previous quarter, with similar declines in both high-end and mainstream. The drop in mainstream was mostly in Asia, particularly Taiwan and China, where macro uncertainty impacted some customers' cadence of new product designs. Within high-end, we experienced declines in logic, as new designs for advanced applications such as smartphones were down, and memory due to order timing from a large customer. FPD high-end was up 14% compared with last year's first quarter, once again buoyed by AMOLED. We have clearly established ourselves among the leaders with this technology, and we have benefited from expansion in industry demand. AMOLED growth was somewhat offset by a decline in demand for G8.5 masks used for large screen TVs and lower demand for LTPS LCD screens in mobile applications.
Both are trends that we have long anticipated and why we have positioned our FPD portfolio to align with growing AMOLED and G10.5+ secular demand. Gross margin was 20.9%, impacted by both the revenue level and China startup costs. Operating expense was higher due to increased compensation expense, China startup activity, and R&D expense for qualification work on several high-end products. As a result, operating margin was 6.5%. Below the operating line, we recorded an FX gain in other income, effective tax rate of 15%, and minority interest that reflected lower pre-tax income from our majority-owned JVs, resulting in net income attributable to Photronics shareholders of $5.3 million or $0.08 per diluted share.
Operating activities resulted in a loss in the use of cash this quarter, primarily due to payment of VAT on tools delivered into China, which we expect to recover in the future, and timing of receivables payments. We drew approximately $29 million on our loan agreements in China to fund VAT payments. Under our agreements in China, we anticipate receiving reimbursement for interest expenses related to these local borrowings. Over time, we plan to repay these loans from operating cash flow generated in Xiamen. The remainder of our debt is a $57.5 million convertible issue, with a conversion price of $10.37 that matures on April 1. If all holders of that instrument convert, approximately 5.5 million shares would be issued. If the bonds are not in the money, so to speak, or the holders elect cash payment, we are well positioned to pay the balance with cash on hand.
Payments of $107 million in capital expenditures, primarily for China, reduced our cash balance to $232 million. During the fourth quarter, we repurchased 1.1 million shares of our common stock for $10.7 million. Since announcing our first share repurchase program last July, we have repurchased a total of 3.7 million shares, returning over $33.8 million to shareholders. With the impending maturity of the convertible issue, the share repurchase program was recently concluded. Our CapEx target for 2019 is unchanged at $210 million. We anticipate spending the majority of the remaining balance during the second quarter as we complete tool installation and prepare for production in our two China facilities. Before I provide second quarter guidance, I will reiterate the reminder that our visibility is always limited, as our backlog is typically only one to two weeks, and demand for some of our products is inherently uneven and difficult to predict.
Additionally, the AFPs for high-end mask sets are high, and as this segment of the business grows, a relatively low number of high-end orders can have a significant impact on our revenue and earnings for a quarter. Given those caveats, we expect second quarter revenue to be in the range of $125-$135 million. Coming off the seasonally soft first quarter, we expect market dynamics to be stable to improving with potential macro headwinds and the seasonal impact of Chinese New Year. Based on this revenue expectation and our current operating model, we estimate earnings for the second quarter to be in the range of $0.03-$0.10 per diluted share, including approximately $0.05 per diluted share effect for China startup expenses. Through the first quarter, we have performed in line with expectations in 2019.
Looking forward, we remain optimistic that we can grow market share this year as customers release new designs. In addition, the ramping of production in China should provide additional support to achieve meaningful growth this year. I will now turn the call over to the operator for your questions.
Thank you, ladies and gentlemen. At this time, if you'd like to ask a question, please hit star then number one key on your touch-tone telephone. If your question has been answered or you wish to remove yourself from the queue, please hit the pound key. We ask that you please mute your line once you've asked your question to prevent any background noise from coming through. Again, that is star then one to queue up for a question. Our first question comes from Tom Diffely with D.A. Davidson. Your line is now open.
Yes, good morning.
First of all, I was wondering if there's some way to quantify the impact you're seeing from the macro headwinds right now. I know it's tough this time of year because of seasonality, but any way to figure out or to calculate what the actual impact is?
Yeah, I think, Tom, that's, as you said, quite tough to quantify. We aren't seeing any impact, first of all, in the FPD business. We're gaining market share in a shrinking market. So there is no effect in FPD. In IC, typically, a downturn impacts our business to a level of between 5% and 10%. That's a typical number for our IC business in a downturn. So I think that's the best we can do. Yep.
Okay. And then you talked about the impact of the China startup being 3-6 cents per quarter.
Is that just the flat panel facility at this point, or is that both facilities?
That's both, Tom. Both facilities. That's a combination.
And what was it in the reported quarter?
I think we said $0.04 before the effect of our FX recording and $0.02 net.
Okay. So it sounds like you expect that to disappear or to be profitable in China by the end of the year. Does that just require a ramp on the flat panel side to get to that break-even?
Essentially, that's what's in our plan. Both plants should be online by the end of the year, and our budget shows that we should be profitable overall.
Okay. Okay. Great.
And then recently, Applied Materials talked about how there's been a little bit of a slowdown in the equipment ordering of G10.5, but I assume your customers are already in place and running product, and so the impact of you should not be too dramatic?
Yeah. So we started construction of our FPD facility last December, and we are going as fast as humanly possible, and sometimes I think even faster than that, to bring that factory online by the end of March. The reason for that is, if you look at the landscape, right, BOE a year ago brought their first G10.5 factory online in Hefei. This April, March-April timeframe, CSOT's first factory in Guangzhou will start its volume ramp. That timing, as you can see, is not fortuitous with where we've been driving our factory to be online.
And then BOE's second G10.5 factory will need its first reticle set early summer. So we've worked very hard to position our factory in Hefei to take advantage of the second and third factories coming online, one from the point of view of being there for the volume ramp, the other from the point of view of being POR. So the delays in or softening in the G10.5 equipment spend has basically been from, with maybe one exception, companies we would call or describe as second-tier players. The companies that we have contractual commitments with are the strong players, the winners, and to the best of our knowledge, they haven't backed off one bit on their timetables. So no, it doesn't affect our business plan because our business plan is based on the winners, was, is, and remains based on the winners.
Okay. Great. Thanks.
Then finally, when you look at AMOLED and the potential of that really ramping up over the next few years in China, it seems to be a big incremental opportunity for you. Do you have the capabilities, or will you have the capabilities to serve that out of the same Chinese facility you're doing 10.5 in, or is that going to be served, or would that be served out of Korea?
Yeah, it'll be a mix and match. Right now, there's no one in the business that can make the quality reticles that we do out of our Korean site. And we've been building FPD reticles there for 20 years, more than 20 years. And as you know, historically, Samsung has been our partner. They remain the technology driver despite all the great progress by a number of Chinese manufacturers.
Your best technology generally is created by your toughest customer. So as long as our toughest customer is in Korea, our best reticles are going to be made there.
Okay. Thank you very much.
Thank you. And our next question comes from Patrick Ho with Stifel. Your line is now open.
Thank you very much. Peter, maybe as a follow-up to your prepared remarks regarding China and some of the macro headwinds you're seeing there, you noted that you're seeing it in their foundry logic segment. Are you seeing any on the memory side of things, given that their ramp-up of memory, particularly on the NAND side, has been slow to transpire, given some of the yield issues that they're working through?
Yeah. So as far as China goes, in our prepared remarks, and maybe I'll turn it over to Chris after I make one or two quick comments.
First, one thing that surprised us in the quarter was we more or less expected our memory business to move along as it was, but we had some orders pushed out, and as I sit here, those orders have materialized, so right now, we're swimming in memory reticles, and our memory business today is really dominated by large multinational manufacturers or foundry memory manufacturers in Taiwan. That's what dominates our memory business. We happen to be POR at what we believe to be the most advanced domestic NAND flash manufacturer in China, and of course, we have some memory business with some of the other players in China, but certainly, the speed at which they move will be a governor on the rate at which our high-end memory business can grow in China. Chris, do you have anything else you want to add to that, Chris?
Not really.
I mean, just to say, regarding macro headwinds and that sort of thing, I don't think that's been a big factor on the Chinese memory ramp. It's more related to just the challenges of getting those factories into mass production. So I think they continue to work on it. They're making progress. If anything, the current pricing climate in memory is forcing them to shrink a little bit faster to stay competitive and add more layers on the 3D NAND side. So we're seeing a little more aggressive pursuit of the technology among these Chinese memory foundries. But generally, I think it's just proven to be more challenging than many anticipated to get those fabs really in mass production. So we're seeing, I would say, kind of slow, steady engagement with that community. And we do expect eventually the yield situation to rectify itself and to see the production ramp.
But it's kind of independent of any macro problems or headwinds.
Great. That's helpful. And maybe for either Peter or John, in terms of the CapEx spend, given the expectations of a strong display ramp, and that's an area where I believe you've got a lot of opportunity, how flexible are you in terms of your CapEx spend where if China IC remains sluggish because of their challenges internally, how flexible are your CapEx in terms of could you shift some of that over to display given the promising outlook you have in that segment?
Yeah, Patrick, as you know, because you've been around the company a long time, one of the things that has enabled us historically, I think they compete as a small company in an industry of large players is we're very flexible, and we do our very best to move to focus our investments where the opportunities lie. I think it would be overly pessimistic right now to think that we would pull back on our IC investment in China. We see some on the logic side, some potential partners moving pretty aggressively, and we want to be there to support them to ensure that with the exception of SMIC, the China IC market remains merchant. That's also one of the reasons why we partnered with DNP.
We walk into all the Chinese customers, particularly the foundry logic guys, and we tell them, "Look, together Photronics and DNP are a billion-dollar mask company. You're trying to compete with TSMC. So why don't you let us handle the photomask challenge, and you can focus on the silicon because you've got a big enough job in front of you with that alone already." So as I said, right now, FPD is sold out. We're going to bring capacity online into a sold-out business, ideal. Our IC business is not sold out. So we're trying to adjust our timing to be beyond the downturn so that when the capacity comes online, it's coming online into a very strong market. So that is the only message we're trying to send and nothing more. Now, going back to FPD, your comment about the opportunity, yeah, it's big.
I expect, although not sure, that by the end of the year, the capacity we've installed in Hefei will be sold out. That means if we want to maximize our revenue growth, additional capacity will be needed. The good news is Hefei is now sitting at the point where the rest of our business sits, and that is we don't have to add a whole line. We don't have to add a coder, an etcher, a metrology tool. All we need to do is add litho and/or inspection. The capital efficiency of incremental CapEx goes up as far as revenue generation is concerned. Yeah, we're actively right now evaluating what we need to do to maximize our growth, but also our financial returns at the same time. We have a really strong position in AMOLED. We want to build on it, exploit it.
We do have incremental capacity coming online. Should address G10.5 and also our AMOLED market position, so we're feeling pretty good about what we've done, the timing of what we've done, and maximizing our growth quarter by quarter by quarter- by- quarter as we go.
Great. That's helpful, and maybe as a final question for me in terms of for John, in terms of OpEx management, given the ramp of the two China facilities as the year progresses, how do you look at your OpEx trends and how much that could go up as 2019 progresses? Thank you.
From first quarter, Patrick, we're probably not going to be increasing a lot. We've got a pretty good head start on the resources that we need to put into both China plants, so it will be increasing somewhat, but I think we're at a pretty good run rate where we are.
Great.
Thank you. Thank you. And I'm showing no further questions in the queue at this time. I'd like to turn the call back over to Peter Kirlin for any closing remarks.
So in closing, I thank e ach of you for your time and interest in Photronics. We're in a great position to continue growing this year as we begin production on our new China facilities. I look forward to updating you on our progress.
Ladies and gentlemen, this concludes the conference call for today. We thank you for your participation and ask that you please.